Washington, DC 3rd Quarter 2009

It’s Just A Flesh Wound

by Richard J. McBride Jr., President

Like the Black Knight refusing to acknowledge defeat to King Arthur[1], the market continues to present an optimistic face in spite of evidence to the contrary. Fortunately for us, we get to play the role of King Arthur (for our clients) while landlords seem intent to carry on as the Black Knight. It may be “merely a scratch” to their portfolio, but the bottom line is that many new, vacant properties, are hopping about on a single leg after having their other limbs severed from a lack of new tenants. But enough silliness…after signs of life in the spring, the Third Quarter proved a reversal of fortune with 1,350,231 square feet of negative absorption and the overall vacancy rate climbing to 13.4%. Unlike previous quarters where there was a bright spot in at least one submarket, the 3^rd quarter was consistently gloomy. All property types and all submarkets recorded strongly negative absorption[2]. As demand was shrinking, supply continued to grow, with an additional 1,737,872 square feet of new space in 18 buildings were delivered to the market. Another 7.4 Million square feet is currently under construction and set for delivery over the next year. Bottom line: local vacancy rates are at their highest levels in 16 years and should continue to rise for the next several quarters..

The bright side of life is that as a purely Tenant Representation organization, it’s simply a wonderful time to be active in the market. “Free” rent is alive and well, tenant concessions are up and construction costs are down. In the Virginia suburbs we’re regularly seeing concession packages in excess of 20% of the rental obligation (i.e. free rent + improvements > 1 year’s rent for a 5 year term). In the District, face rents have fallen slightly while concession packages are readily over $100 per square foot for 10 year terms in new buildings. Just as importantly for our clients, what used to cost >$100/square foot to construct is now around $75/square foot. 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 last quarter of this year and into the first quarter of 2010. As we predicted on our last report, recent indicators show that the recovery started last quarter (3.5% increase of GDP). Real estate is a lagging indicator (firms hire & grow after their business picks up) and most landlords will remain anxious into the New Year. But the great deals won’t last forever. Once the current wave of buildings under construction has passed, nothing new will be developed for a while. There may be the occasional pre-leased building built, but speculative development will be taking a holiday. Case in point: in the District, only 1 new building may be completed for delivery in 2011.

One interesting phenomenon of the financial crisis remains 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.

But What Does It Mean?

• Demand will be up and down for the next several quarters while vacancy rates continue to rising due to new building deliveries already in the development pipeline.
• The recovery has started, but there is no evidence of support for long term growth.
• Because Real Estate is 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 12 months we expect to see continued softness in the Class A market throughout the Metropolitan area.

[1] References to Monty Python and the Holy Grail are used entirely without permission and those who object will be sacked and subject to sarcasm of the most severe kind. Exhibit A: http://www.youtube.com/watch?v=zKhEw7nD9C4

[2] 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.