The Santa Rosa office market has continued to hold steady, after strengthening throughout 2017 and 2018.
Tenant demand in the office sector has slowed slightly, but we currently don’t see signs of companies retrenching. Vacancies are down slightly, and rental rates have held on lower-quality properties and increased slightly on the highest-quality buildings, as available inventory is lacking.
We believe the reasoning for the flattening is related to the labor market. Most transactions in the marketplace have been lateral moves without much growth in square footage. The unemployment rate in Sonoma County was 2.6 percent in December 2018, and we hear that companies are struggling to find employees they need to grow their businesses.
The vacancy rate for Santa Rosa office space stood at 10.9 percent at year-end, down from 11.7 percent at the end of the fourth quarter of 2017. This decrease represents approximately 60,000 square feet of positive absorption. Based on current tour activity, we anticipate first-quarter vacancies to remain relatively flat, with a similar vacancy reduction of about 0.5–1.0 percentage points by the end of 2019.
We are currently seeing class A office properties in the best locations commanding rents above $2.25–$2.50 per square foot monthly, fully serviced. The lack in inventory of these buildings provides the owners the ability to hold firm on their pricing and offer less in terms of lease incentives.
Office rents in older-generation properties are $1.70–$1.95, as property owners find themselves on much stronger footing than in previous years.
It should be noted that many of these older properties need updating and don’t meet the quality expectations of tenants. That is leading to some tenants circling the market waiting for the right opportunity, especially in the smaller segment of the market, 500–1,500 square feet.
Tenant inducements such as free rent can still be negotiated, albeit on much lower levels than over the past few years. The free rent is being used by landlords to help bridge the gap between expectations and provide lower “effective rents” to tenants, while keeping the higher lease contract rates. While in the past, up to six plus months of free rent could be negotiated, we are seeing free rent being reduced to one or possibly two months at the maximum.
In addition, turnkey tenant improvement packages are still prevalent in office lease transactions, as many landlords can obtain better contractor pricing than tenants, based on relationships. However, we are witnessing tremendous upward pressure on subcontractor pricing resulting from the lack of labor attributed to the reconstruction of residential properties impacted by the 2017 fires.
These increases are likely to have an impact on rental rates in the near future as well as require tenants to fund some of the improvement costs. This is especially true on shorter-term leases that do not provide a long enough amortization period of the costs over the lease term.
The purchase market for owner-user office buildings has slowed slightly, resulting more from a lack of supply than that of lower buyer demand, which remains strong. Interest rates have risen slightly over the past 12 months but continue to be at levels that encourage companies to own their real estate.
This low cost of funds continues to provide companies the ability to purchase and secure long-term financing that often results in a lower cost to own a building than leasing it on a monthly cash basis, even more so when the tax advantages of ownership (depreciation) are considered. The lack of supply and continued demand often leads to vacant properties being valued higher on a per square foot basis than leased properties at current capitalization rates of roughly 6.0–7.0 percent.
North Bay commercial real estate market reports
Read more insights from experts in various product types and areas in Sonoma, Solano, Marin and Napa counties: nbbj.news/crereports19