The commercial real estate market in metropolitan Washington, D.C, tells two distinctly different stories. Downtown Washington shows all the signs of a healthy real estate market -- positive net absorption, relatively low vacancy, rising rental rates, steady construction starts and steady tenant demand. In Northern Virginia, the inside-the-beltway Arlington suburbs also reflect of the health of the D.C. market, with healthy activity and rental rates that are holding. The outer submarkets of Washington, D.C., however, continue to suffer from the high-tech industry's slump.

Downtown

Washington, D.C.'s office market is healthy. The fairly even balance of supply and demand continues to result in positive net absorption of 846,279 square feet. The direct vacancy rate rose slightly to 4.1 percent and average asking rental rates continued to climb last quarter, from $38.60 to $39.30 per square foot, full service.

With few exceptions, many of the largest transactions in the second quarter were "bread and butter" deals -- government and law firm leases. The General Services Administration leased space for the Department of the Treasury at 1120 Vermont Avenue, Department of Agriculture at 1800 M Street, Department of the Interior at 1201 Eye Street and Department of Justice at 901 E Street. Conservatism was the motto of the quarter with firms choosing a stay-in-place option versus moving to larger, more expensive new buildings.

The Capitol Hill and the East End submarkets had an excellent quarter, with 581,822 and 486,277 net square feet absorbed, respectively. This activity was caused in part by the delivery of new buildings with significant pre-leasing already accomplished at 101 Constitution Avenue and at the Westory Expansion at 607 14th Street. Each saw its vacancy rate drop. Asking rental rates rose on Capitol Hill to $35.70 per square foot from $34.31 last quarter. In the East End, rental rates may be peaking or hitting a plateau, because they dropped slightly from $42.48 to $42.26 last quarter.

There are several large private transactions of at least 100,000 square feet underway which should generate significant positive absorption this year and provide momentum for next year. The government's appetite for space continues, both in traditional space and locations and in new, expanded areas of the city (NoMa, Southeast, Southwest).

Northern Virginia's Outer Submarkets

In Northern Virginia's outer submarkets, from Tysons Corner and farther out the Dulles Toll Road, the picture is much bleaker, with high vacancy rates, near daily reports of tenants' downsizing and deliveries of new product vacant or nearly so. Rental rates continue to drop in markets that 18 months ago were among the most sought after, to the point of full pre-leasing of proposed construction to guarantee tenants' expansion and relocation space into the future. In addition, vacant sublease space has helped drive rental rates down over the past year.

The second tier of tenants -- lawyers, accountants, consultants -- who followed the telecom and high technology tenants to those non-traditional locations out the Dulles Corridor are scaling back plans in response to that sector's economic slump. As the market shifts back to a more normal stance, empty floors and vacant buildings illustrate the oversupply of space, particularly in the Dulles Corridor. Subleasing has exposed the market's weakness, especially in Tysons Corner, where as much space is available for sublease as for relet.

The good news about sublease vacancy is that vacant sublease space decreased for the first time in a year, which likely means that Richmond has seen the worst of the sublease situation, barring any downturn in the economy.

Suburban Maryland Suburban Maryland's story shows a market correction to an unbalanced situation of about a year ago, when tenants in Bethesda had practically no leasing options. Forced to make decisions in a less than 2 percent vacant market and rental rates that were $10 more per square foot than when they signed their leases 5 to 8 years before, they opted to move north to Rockville or Shady Grove or east to Silver Spring. Suddenly those submarkets became much more desirable, with new product, higher rental rates and a growing tenant base. Bethesda/Chevy Chase, however, is now languishing with higher vacancies than seen in 6 years. Average asking rental rates have dropped back to where they were more than 2 years ago, even though there is significant new space available to tenants in two projects. Bethesda/Chevy Chase has a moratorium on further development, which will allow the market to absorb the current excess space without additional outside pressure.

The bright spots in Suburban Maryland are Rockville, North Rockville and Silver Spring. Brokers report leasing activity is higher in those locations and there is new product for tenants to move into. The National Institutes of Health and the Food & Drug Administration both have continuing expansion needs in Suburban Maryland. The bioscience tenant base also continues to grow, in traditional office space and increasing lab and manufacturing space.

Investment Sales

According to Alan Greenspan, the economy is in recovery and the capital markets are positioned to react quickly as deals are being slowly brought to the table. Investors are looking for product to buy but remain concerned about pricing. This year's cycle is slower to increase than in previous years. Overall, there is still a limited number of properties in the market, and most owners are not in a position of having to sell so many are holding and waiting to see what happens with the market.

A lack of leasing activity in the market, particularly in the suburban markets, has made it hard for buyers to underwrite potential purchases. Some purchasers are making unsolicited offers on properties in the hopes of "knocking something loose."

One of the issues that remains unresolved in the wake of September 11 is the increasing number of lenders who are requiring terrorism insurance. This has been an ongoing problem since September and it intensified at the beginning of the year when most policies expired. The pricing and availability of this insurance remain wildcards in terms of underwriting purchases and setting budgets.

Washington, D.C., is the only market that remains very active; both Boston and San Francisco, two of the former hotspots, have fallen out of favor as the tech market has bottomed out. D.C. remains in favor due to its diverse and stable economic base, steady job growth, high barriers to entry and the government's increasing space needs.

Moving Forward

The next 6 to 9 months will likely be more of the same as the metropolitan Washington, D.C., market tries to attain a better equilibrium between demand and supply. Constraints on new construction, whether imposed by funding sources, government regulations or the lack of available sites, have kept the new supply pipeline in check during this recession. Demand from the traditional tenant base shows why the metropolitan Washington area will continue to be one of the healthiest and steadiest in the country.

The federal government's appetite for more space for itself and its contractors will no doubt fuel additional absorption. The pace at which the government moves, however, means that the rate of government absorption will continue at a steady rate into the foreseeable future. With few exceptions, September 11 events have not prompted the expected rash of leasing activity from either the government or its contractor base.

Joseph Callanan is area director/Mid-Atlantic with Trammell Crow Company.


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