The downtown Washington, D.C., commercial office market is generally recognized as one of the most resilient in the country. However, ripples from the events of September 11 and the struggling economy are moderately affecting this market, which has rarely seen vacancy rates rise above 10 percent.

The historically low vacancy rates in D.C. are primarily due to a constrained supply, caused in part by a building height limitation of 120 feet and government tenancies. (Government agencies own or lease 40 million square feet out of a total 89 million square feet). Additionally, the length of time to assemble land sites typically runs from 3 to 7 years, limiting the ability to add millions of square feet of inventory quickly.

Financing for speculative development has also become progressively more difficult to secure, further inhibiting new construction. Consequently, the supply curve is no different today than 1 year ago. Pre-leasing space in planned projects has become the norm, and tenants with requirements greater than 100,000 square feet seeking a new building must enter the market 2 to 5 years prior to lease expiration to allow for design, financing and construction of a project. A recent example is the Venable law firm's pre-leasing -- 2 years in advance -- of 225,000 square feet in a project to be constructed by CarrAmerica across the street from Washington's MCI Arena. Similarly, Boston Properties has signed the law firm of Finnegan Henderson to a lease at 901 New York Avenue 3 years in advance. These two projects will add a combined 500,000 square feet of office space to the market in the next 2 years, with approximately 50 percent of the space uncommitted.

Two speculative projects that have recently broken ground are 1717 Rhode Island Avenue, a 160,000-square-foot development by Karchem Properties, and Tishman Speyer Properties' One Metro Center, a 418,000-square-foot project located directly above Metro Center. Projected deliveries over the next several years average only 1.5 million square feet annually in a market absorbing 2.4 million square feet annually over a 5-year average. These projections indicate that Washington's space constraints will prevent the overbuilt market conditions that have developed in many suburban and urban markets around the country.

Demand for office space since September 11 has slowed dramatically. Security has become a prime interest to tenants and owners, especially in the nation's capital. With the sluggish and uncertain economy, firms are hesitant to consider expansion and relocation, unless pressured by a lease expiration and/or limitations within their existing building. There was virtually no activity during fourth quarter 2001 and first quarter 2002. This is evidenced by the dramatic fall in net absorption from a 2-year quarterly norm of 600,000 square feet to only 300,000 square feet in first quarter 2002.

Downtown never benefited from the surge of the suburban high-tech market, and subsequently the area has not suffered from the high-tech collapse. However, D.C. has seen an increase in sublease space, as slower growth rates have left the area's business tenants with excess expansion space. The larger tenants in Washington are professional service firms, many of which are law firms. Law firms have been the catalyst driving most of the commercial real estate growth and development in D.C. and a decline in law firm growth rates have had a material effect on the demand for new and additional office space.

The vacancy rate in D.C. has increased to 7.5 percent, including sublease space. The overall impact of that increase has affected small- to medium-sized blocks of space. Limited options have caused the larger blocks to be relatively unaffected. As a result, buildings offering more than 100,000 square feet are even beginning to push rental spikes.

Net absorption for the second quarter will likely be as low as the first quarter. The outlook for the remainder of the year predicts improvement. The Washington, D.C., office of CB Richard Ellis forecasts a year-end absorption total of approximately 1.3 million square feet, compared to 1.8 million in 2001. The significant law firms active in the market should sign during the second and third quarters. Unfortunately, they will not impact absorption figures until the firms occupy in 2003 and 2004. Rental rates for large, well-located sites will continue to escalate and peak around $50 per square foot. Smaller tenants will continue to have multiple options. The sublease market will affect both Class A and Class B space as tenants opt for the more attractive terms offered through a sublease. This balance of supply and demand has and will continue to attract major institutional buyers around the world.

Following the early 1990s, the real estate industry questioned whether Washington was susceptible to overbuilding and limited demand. Due to its supply constraints, steady economic and tenant bases, Washington is exhibiting its strength and proving its resiliency. The area should continue to outperform most large office markets in the United States for at least the next 5 years.

Pat Marr is senior vice president of corporate services with CB Richard Ellis in Washington, D.C.


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