D.C. transactions keep market churning, churning, churning

Editor's Note: Our nation's capital experienced the same recent cyclical gyrations in its real estate markets as the rest of the country. But many important distinctions must be drawn. The first is a District of Columbia government that has seen much turmoil in recent years, and now operates under the supervision of a financial control board. Also, the District's absorption of office space in 1995 reached only 500,000 sq. ft., while lease renewals generated the lion's share of activity in the market. One big deal looms on the horizon which will greatly impact the local office market - the move by the World Bank and the International Monetary Fund into new digs, dumping some 1.5 million sq. ft. of space back onto the market.

To provide a better overview of the D.C. real estate market, we recently assembled a panel of local experts for breakfast at the Mayflower Hotel, and here are their comments.

Q: From a national perspective looking into the D.C. market, much has been made regarding the District's financial woes. Are those woes impacting the local real estate market?

Andrew Genova: To the extent that it's giving the District a black eye, it is affecting us. The population has dropped in D.C., but all in all on the real estate side, the District does not lease enough space to cause major shock waves, whether they are up or down. But it's the fact that they haven't been aware of people moving out of the city, they haven't been proactive and maybe this is more of a perception, but the perception has become reality over time.

Q: Is that good or bad? Does it make the suburbs look more attractive?

Genova: It creates an opportunity because a lot of the businesses are now at a point where they are pretty much fed up with the lack of direction by the District and are now jumping in saying, `Here's how we think we can help.' Long term that's good. Short term, right now we don't know.

Robert Cohen: I think the District doesn't have that big an impact on our real estate industry. They don't have any relationship to tenant retention and they aren't focused on what the problems are. Investors are looking at the reality. Tax rates are way too low, and economic development is relatively nonexistent.

There are some things that are happening there that three to five years down the road will have a major impact. The new convention center, the new arena, that will open up another part of town. There are a lot of people coming up with a lot of creative ideas out there.

Brendan McCarthy: I think the perception investors have of the city is that the federal government won't let the city sink into the ground. It's been a city that has grown when most cities have seen an exodus from the center city and are trying to revitalize. I think that Washington has grown due west from the shopping district and that pretty much the only exodus has been retail from that part of Washington.

As far as the business part of it, the growth of office space, the tenant base has grown over the past 20 years. It's probably the first time since I've been doing the business that the opportunities in Crystal City and Roslyn actually have tenants moving back into the city at less rent. The biggest reason for the exodus from Washington and the growth of the suburban markets is cost. Today, with the large pockets of second-generation space that in the past has been absorbed by the tenant base in the building through the growth of the law firms and associations, there are numerous pockets of 20,000 sq. ft. to 40,000 sq. ft. spaces which has driven the price down on that side of the tenant base, an environment of interest for people that are operating on the perimeter to come back into the city. I don't think there's the fear that the city's going to collapse, because the federal government won't allow it.

Q: Like a lot of Corporate America, the federal government continues its own downsizing. How big an impact does the federal government have on the D.C. real estate market?

David Redmond: How much of the federal workforce do you think we have in the Washington, D.C., MSA (metropolitan statistical area)? Only 12%. The rest are spread over the rest of the country.

Genova: Of the amount of space that's used, approximately one-third is the number I heard. The reduction in the federal government, I think, is tied into the District's problems, which impact an outside investor's view of the market. If you read Emerging Trends from Equitable, D.C. wasn't ranked high on the list of investment areas, but their overall message was investment is back. We're seeing a lot more building sales this year. We've seen a lot of movement among the tenants. The thing we really don't have is real growth of the tenant base. Net absorption is fairly flat and, for the third or fourth largest office market in the United States, that's a pretty important issue.

Bill Magner: When you get up to Boston, you're in another world. They say, `What's going on down there? When are you going to turn off the lights?'

Lance Ford: Some of that is relative. If you get outside Washington, a 15% vacancy is a great thing. I think Washington has historically been used to under 1% vacancy, so 10% or 9% is like the sky is falling, but relative to other markets across the country, it's still a great place to do business.

