Overview
Two thousand and six was another year of surprising strength for the Washington, DC region. With a benevolent local economy, the commercial leasing market remained one of the most vibrant in the nation. By year-end, the office market reported an overall vacancy rate below market equilibrium (10%), and rental rates were at all-time highs. Likewise, soaring demand for industrial and retail properties continued to fuel higher occupancies and rental rates for these sectors across the region. The for-sale housing market moved out of the limelight, after a phenomenal run for the past nine years, and the area's job market was healthy. Consequently, the apartment sector continued to be energized by a swelling number of renters so that occupancies continued to escalate, boosting rental rates. All told, the market saw another round of buying frenzy for all types of commercial real estate.

Just when it seemed that 2005 was the best year since 2001, the District of Columbia's office market topped itself yet again, ending 2006 with an even sturdier set of fundamentals. All submarkets experienced single-digit vacancies so that the overall vacancy rate of 7.3% is near its five-year low of 7.0%. Another sign of strength is ever increasing rental rates for all building classes, which set a new record every quarter in 2006. By year-end, the average asking rent was up $1.50 per square foot (psf) from 2005 to $43.83 psf. The strongest gain was for class B and C properties, with average rents jumping in every submarket by over 10% to $43.19 psf and 2% to $37.10 psf, respectively, from the previous year. As a result, some tenants in lower-grade properties locked in new leases ahead of schedule to avoid future increases. One such example is law firm Sughrue, Mion PLLC which opted to renew its 95,399-square foot (sf) lease at 2100 Pennsylvania Avenue through 2016. The Urban Institute, a non-profit organization, also decided to remain at its current office in 2100 M Street through 2010 after initially exploring other available options. Meanwhile, the average asking rent for class A properties stabilized at $47.63 psf - just shy of the all-time high of $47.88 psf. Rents for new premium space were even driving upward of the mid-$60s psf in the East End and low to mid-$50s elsewhere.

The strong performance of this market continues to benefit from a healthy tenant demand, anchored by a job growth that remains enviable. Tenant demand is coming from traditional bulwarks - the government, law firms, and non-profit groups - which have also been responsible for the surge in large transactions. In 2006, three government agencies signed leases close to half a million square feet each - the District government (500,000 sf), Department of Justice (465,513 sf), and U.S. Immigration and Customs Enforcement Agency (403,897 sf). As a result, leases over 50,000 sf totaled 3.0 million square feet (msf) compared to 1.6 msf in 2005. There also seemed to be a strong appetite for high-end new spaces, with private-sector tenants pre-leasing close to 500,000 sf in 2006 and paying top rents for them. In the fourth quarter of 2006, the law firm Cooley Godward signed a lease for 54,000 sf at 777 6th Street with gross rent in the mid-$50s. That followed notable leases signed in comparable class A buildings by law firm Jenner & Block and global consulting firm FTI Consulting, Inc., with rents in the mid to upper $60s.

Furthermore, the District continues to benefit from a steady growth of private sector tenants. In the second quarter of the year, law firm Jones Day renewed and expanded its lease, which jump-started the construction of 260,000 sf class A building at 300 New Jersey Avenue in Capitol Hill. The plan is to connect the new building to its existing offices at 51 Louisiana Avenue. Another example is the 67,163-sf lease (up from 40,000 sf) of Biotechnology Industry Organization at 1201 Maryland Avenue in Southwest. The company's decision to relocate its headquarters was to accommodate the growing workforce of this trade firm.

Much of the attention continues to focus on the robust office development that has dominated the District's landscape since 2000. Last year saw a record level of completions in the District, yet absorption remained so strong that only 1.4 msf were available out of the 4.3 msf of new space that delivered during the year. The most noteworthy completion was that of the 1.4-msf headquarters of the Department of Transportation in the fourth quarter. While the development pipeline shrunk to 3.7 msf by year-end 2006, developers remain confident and are ready to invest in an additional 3.7 msf of new projects in the next two years.

After experiencing three consecutive years of exceptional growth in market fundamentals, the Northern Virginia office market stabilized in 2006. The overall vacancy rate hovered close to market equilibrium (10.0%) throughout the year. As expected, the close-in markets reported the lowest vacancies - 7.5% for the City of Alexandria and 10.1% for Arlington County. Due to the addition of over 430,000 sf of new vacant space to these markets during the year, those vacancy rates represent an increase of 1.0 and 2.0 percentage points, respectively, from 2005. Meanwhile, markets outside the Beltway continued to improve. Compared to 2005, vacancies slid by 0.2 percentage points to 11.4% in Fairfax County and 4.5 percentage points to 27.0% in Loudoun County. As overall vacancies remained tight, rental rates continued to strengthen across all submarkets. The average class A rental rate hit an all-time high of $32.84 psf, with new projects commanding up to mid-$40s. Rents for class B and C space also racked up advances of $1.00 psf to $28.01 psf and $0.50 psf to $24.72 psf, respectively.

