Washington, DC 2nd Quarter 2009

A Serving of Free Lunch Rent

There may be no such thing as a free lunch, but free rent seems to be coming back in vogue. With a plethora of empty buildings being delivered across the metro area, rising vacancy rates and huge tenant concessions, it’s starting to look like the 1980’s all over again. What’s next? Skinny ties, leg warmers and new wave music? Rental rates may not be down to where they were 20 years ago, but we’re negotiating concession packages that remind me of the old days: free rent and improvement allowances equal to 15-20% of lease values. With construction costs down, improvement allowances are now more than covering the cost of new build outs and rental abatement is further lowering effective occupancy costs. Rental abatement amounts vary greatly from deal to deal and submarket to submarket. For example, along the Dulles Toll Road, 5-6 months of free rent on a 5 year term is now the norm. Downtown, we typically see 3-4 months free on a 10 year term, but have also negotiated for up to 10 months free (as part of a $135/sq. ft. total concession package).

Of course “free” rent is really just another way of lowering the effective cost of occupancy. While these concession packages are fairly huge, keep in mind that full service rental rates in new buildings are still in the upper $60’s to mid $70’s per square foot. As good as the market is now (for tenants), we believe that the sweet spot for concessions will occur over the second half of the year. Early indicators show that the recovery has already started but we’ve yet to see the impact of the Federal stimulus package. Although economic activity should be brisk after Labor Day, real estate is a lagging indicator (firms hire & grow after their business picks up) and most landlords will remain anxious through at least the end of the year.

One interesting phenomenon of the financial crisis is the upside down cost of owning vs. leasing. Traditionally, leasing has been the least expensive method of occupying office space. Now that the cost of borrowing is somewhere around 6% and sale prices are flat, the cost of owning is frequently less expensive than the cost of leasing office space. Owning isn’t the right decision for every organization. However, if your organization is relatively stable in size and is able to pull together the equity required for a purchase, you may want to include purchase opportunities in your mix of options.

The overall vacancy rate increased to 12.8%, due to almost 3 million square feet of space in new buildings being delivered to the market. One telltale of a relatively healthy local economy is that, demand for office space has started to firm up. Demand, as measured by absorption1, was only slightly negative in the second quarter. Space occupied in the Washington DC office market shrunk by a scant 126,123 square feet, or about .03%. Downtown Washington, DC actually posted positive absorption (228,383 square feet), while new building deliveries pushed the vacancy rate to 10.7%. Meanwhile, the suburban markets recorded negative 354,506 square feet of absorption and their vacancy rate rose to 13.8%.

Looking ahead, over 11 Million square feet of new space is still under construction. Until most of that is absorbed, vacancy rates will continue to rise and effective rental rates will continue to come down.

BUT WHAT DOES IT MEAN?

• - Demand is holding firm, but vacancy rates are rising due to new building deliveries already in the development pipeline.

• - Early indications are that the recovery has started

• - Given that Real Estate tends to be a trailing indicator, the next 2 quarters should offer the “best” terms for tenants in DC although Northern Virginia should see very aggressive opportunities available over at least the next 4 quarters

• - Very Low Interest Rates have made the cost of owning lower than renting in many submarkets.

• - Effective rental rates have decreased by more than 10% as concessions have increased and coupon rental rates are lower.

• - Construction costs dropped by 20-25% over the past 6 months resulting in the return of “turnkey” build outs.

• - This is a great time for tenants to be in the market. Virtually every submarket in the Washington, DC Metropolitan area is abounding with excellent short-term and long-term leasing opportunities. The slowing economy and softer market has created very good conditions for our clients. On the other hand, subleasing excess space has become more challenging. Over the next 9-12 months we expect to see continued softness in the Class A market throughout the Metropolitan area.

1 Absorption is the net change in occupied space over a given period of time. For example, if an organization vacates 10,000 square feet of leased space and moves into 12,000 square feet of space, the result is 2,000 square feet of positive net absorption. If an organization vacates 10,000 square feet and moves into 8,000 sq. the result is 2,000 square feet of negative net absorption.