Office Space Trends: More Vacancies but Higher Rent

Commercial real estate in the Washington area continues to command high rents, but rising vacancies and a drop in new construction have led some analysts to warn of a slowdown in what has been a hot market for several years.

Growth in demand for office space slowed as federal agencies pared back spending on contractors and several buildings in Northern Virginia came on the market before being fully leased to tenants.

The market remains healthy but will not keep up the breakneck growth of previous years, said Sigrid Zialcita, director of research for Cushman & Wakefield, a real estate company.

"We are not expecting the same level of activity as in the past. Those days are gone," she said. "But it does not mean this is bad, because we are still going to expect some modest growth in activity, but not as robust."

All told, the Washington metropolitan area remained one of the country's most vibrant markets for commercial office space, anchored by the large, steady employment presence of the federal government. At the end of the second quarter, there were 128 buildings under construction, for a total of 16.1 million square feet.

Rising construction costs and strong demand for premium office space in desirable locations drove average rent up throughout the District and neighboring suburbs in the second quarter, real estate analysts said. Private-equity buyouts of real estate companies -- including Blackstone Group's $39 billion purchase of Equity Office Properties Trust in February -- also contributed to rent increases as new landlords sought to recoup the premiums paid for those acquisitions, Zialcita said.

At the midyear mark, the area's average rent per square foot for office space was $32.91, an increase of 6.4 percent from the comparable period a year earlier, according to the Bethesda research firm CoStar Group. The rate of vacancies in office buildings was 10 percent, up 1.2 percentage points. And demand, as measured by the change in occupied office space over time, was 1.6 million square feet, a decrease from 2.5 million square feet last year.

A total of 26 buildings, representing 2.1 million square feet, were completed in the quarter, compared with 36 buildings for 3.4 million square feet at the end of the second quarter last year.

The District continued to be the bedrock of the area's market. The average rent at the end of the quarter was $45.16 per square foot, an increase of $3 over last year.

"We are seeing meaningful rent growth, yet compared to New York and other big cities that we would put ourselves in the same category as, our rents are not out of the realm of what they should be," said Matthew J. Klein, president of Akridge, a real estate company in the District.

Law firms and lobbyists scrambling for amenity-rich "trophy" buildings in the central business district and East End and West End neighborhoods drove rents in premium buildings to an all-time high, according to a report by the commercial real estate firm Jones Lang LaSalle.

In the second quarter, BP America and the Securities Industry and Financial Markets Association signed leases with rents in the low to mid-$70s. Comparable space was leased in the high $60s just six months earlier, a Cushman & Wakefield report said.

The District's vacancy rate, however, increased to 8.2 percent -- up from 7.4 -- and demand fell sharply, to 295,000 square feet from 611,000.

Relocation of federal agencies helped hold up demand for D.C. office space. The Equal Employment Opportunity Commission's lease at One NoMa Station was the largest rental transaction recorded in the NoMa neighborhood -- north of Massachusetts Avenue for a few blocks on either side of North Capitol Street -- in two years, according to Cushman & Wakefield.

In Northern Virginia, a boom in speculative building, particularly along Route 28 in Fairfax County, helped push the vacancy rate to 11.2 percent from 10 percent, as developers put up new office buildings without pre-leased tenants for the first time there since the tech boom, Zialcita said. A slowdown in the number of government contracts awarded was also blamed for the uptick in vacancies.

The average rent per square foot in Northern Virginia was $30.49 in the second quarter, an increase of $1.95.

Even as federal contracting slowed, companies performing government work dominated the list of the largest transactions. MPRI, a subsidiary of L-3 Communications, a defense contractor, leased the most square feet in Northern Virginia during the quarter. The company leased 29,000 square feet at the Independence Center Building II in April and then 127,000 square feet at Braddock Place I in Alexandria in June.

Commercial property investment remains strong in Northern Virginia. For the first six months of the year, $6.8 billion worth of properties valued at $10 million or more had sold, compared with $4.5 billion sold in all of 2006, according to a report by Cushman & Wakefield. The total was skewed by Blackstone's acquisition and subsequent sale of $3.3 billion in Northern Virginia commercial buildings as part of the Equity Office deal.

In Maryland, vacancy rates also rose. Rockville, Chevy Chase, Silver Spring and downtown Bethesda remained strong as a dearth of premium buildings kept vacancies low. Prince George's County, however, continued to report elevated vacancies.

The average rent per square foot in the Maryland suburbs was $26.25, an increase of 6.7 percent, while the vacancy rate was 10.5 percent, up from 9.7 percent.

Two construction projects broke ground during the second quarter in Maryland: Burtonsville Office Park 5 and 6730 Rockledge Drive in North Bethesda.

Morgan Sullivan, senior vice president for Jones Lang LaSalle's Maryland office, said a moratorium on new office structures in Bethesda had limited the vacancy rate there.

Sullivan noted that the National Institutes of Health, typically a large consumer of commercial real estate in suburban Maryland, has not made any major expansions in the past three years.

"It points to the fact there is a Republican administration," Sullivan said. "When Republicans are in place, the focus is more defense-oriented, and when the Democrats are in office, the focus is more on [issues like] health care."