After nearly four years of substantial growth within the regional economy and office market, the region started to display signs of a slow down during the first quarter of 2007. While rents continued to increase throughout the region, vacancy trended upward with the continued inflow of new deliveries to the market at below-average preleasing levels and the start of a new round of subleases.

Helping accelerate the slowdown, local employment additions throughout the region continued, but at a slower pace than experienced in 2005 and 2006. The region created 48,100 jobs in the twelve months ending in February, down from highs of 65,000 - 80,000 throughout 2005 and 2006.

The market remained tight compared to other metropolitan regions, but an increase in the amount of development activity and slow down in demand have caused vacancy hikes over the past two quarters. In the first quarter, one million square feet of space were added to the market with just one-third of that space leased at delivery, down from historical norms in the 50% to 65% range, depending on the jurisdiction. Additionally, the market absorbed 466,547 square feet, the lowest quarterly total since the 3rd quarter 2003. Further vacancy jumps are likely as an additional 9.9 million square feet of inventory are scheduled to roll into the market throughout the remainder of 2007 with more than 5.9 million square feet of that total not yet leased.

Sublease space has returned. In the past quarter, numerous large subleases have been placed on the market throughout the region. Defense contractors, law firms, consulting outfits and high-tech companies have all recently placed space on the market as they are preparing for a slowdown in the national and regional markets. Over the next 9-18 months, we expect this trend to continue. As a result of the uptick in development activity combined with the reemergence of sublease space, direct vacancy climbed from 8.0% to 8.2%, while total vacancy, which includes sublease space, increased to 9.6%. We expect vacancy to increase gradually throughout the remainder of 2007 and into 2008 due to the new space coming on to the market.

So rental rates have gone down due to the slower pace of the market? No, the market continues to register asking rent increases. One reason is the steady demand that has tightened the market. The other reason: portfolio sales. CarrAmerica and Equity Office portfolios have registered significant rental rate hikes over the past nine months. Carr's former portfolio, now owned by Tishman Speyer through Blackstone, has displayed rental hikes of 17% in Northern Virginia and 23% in the District. Equity's DC region portfolio, purchased by Blackstone and subsequently flipped and under contract to Beacon Capital Partners, has increased rents 6% in Northern Virginia and 11% in the District to date. While these increases appear significant, the majority of the above-mentioned building rents were well-below market and number of buildings display significantly higher rents due to upcoming renovations to the existing buildings. However, while asking rents have shot up due to the increase in rents at these buildings and demand, effective rents have remained fairly stable year over year especially among larger leases, as the amount of concessions, in the form of free rent and increased tenant improvement allowances, have increased.

Similar to the Northern Virginia market, the District's market has also separated into two markets: private sector markets versus local and federal government markets. Since federal leasing activity has been almost non-existent in terms of net new growth over the past two years, NoMa and Southwest, which largely target federal tenants, have experienced increases in vacancy and minimal rental rate growth. While these markets account for just 16% of the total space in the market, they represent more than 30% of the vacant space in the market.

Washington, DC Total Absorption (SF) vs. Total Vacancy (%)

In contrast, the CBD and East End, combined with the other smaller submarkets that make up the DC office market, have experienced significant growth in private sector demand and thus vacancy at the end of the first quarter stood at 5.1%, while rental rates across markets have increased from 7% to 14% throughout the various markets.

With federal demand likely to remain slow through 2008, we expect market fundamentals in NoMa and Southwest to increasingly favor tenants, while conditions in Core downtown (CBD & East End) will continue to remain tight with high levels of preleasing and rental rates growths benefiting the landlord.

Northern VA Total Absorption (SF) vs. Total Vacancy (%)

At the end of the first quarter, 4.6 million square feet were under construction in Reston/Herndon and Route 28 South with 19% of the space preleased. With more than 3.7 million square feet of space still available, these markets will continue to experience increases in vacancy with downward pressure on rents likely over the next twelve months. Should either the regional and/or national economies slow further in 2007 and into 2008 and cause further increases in sublease space, landlords in these markets will face increased challenges to fill new space and / or backfill existing space left by tenants moving to new developments and / or downsizing.

Northern Virginia's Inside the Beltway markets, which include Alexandria and Arlington County, in addition to other markets like Tysons Corner, Merrifield and Fairfax Center, continue to experience tightening conditions as demand remains strong and development activity remains guarded. The remaining markets in Northern Virginia, minus Reston/Herndon/Rt. 28 South, have a combined 2.3 million square feet under construction, with 50% preleased. We expect rental rates in these markets to grow at or above the 5% to 12% range over the next twelve months as vacancy levels are expected to decrease or remain relatively stable in all of these markets through 2008.

While vacancy decreased during the first quarter, we expect vacancy levels to increase next quarter due to the delivery of eight buildings to the market with minimal preleasing to date. These buildings will deliver in Frederick and Prince George's County, as well as to the submarkets of Bethesda-Rock Spring, I-270 Gaithersburg and Rockville and Rockville Pike and will have no ill impact on rental rates in any of these markets. Historically, the Suburban Maryland market has lower levels of preleasing than that of the District and Northern Virginia so the likelihood that the vast majority of the space that delivers in the 2nd quarter is fully leased within the next 12-18 months is not unlikely.

While Class B rents remained at $24.89 per square foot at the end of the first quarter, Class A rental rates throughout the market jumped 4.7% during the quarter to close at $27.60 per square foot. Class A rents will continue to soar higher as vacancy in the entire 27.5 million square foot market registered 6.9% at the end of the first quarter, nearly half that of the Class B market.

Suburban MD Total Absorption (SF) vs. Total Vacancy (%)