However, signs of a slowdown are evident in 2006 activity. Tenant demand eased off its torrid pace. The volume of new leases has steadily declined after peaking at 12.6 msf in 2004 to 8.8 msf in 2005 and 7.6 msf in 2006. In addition, large transactions have continuously dwindled; only 1.6 msf of new leases over 50,000 sf were executed in 2006 compared to 3.6 msf in 2005 and 6.7 msf in 2004. As a result, overall absorption has slipped from its highs of 6.8 msf in 2004 to 4.9 msf in 2005 and posted 1.2 msf in 2006.

This moderation is in line with the area's employment trends, which slowed over the course of 2005 and more substantially in 2006. Part of the slowdown was due to slower growth in defense spending. This has resulted in a weaker expansion of employment in professional and business services, both sectors of which have been among the main drivers of growth in the past three years. As a result of slower demand, some large blocks of space being returned have yet to be backfilled. Examples include spaces vacated by the Environmental Protection Agency at 1901 South Bell in Crystal City and global engineering and manufacturing company ITT at 1761 Business Center Drive in Reston. Even so, demand remains healthy enough to help counter any drag from the proliferation of new office projects. Approximately 2.5 msf came online in 2006, and yet, nearly half was already absorbed upon delivery.

Tenant demand was fueled by the usual suspects: the federal government and its contracting agencies. Both have leased large blocks of space close to half a million square feet each in 2006, and have shown a real preference for top-grade space. Notably, contractors have been snapping up brand-new buildings in the Route 28 South and Reston/Herndon markets, while government agencies involved in the fight against terrorism have been leasing class B properties that are being redeveloped into larger, state-of-the-art facilities. Among the most notable leases involved the FBI, CIA, DFI International, Northrop Grumman, and APPTIS, each of which leased over 100,000 sf in 2006.

The Suburban Maryland office market ended 2006 with another solid and stable performance. Overall vacancy remained tight at 10.0% throughout the year, with some markets in Montgomery County already having begun to feel the strain. In Bethesda/Chevy Chase and Silver Spring where vacancies are the lowest, there were no available large blocks of space over 100,000 square feet (sf) at the end of the year. However, large blocks of new space are expected to come online in both these submarkets in the next two years. The overall vacancy rate in nearby Prince George's County ended 2006 at 14.7%, slightly higher than 2005 levels. Despite the increase in vacancy rates, stable occupancy sparked higher rental rates, which at the close of the year were at three-year highs. The average asking rental rate rose by $1.00 per square foot (psf) to $27.87 psf in Montgomery County and $22.37 psf in Prince George's County. Rents for lower-grade space grew most rapidly from 2005 to 2006, rising over 7.0% to $27.16 psf in Montgomery County for class B and $21.76 psf in Prince George's County. Class C space rent grew 8% to $22.80 psf and 28% to $16.32 psf from 2005 for both counties, respectively. Class A rents remained close to their all-time highs at $28.22 psf with trophy rents in the high $30s to low-$40s.

Steady improvement in tenant demand was the main pillar supporting this strength. The volume of new leases rose to 3.4 msf in 2006, while overall absorption was 519,759 sf. Such resurgence in demand is indicative of healthy job creation in the office-using sectors, which added nearly 7,000 net new jobs in 2006. It is not a surprise then that the unemployment rate of 2.9% was, once again, one of the lowest in the nation. Moreover, the area continued to benefit from an expansion in a broad swath of industries. This is evident in a number of leases that were signed throughout the year. The U.S. Nuclear Regulatory Commission, which is headquartered at One and Two White Flint North, leased over 66,000 sf at 6003 Executive Boulevard in Rockville to house its growing workforce. Another notable example was financial services firm American Capital Strategies that leased 38,170 sf at Bethesda Place II in the first quarter due to an expanding workforce.

Another factor that helped buttress the area's strong office market is construction activity, which has been tame since 2003. In 2006, only five projects totaling 679,888 sf were completed, with 335,820 sf available upon delivery, including 5425 Wisconsin in Chevy Chase - which had over 90,000 sf for sublease upon delivery in the second quarter - close to being fully leased by year's end.