Cohen: We were insulated for a long time, but real estate is cyclical. In Washington, D.C., we were foolproof, we couldn't have a bad year.

Chuck Pilchard: Outside the District especially, it is having an impact on leasing trends in the short term. A lot of people are pushing off decisions.

Q: How are the dynamics affecting the multifamily markets?

J. Michael Curtis: Right now, an increase in rents is possible, because vacancies are running at 1% or 2%. It's hard to get into the area. Cap rates went up half a point and are starting to come back down. They went from 8.5% to 8.25%. The reason for that is limited supply. It's hard to get into this market to build apartments. It's hard to buy a house. Basically the population's grown less than 2.5%.

Another interesting thing about the institutions is that whenever the stock market goes up, they allocate 5% of their money for real estate, and they are jumping back into the market. There's a lot of money chasing a finite product. Here you can buy significantly below replacement cost. You can buy older stuff for $20,000 to $25 000 a unit.

Ford: We manage about 6,000 apartments, most of which are in the District of Columbia. We see frustration by institutions, because they aren't going to come here except maybe on trophy projects in the District, primarily because of rent control. That severely damages the possibility for investors interested in multifamily projects inside the District. Outside the District, it's a different story. There's been a lot of activity out there.

Q: Office absorption for 1995 was at least flat if not negative. How does the trend look going forward?

Magner: There's not the demand for space. All of these issues are market factors for office space. You're looking at Washington and the whole metropolitan area and the technology sector. We see tremendous absorption and activity way up in Northern Virginia, while the federal and local government here in the District are quiet.

Q: Renewals accounted for most of the leasing activity in 1995. Why?

Genova: We found in most of our transactions that there were four or less years remaining on the lease. I think in 1996 we'll stay under 100,000 sq. ft. on the net side, and less than the 4 million on the gross side that we saw in 1995. I think 1997 and 1998 is probably going to be our turning point.

Cohen: There's been a heck of a lot of activity. There are a lot of transactions going on. Some of it's musical chairs; some of it's companies going out of business and people starting new businesses. The net absorption in the District has been terrible, but 150 people or more (referring to the brokerage community) are making a good living.

Magner: We have a tremendous and dynamic market here that will continue to churn, and if you look at how real estate shifts, there are real opportunities for investors.

McCarthy: The better buildings are leasing up, rents are increasing in those buildings. Opportunity comes out of the tremendous activity we're experiencing.

What we don't have in the market is the demand of 1987 or 1986, or even 1990. What no one has been able to pin down is the internal growth of companies that have been hit by the recession and the changing technologies of the office environment and the need for space. Particularly in downtown Washington, in those buildings that had tenants that were moving to new construction, there was virtually never any vacancy in that second-generation space. The large pockets of space, which are driving the economy of downtown Washington and keeping rents low, are second-generation vacancies that are not being absorbed by the existing tenant base in those buildings.

Q: The D.C. market is unique in that there is a lot of Class-B space. What's it going to take for rents in new Class-A space to justify more construction?

McCarthy: The large pockets of space have kept downward pressure on rents.

Genova: There's not going to be any spec development today unless the land component gets close to zero, and even then the demand will have to be there. There is no underlying belief that there is demand in this market. The key point is that the B-grade properties are not moving. There's no way you can sell an investment in a new office building at $40 a foot on a spec basis.

Pilchard: That's really the challenge, how to move that B space. The other thing that will have a tremendous impact is the consolidation of the World Bank and the IMF in 1997.

McCarthy: If a tenant's choice is to pay $35 in Roslyn or $22 on Connecticut Avenue, you're going to come back downtown. It's just pure economics.

Cohen: There are other B properties that are being recycled as hotels or for residential use. The other guys who don't do it, they can't afford the ADA (Americans with Disabilities Act) and they can't get the rent.

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