Quarterly: Winter 2004 - GWCAR - Greater Washington Commercial Association of REALTORS

CBQ >> Winter 2004 Issue

Government Keeps Regional Market Afloat

by David J. Masters, Director of Research, Senior Financial Analyst, Advantis Real Estate Services Co.

Metropolitan Area Summary

The Washington, DC metropolitan area is one of the few office markets in the United States that generated jobs as well as positive net absorption during the national "jobless recovery" of 2003. The resilience of the region's economy is reflected by 36,200 net new jobs generated in 2003. The region has been buffered from the recent national economic downturn by the continued growth and stability of the federal government. Federal spending estimated at $93.6 billion for fiscal year 2003 represents one-third of the region's $274.4 billion economy. The large increase in procurement spending for homeland security and the war on terrorism during 2003 benefited the region economically and spurred demand for office space from government contractors and agencies.

Year-end 2003 office market statistics indicate the region has reached the bottom of this real estate cycle, which started downward during the first quarter 2001. Office demand generators such as government contractors and law firms signed large lease commitments or restructured/ renewed existing leases during 2003. Lease activity greatly increased by year-end with tenants motivated to lock in low rental rates well ahead of lease expiration. Nearly 4,400 leases representing 31 million sf of office space were signed in 2003 in the region. Tenants occupied 7.3 million more square feet of office space at year-end 2003 than they occupied at year-end 2002, while office deliveries totaled 5 million square feet.

The region contained 37.4 million square feet of available vacant space at year-end 2003, a 12.7% overall vacancy rate that includes 29.9 million square feet of direct space and 7.5 million square feet of sublet space.

Tenants that "over-leased" office space during the frenzied market of 1999-2000, have since given back unoccupied space by subleasing or returning it directly to building owners. Sublease space decreased by nearly 3 million square feet during 2003 through aggressive leasing activity and space given back to building owners.

Sublease space continues to negatively impact rental rates in many submarkets. To compete with sublet space, building owners have decreased rental rates and increased tenant concessions such as free rent and improvement allowances.

The outlook for the Washington, DC metropolitan area office market remains positive. Local economists have forecast increased job growth, with 160,000 net new jobs from 2004 through 2006.

Historically, 55% of new jobs require office space in the region, with an average of 250 square feet per employee. Should forecast employment growth come to fruition, 22 million square feet of net absorption would be generated over the next three years. Effective rental rates will continue to stabilize and remain flat for most submarkets through year-end 2004. Office deliveries planned for 2004 total 6.5 million sf, which are 57% pre-leased. Tenants continue to have the upper hand in lease negotiations with landlords in most submarkets. The landlord's mantra, "stay alive to 2005," still reverberates through a number of distressed suburban submarkets.

DISTRICT OF COLUMBIA

The nation's capital remains the most stabilized downtown market in the country with a 7.5% overall vacancy rate, which includes 5.85 million SF of direct space and 1.55 million SF of sublet space. Lease activity remained healthy through 2003 with approximately 1,150 deals signed totaling 8.4 million SF, and nearly 2.35 million SF of net absorption. Seven buildings totaling 2.39 million SF delivered 52.9% pre-leased (1.26 million SF). Deliveries accounted for more than half of the net absorption that occurred in 2003.

Primary office demand generators include federal government agencies, law firms and professional service firms as reflected by the accompanying list of office leases. The largest leases executed in 2003 were by law firms that included pre-lease commitments or renewal/restructures well-ahead of lease expirations to take advantage of current rental rates. Large tenants are motivated to lock up space ahead of their lease expirations due to the limited number of quality large blocks in the pipeline. Prospective future demand is anticipated by the notable number tenants in the market with space requirements over 50,000 SF in the next 24 months.

Developers have been attracted to the District of Columbia due to the stability provided as the home of the federal government, barriers to entry for new development from the lack of available sites and size limitations due to the building height restriction. Reflecting confidence of the DC office market, developers broke ground on seven office buildings in 2003, including two buildings totaling 800,000 SF in the Southwest submarket on a speculative basis (One Patriot Plaza- 280,000 SF, Potomac Center North- 520,000 SF). Sixteen office buildings totaling 4.75 million SF were under construction at year-end 2003, which are 40% pre-leased. Ten buildings totaling 2.93 million SF are scheduled for delivery in 2004, which are 44% pre-leased. Five buildings totaling 1.32 million SF are scheduled for delivery in 2005. The amount of available vacant space in the pipeline totals 2.9 million SF.

Due to the amount of available vacant space in the pipeline for 2004 delivery, vacancy rates are likely to increase in the short term. In addition, many of the buildings under construction were started with pre-lease commitments from large tenants currently occupying space in the market, which will require backfilling.

The federal government (GSA) continues to generate demand for office space for agencies and contractors. GSA leased/renewed more than 1.3 million SF during 2003 within the District. GSA leases about 14.5 million SF of office space in the District, and has potential future space requirements up to 2 million SF.

