Totah: “The large majority of San Diego investors would appreciate a normalized market—specifically, less rental-growth speculation and more appropriate yields.”

SAN DIEGO—The main reason buyers are venturing outside their backyard to invest is yield, since investors are accustomed to a certain pricing level and yield expectations, Marcus & Millichap’s Nick Totah tells Totah is associate director of the Totah Group, a national office and industrial-properties group with M&M, and he says markets like Arizona, Texas and Colorado can offer the yield investors here are seeking.

In addition, Totah says he has been selling a large majority of the private-level-investor office deals in San Diego to outside investors from Northern California. “I often have conversations with local owners since the market and cap rates appear too frothy, in their opinions; however, investors in Northern California tend to find our market and returns relatively healthy in comparison.” He notes that many San Diego investors/owners are entertaining the idea of exiting the San Diego market and moving toward Arizona, Texas and Colorado.

We spoke with Totah about this trend, the reasons behind it and the appeal of other markets. What are investors’ reasons for looking outside of their backyard to invest?

Totah: The main reason is yield. Investors are accustomed to a certain pricing level and yield expectations. Being that San Diego has had a very bullish market, this has caused significant cap-rate compression, and demand has increased significantly. Specific to the office product type, we have seen returns compress anywhere from 75 to 150 basis points. What would entice them to stay in their current market and what would entice them to leave?

Totah: The large majority of San Diego investors would appreciate a normalized market—specifically, less rental-growth speculation and more appropriate yields. Additionally, the levels of available inventory are historically low. This can make the decision to sell increasingly difficult since it would be difficult to replace your current asset. If you own a property in one of the best cities like San Diego, it will take many levels of encouragement to entertain a sale and purchase elsewhere.

The inverse also rings true for many. As a local investor, if given the opportunity to take advantage of my equity in a compressed-cap-rate environment and increase my cashflow in another state, this is something to consider. In addition to its equity position, California is one of the most difficult states in which to conduct business. Taxes and regulations are challenging values of office product—for example, Title 24 (energy-efficiency code), storm-water recapture, amongst many others. What are the pros and cons of San Diego office investment? 

Totah: San Diego is a well-diversified economy with multiple geographic constraints. The market is supported by many well-respected research universities and institutes, and its life-science industry is a major contributor to our economic growth. The San Diego office market can offer the housing and quality of list which Millennials are demanding in the workplace.

The cons of the San Diego office are in consideration of the cost of living, lack of public transportation and overall smaller startup and tech footprint. Although office rents have made positive gains, and overall vacancy levels are down to around 11%, we are experiencing a lack of new development. If you look around our city, you will notice most of the development is specific to multifamily rentals and condos. Fundamentally this makes sense, considering the cost to build and operate. Multifamily has proven to have less inherit risk, lower interest rates, much lower re-tenanting cost and ownership cost, and investors are achieving a premium in rents. What is the appeal of markets like Arizona, Texas and Colorado for investors?

Totah: The major appeal is yield and no state income tax in some scenarios. In addition, many of these states are offering business and investors state incentives, making the decision a bit more attractive. I don’t believe we would see the same level of capital migration without the current historic financing and cap-rate compression. San Diego is one of the best and most undervalued markets in the country; it has all the right components for a wonderful investment opportunity. However, much of the growth has happened rather quickly and is causing many investors to start thinking differently.