At mid-year 2006, Washington, DC remained the place to be, with a 6.3% vacancy rate; one of the lowest in the nation. Despite a supply increase of 1.5 million square feet, vacancy inched down 20 basis points since the end of the first quarter. Year-to-date net absorption totaled 1.3 million square feet, and based on early third quarter leasing activity, we expect continuous demand in the second half of the year.

The burst of leasing activity, especially from the Federal Government, is keeping overall rental rates at an all-time high, averaging $41.50 per square foot full service with Class A rents averaging $46.50 per square foot. Rental rates in Trophy Class buildings also continue to swell, averaging $57.00 per square foot full service. As we saw at year-end 2005, professional service and law firms looking to expand and relocate are driving the Trophy and Class A markets, as are not-for-profits in the Class B market.

Of the 6.5 million square feet of tenant demand tracked by West, Lane & Schlager in the second quarter, nearly 30% stemmed from the requirements of legal and professional service firms. We do not expect the demand to subside any time in the immediate future because many firms with large (80,000 SF + blocks) requirements and lease expiration dates of 2008 and beyond are already in the market searching for new and/or expansion space.

Absorption
Accounting for 32% of the metropolitan region's office market, Washington, DC's office market comprises 1,430 buildings totaling 124.7 million square feet. It has averaged 2.3 million square feet of net absorption per year for the past 10 years, while its vacancy rate has averaged 7.5% for the same time period. Demand for office space is typically fueled by law firms, the government, and service sectors, which still dominate leasing activity.

At the end of the first half of the year, the Central Business District led the submarket absorption race, accounting for 42% of DC's overall net absorption. However, the Southwest submarket was a close second, accounting for 39% overall of positive net absorption. The eruption of Southwest's leasing activity in the second quarter was an anomaly sparked by FEMA, the Department of Health & Human Services, Office of the Comptroller of the Currency and the Surface Transportation Board collectively absorbing 230,000 square feet at 395 E Street, SW. In the second half of the year, we anticipate the East End to edge out Southwest and regain its first or second place position. This will be due to sustained activity in the legal sector which has historically been drawn to DC's core submarkets.

Demand
While large lease tenants are driving demand in new developments and Class A buildings, many smaller deals are still being executed, especially within the 43 million Square foot B Class market. Typical users include not-for-profit organizations and small professional service firms with requirements ranging from 5,000 to 25,000 square feet. Because activity in this market has remained constant, many of the remaining available options are in the B to B- market, rather than B+. Despite a marked difference in the quality of available B Class space, vigorous activity has bolstered rental rates to the high $30s to low $40s.

Additionally, there are still a number of large requirements in the market stemming from both law firms and the government. Despite a stall in leasing activity at the end of 2005, the government will continue to pick up throughout the remainder of the year and into 2007, absorbing some of the large blocks of space on the market in addition to space in buildings currently under construction and renovation. However, we expect that much of this activity will occur in emerging submarkets such as Southwest and NoMa.

Although government leasing activity will remain strong, activity from law firms is what will continue to drive DC's market. The legal sector is predominantly focused on new developments, as they offer large blocks of high-quality space. Of the 1.5 million square feet that have delivered thus far in 2006, nearly 40% of it has been preleased by law firms. However, due to a lack of infrastructure and amenity base in development-rich submarkets such as Southwest, law firms will continue to focus on more established neighborhoods such as the East End.

New Deliveries/Development
Six buildings have delivered thus far in 2006, totaling just over 1.5 million square feet. These buildings include 1601 K Street, NW and 1875 Pennsylvania Avenue, NW in the Central Business District; 950 F Street, NW and 1121 14th Street, NW in the East End; 25 Massachusetts Avenue, NW in Capitol Hill; and 600 Maryland Avenue, SW in Southwest. Cumulatively, these properties were 67% leased upon delivery, including Wilmer Hale's build-to-suit headquarters at 1875 Pennsylvania Avenue, NW.

In addition to the 1.5 million square feet of newly-delivered space, the remainder of the development pipeline comprises 24 buildings totaling 6.9 million square feet. Delivery dates extend into 2008. Approximately 42% of this space has already been leased, signaling continued healthy demand.

The continuation of speculative construction indicates that developers hold bullish views for the future of Washington's office market. Similarly to what we saw last year, the total amount of space currently under construction represents an overall 5.5% increase in supply, the largest in over a decade. Before last year it seemed that such a large increase in supply would disrupt vacancy levels and decrease rental rates, however with few alternative options fueling a high demand for large blocks of Class A space levels, we are seeing this space absorbed into the market without disrupting current conditions.

Rental Rates
Despite the slight uptick in vacancy, rental rates - especially for Class A space - continued their ascent during the first half of 2006 due to steady demand and the limited availability of large blocks of space. Rental rates for Class A and B space ranged from $45.00 to $60.00 per square foot full service and $35.00 to $45.00 per square foot full service, respectively.

Depending on lease terms and building quality, typical tenant improvement packages varied from $25 to approximately $60 per square foot in new buildings. Average annual rental rate escalations ranged from 2% to 3%. Ten-year leases also included rental rate "bumps" in the sixth lease year of $1.00 to $3.00 per square foot. Rental rates should remain strong at this level for the remainder of 2006, despite an influx of 1.1 million vacant square feet delivering to the market by the end of the year.

