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Office-Space Market Stuck in Downdraft
Slump Pushes Vacancies Up, Rents Down

By Dana Hedgpeth
Washington Post Staff Writer
Tuesday, May 26, 2009

The Washington area market for office space has suffered one of its toughest stretches ever so far this year, as vacancy rates have shot up, rents have dropped and few new buildings have started construction. The slump is likely to continue for the rest of 2009, real estate experts say, as roughly 11 million square feet of new space is under construction and expected to come on line in the coming years.

"We're definitely going to see vacancies going up for the balance of the year and into next year," said Sigrid Zialcita, director of research at Cushman & Wakefield, a commercial real estate firm. "Demand is going to be lackluster while there's so much inventory right now. Unemployment is going to go up like the rest of the nation. Companies are preparing for the worst. There's still going to be cost-cutting down the road."

As of yesterday, the vacancy rate for the District and the close-in suburbs was up to 12.5 percent from 11.1 percent at the end of the second quarter last year, according to CoStar Group, a real estate research firm. Rents were down to $33.47 a square foot from $34.55. Few new buildings have broken ground, as credit markets remain extremely tight.

"Unless they're already in the ground, they're not starting," said Steven A. Levin, managing director at Spaulding & Slye. "Any development project needing a loan over $25 million requires multiple lenders, and the guarantees are onerous. The amount of money you can borrow is also reduced."

That leaves many investors and others worried about loans going into default, as some owners are already renegotiating their loans with their lenders.

Dennis K. Moyer, a commercial real estate lawyer with Goulston & Storrs, said some of his clients are reviewing their existing loans and wondering whether they'll be paid, even on properties that are doing well. "The next wave that comes is likely the workouts, foreclosures and restructurings," he said.

The slowdown is fueled by overly rosy expectations. Developers who had expected to get rents of $40 a square foot, for example, are now hoping to earn around $30 a square foot on buildings in the city and the surrounding area, according to Moyer.

"The deals have not just slowed -- they've virtually stopped," he said. "All the things that kept us busy from 2005 to 2007 began to slow down last year and have come to a virtual halt this spring." His firm recently laid off about 10 of roughly 200 attorneys at offices in Boston, New York and Washington.

In the District, vacancy rates are at 10.5 percent, up from 8.6 percent at the end of the second quarter of last year. Rents are around $47.49 a square foot. Construction has stopped on five projects in the past year, according to a recent report from Cushman & Wakefield. The primary concern, say brokers and developers, is the 7.9 million square feet under construction, mostly north of Massachusetts Avenue and in Southwest -- areas that are unproven office markets and could become overbuilt.

In Prince George's and Montgomery counties, office vacancy rates jumped to 13.4 percent from 12.3 percent in the second quarter of last year, while rents have remained stable at around $27 a square foot. CapitalSource, a commercial lender based in Chevy Chase, had pre-leased 130,000 square feet at Wisconsin Place, an office building being developed by Boston Properties, but "reeling from the impact of the economic downturn" it has returned more than 60 percent of the space, said Cushman & Wakefield.

Northern Virginia, real estate experts say, seems to have learned its lessons from the boom and bust of the dot-com era, as only 1.6 million square feet is expected to be built in the next two years. The only proposed project with a major tenant is a 355,000-square-foot office building in Ballston, where a Defense Department agency is leasing the whole building. Northern Virginia's vacancy rate is up to 13.5 percent from 12.4 percent the second quarter of 2008, and rents are down to $28.96 a square foot from $30.60.

But Virginia's residential market continues to suffer, according to a recent report from the University of Virginia. Only 27,500 building permits were issued in 2008 -- less than half the activity of four years ago. In Northern Virginia, the number of permits issued is down 64 percent, and in Winchester it is down 77 percent.

"For the past few years the housing industry has suffered through a number of calamities, beginning with poorly conceived mortgage products, to skyrocketing foreclosure rates, to falling home prices," said Michael Spar, a University of Virginia demographer. "One of the casualties of this meltdown has been new-home construction."

There are some signs of hope for the office market, some experts say.

Washington could fare better than other markets such as New York or Chicago because it has the federal government as a major tenant along with companies that do business with it. Some experts are hopeful that the market here could eventually get a boost if the federal government needs space for any of the new regulatory agencies being discussed.

"Will that be enough?" Zialcita asked. "We'll have to see."

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