Washington, DC Year End 2004

Market Momentum

The Washington, DC metropolitan area commercial real estate market was running on all cylinders last quarter, finishing off a very healthy year with strong absorption, higher rents and lower vacancies. Given that our market added almost 80,000 new jobs last year, it is not surprising that our Metropolitan area absorbed over 10 Million Square Feet of office space, up from 6.2 Million Square Feet in 2003. Average rents throughout the Metropolitan area rose 5.4% and 57 buildings delivered a total of 6.2 Million Square Feet of new space.
Northern Virginia continued to dominate the market’s activity with 7.2 Million Square Feet of net space absorbed, compared to 1.8 Million Square Feet in Suburban Maryland and 1.3 Million Square Feet in the District. Vacancy rates are down 1.5% from a year ago (12.3% YE2003 to 10.8% YE2004) with the District unchanged from last quarter at 8.4%, Northern Virginia down 2.5% (from 15% to 12.5%) and Suburban Maryland 0.7% lower (11.8% YE2003 to 11.1% YE2004).

Additional Rents Rising

After a decade of remaining flat, Building Operating Costs in all classes are rising significantly faster than inflation. For the past two years, operating costs in most Class A buildings have been seeing rapid increases due to spiking prices in several areas and increased level of services provided by most Class A Buildings. Projected 2005 operating expenses and real estate taxes for several Class A buildings in the District are approaching $20 per square foot. The major factors driving these increases are: insurance, energy, taxes and building amenities.

All buildings in the Washington, DC Metropolitan area have felt the effects of 9/11 through increased insurance premiums to cover terrorist related events. Some buildings have also invested in additional security measures, but most have simply increased the duties of their pre-existing security guards or lobby attendants. Sharply rising energy prices have directly increased the cost of utilities to provide cooling and power. Building amenities, such as fitness centers and security personnel have further pumped-up payroll expenses.
Most tenants have seen very large increases in the tax portion of their passthroughs as well. The red-hot investment market has caused property values to soar and real estate taxes to rise accordingly. The result has been unprecedented and frequently unexpected increases in additional rent for area tenants.

But What Does It Mean?

Operating Expense (a.k.a. Additional Rent) provisions are one of the most important sections in leases, in that they can have the greatest impact upon the economics of your tenancy over the lease term. Typically, other major terms and conditions have already been negotiated prior to a lease being drafted. When the tenant is able to wield sufficient leverage, many of the key operating expense provisions may be negotiated in the letter of intent, but frequently that is not the case for smaller tenants. Strategies for negotiating these provisions include: correctly defining the base year; delaying the commencement for any passthroughs of increased operating expenses and real estate taxes for at least one year following the lease commencement date; re-setting the base year for operating expenses at the time a lease is renewed, capping increases on “controllable” expenses (i.e. wages, cleaning service, etc.); and negotiating a detailed list of specific expenses and real estate taxes the landlord must exclude as reimbursable expenses.
Many landlords will use the Operating Expense provisions of the lease as another way to raise their effective rental rates. It is especially common for landlords to try to maintain the old (lower) base year when renewing leases. As Operating Expenses escalate, it is that much more important to aggressively negotiate these provisions correctly when renewing or relocating.