Outlook
Continued economic invigoration will enable strong leasing activity to continue in the second half of 2006 and beyond. Smaller groups will still find opportunities throughout the A and B markets, including absorbing sublease space. Larger tenants, such as law firms, will continue to look primarily toward new construction for relocation and expansion opportunities.

While 2005 saw a shortage of large blocks of Trophy and Class A space, the delivery of 2.1 million square feet in seven renovated and speculative buildings scheduled for the second half of 2006 will increase the supply. Despite the influx of new inventory, it is unlikely that we will see a significant increase in vacancy rates due to continued high demand.

Courtesy of CB Richard Ellis

Northern Virginia continues to be a market in demand. While the vacancy rate climbed slightly to 8.4%, over 1.1 million square feet was absorbed and 1.6 million square feet delivered around the region. Crystal City had the strongest quarter as 629,159 square feet was delivered and 481,663 square feet was absorbed.

During the second quarter, Inova Health System revealed plans for two new locations. The first location in Lorton will be a 107,000 square foot health center to open in 2008. The Lorton area is experiencing a renewed boom, resulting from the redevelopment of the old prison site. The second location will be a new research center in Leesburg that has the potential to be as large as 700,000 square feet. This continues the growth and interest by the medical research industry in Loudoun County, following the first quarter move-in by the Howard Hughes Institute last quarter.

In June 2006, the long-awaited first new span of the new Woodrow Wilson Bridge opened to outer loop traffic. Inner loop traffic was shifted to the new bridge in July 2006. The old drawbridge will be torn down and the second new span built in its place. The new inner loop bridge is expected to be completed in the fall of 2008.

The Wilson Bridge will replace an old, decaying structure that was seeing higher-than-expected daily traffic flow. The new bridges will be able to adequately support the high number of cars that cross the Potomac River each day. In addition, the new bridges will be 20 feet higher, resulting in fewer openings of the drawbridge to accommodate the boats that travel beneath it. The new bridges will also be six lanes in each direction, with four general purpose lanes. This matches the number of lanes on the Capital Beltway and will reduce the current bottlenecks as traffic reduces from four lanes to three to cross the bridge.

Another major transportation project in the region is the Metrorail extension to Loudoun County. When completed, the new line will be 23.1 miles and contain 11 stops. Construction of the project is slated for completion in two phases. Phase I includes construction of five new stations, breaking off from the existing Orange Line and extend through Tysons Corner to Wiehle Avenue, beginning in 2007 and ending in 2011. Phase II will extend the rail line along the Dulles Toll Road and terminate in Eastern Loudoun County at Ryan Road. Phase II will include six stations and complete in 2015.

The most unsettled issue with the project is the debate surrounding tunneling through Tysons. In May a panel of engineers was enlisted to evaluate the possibility of constructing the entire stretch through Tysons underground. However, the costs associated with underground construction could lead the Federal Government to withdraw the funding they are supplying for Phase I. Without the tunnel, cost estimates for Phase I are approximately $2 billion. Preliminary estimates for tunnel construction alone would add $200 to $600 million. The evaluation panel will give their recommendations to Virginia Transportation Secretary Pierce Homer in July.

Courtesy of CB Richard Ellis

The Suburban Maryland office market displayed strong activity during the second quarter 2006, indicated by a vacancy rate of 8.8%, improved even from 2005's five-year record breaking low of 9.3%. Market conditions further tightened in the Bethesda/Chevy Chase submarket. Net absorption for the quarter hit negative 276,116 square feet on the 77 million square foot market.

The largest lease was signed by the GSA at 11700 Beltsville Drive for 64,316 square feet, followed by Supernus Pharmaceuticals at 1550 East Gude Drive leasing 44,500 square feet. First quarter non-renewal lease transactions were dominated by an increase of mid to small-size users market wide, ranging in size from 5,000 to 25,000 square feet including Harris Corporation's 25,000 square feet leased at 1301 McCormick Drive in the Largo submarket area, and 16,877 square feet to house the medical offices of Dr. Horton at 15810 Gaither Road in the Gaithersburg submarket area.

The Suburban Maryland asking lease rate dropped slightly to $25.30 at the end of the second quarter. This is in contrast to last quarter's average rates for full service leases rising from $24.57 at year-end 2005 and reaching $25.99 during the first quarter of 2006.

The office vacancy rate significantly improved from first quarter 2005, improving from 10.4% to 8.8% this quarter. Distinctively, Montgomery County improved by 2.7% to an overall vacancy rate of 7.5%, while Prince George's County increased 1.4% from last year's second quarter rate of 10.2% to an overall rate this quarter of 12.3%.

With a stabilized vacancy rate, the second quarter of 2006 brought to the market two newly developed properties contributing 225,313 square feet, with 7% preleased. New development in Suburban Maryland has steadied with nearly 516,371 square feet poised for delivery by year-end 2006. The largest building to deliver in 2006 encompasses 202,147 square feet at 5425 Wisconsin Avenue in the Bethesda/Chevy Chase submarket with 100% preleased to the Mills Corporation.

Another 1,741,597 square feet is in the pipeline for year end 2007. The largest of these developments is the Watkins Mill Road Project, a three building complex totaling approximately 750,000 square feet. The largest building, at 350,000 square feet, is set to deliver July 2007.