The outlook for the District of Columbia's office market remains positive, with continued tenant demand and stabilizing rental rates. Vacancy rates will likely increase in 2004 with the amount of vacant space added from new deliveries. Tenants requiring contiguous blocks under 25,000 SF will continue to find many options. Larger tenants with space requirements over 100,000 SF beyond 2005 will find limited options. In 2004, developers will likely option sites for future development opportunities along the periphery of the urban core- east of the new convention center, near the future Southeast Federal Center and within the Anacostia Waterfront Initiative area.

SUBURBAN MARYLAND

Suburban Maryland reflected weakening market fundamentals in 2003. The overall vacancy rate at year-end 2003 was 13.8% that included 7.3 million SF of direct space and 1.7 million SF of sublet space. The "inside-the-beltway" submarkets of Bethesda/Chevy Chase and North Bethesda began to recover by year-end from the departure of major tenants such as Discovery, who relocated their 600,000 SF headquarters to Silver Spring. Prospective future demand is likely from government-related contractors and price-conscience tenants relocating from the District of Columbia. Tenants located in Class "B" buildings in the District of Columbia can relocate to Class "A" buildings near Metrorail stations in Suburban Maryland at lower rental rates, and be located closer to their employees' residences. This is reflected by the decision of Union Labor Life Insurance Company and the American Nurses Association to relocate from DC to Silver Spring. ANA pre-leased 50,000 SF to kick off an 183,000 SF building located at 8515 Georgia Avenue and ULLICO leased 90,540 SF in Trizec's Silver Spring Metro Plaza existing office complex.

New construction and deliveries in 2003 were mostly build-to-suit's for the expanding federal agency- The Department of Health & Human Services (HHS), which includes the National Institutes of Health and the Food & Drug Administration (FDA). During the 4th Quarter, The JBG Companies broke ground on a 228,000 SF build-to-suit in North Rockville for HHS. An 82,000 SF building is under construction in College Park for the FDA, and a 142,500 SF building in North Rockville delivered 2nd Quarter for HHS. Office building deliveries totaled 957,500 SF for year-end 2003, with 1.2 million SF scheduled to deliver in 2004.

Suburban Maryland's office market should reflect modest improvement during 2004. Pent-up demand from government agencies and contractors, including bio-defense and healthcare sectors will generate new leasing activity. Supply will remain constrained with limited speculative projects likely to break ground during 2004. Rental rates will stabilize and remain flat during 2004 after two years of declines.

NORTHERN VIRGINIA

Northern Virginia's office market finally stabilized by year-end 2003 after a precipitous market downturn since the "tech wreck" of late 2000. Federal spending flowed to defense-related government agencies and contractors by mid-year 2003 generating significant leasing activity from pent-up demand that closed by year-end 2003. More than 2,000 leases were signed in Northern Virginia in 2003 with a total leasing activity of nearly 15 million SF, and 4.5 million SF of net absorption. Despite improving market fundamentals, a number of distressed submarkets still have significant amounts of available vacant space and so-called "shadow space" that is not being marketed for lease that will have to be absorbed prior to a significant market turnaround. Northern Virginia's overall vacancy rate of 16.0% reflects 16.7 million SF of available vacant direct space and 4.3 million SF of sublet space. Sublease space that reached a high of 7.3 million SF at year-end 2001, has declined to 4.3 million SF at year-end 2003 through aggressive leasing and take-backs by building owners. Rental rates for direct Class "A" space that climbed to the high $30s PSF on a full service basis in many submarkets in 2000, are in the low-to-mid $20s PSF range, and will likely remain flat through 2004. Competition by landlords with more than 21 million SF of vacant space will continue to put downward pressure on rental rates. New supply will remain constrained with 2.4 million SF scheduled to deliver by year-end 2004.

INVESTMENT SALES

The DC region's investment sales market generated a record-setting $6.2 billion sales volume in 2003. The frenzied sales pace was fueled in part by the availability of low-rate financing that drove pricing upward, while boosting leveraged returns. A diverse group of investors including REIT's, equity funds, pension funds, foreign investors and private investment groups aggressively bid-up stabilized buildings in Downtown, D.C. and close-in submarkets such as the Rosslyn/Ballston Corridor and Alexandria. Class "A" buildings surpassed $500 PSF in DC and $300 PSF in close-in Northern Virginia submarkets. Opportunistic and "Value-Add" investors paid more for lease-up risk in select distressed suburban submarkets of Northern Virginia and Suburban Maryland.

Going-in cap rates range from 7.0% to 8.0% for Class "A" buildings in Downtown, D.C. and close-in markets, and 8.0% to 9.5% for Class "B" buildings based on stabilized net income. Terminal cap rates range from 25 to 75 basis points over going-in cap rates. Looking ahead to 2004, 23 properties are under contract regionally totaling $1.1 billion, and 30 properties are for sale representing nearly $1 billion in potential sales volume.