Marching forward

On the morning of Sept. 11, Washington, D.C., was plunged into the worst kind of national spotlight. The impact from the events of that day will be felt for many months to come as the city tries to get back to some sense of normalcy.

In the weeks following the attacks, the possible permanent closing of Reagan National Airport was a major concern of the commercial real estate community. J.W. Marriott, CEO of Marriott International, Bethesda, Md., stated that government officials had to reopen the airport to help demonstrate the safety of the nation's transportation system to the traveling public.

“They've got to open it,” Marriott said. “This is the worst I've ever seen our business.” He estimated that in the week following the terrorist attacks, business in Marriott hotels was off by 40% to 60% nationwide.

In early October, President George W. Bush announced that the airport would reopen.

But during recent times when other forms of turmoil — specifically economic — affected the D.C. metropolitan area, its commercial property markets have shown some serious staying power. And despite recent events, the stability created by the federal government and several other business sectors remains intact.

Lee Alexander, managing principal in the Washington, D.C., office of New York-based Insignia/ESG, said the area has several factors working in its favor, including a diverse tenant base with the federal government as its foundation and the largest national job growth for the 12-month period that ended in June of this year. According to the U.S. Census Bureau, 85,500 new jobs were created in the D.C. metropolitan market during that period.

Earlier this year, Baltimore-based Johns Hopkins Real Estate Institute predicted that a national downturn would not rain on the Baltimore/Washington, D.C., region's commercial real estate parade. The Institute based its conclusion on a survey of 150 leading real estate and related industry experts.

Still, there are some warning signs that bear watching. Chief among them are the state of the suburban office market and the August announcement by AOL Time Warner that it will lay off 1,500 workers at its headquarters near Washington Dulles International Airport.

Office: Downtown thrives, suburbs struggle

D.C.'s downtown and suburban office markets have been on a roll for years. But now, the reviews are a bit more mixed, and it looks like a tale of two markets headed in opposite directions: Downtown is peaking, and the suburbs are struggling with the collapse of the technology sector. Downtown, the story is a familiar one, as space is in tight supply.

The office vacancy rate in Washington, D.C.'s central business district (CBD) has stayed below 5% during the past year, according to Kurt Stout, client services manager in the Washington, D.C., office of Northbrook, Ill.-based Grubb & Ellis.

Thankfully, demand in the CBD has been consistent and new supply has been limited. “Although we have seen an increase in the amount of sublease space coming to the market, it has been moving quickly at acceptable rates,” said Audrey Z. Cramer, executive vice president in the Washington, D.C., office of New York-based Cushman & Wakefield. “One of the most significant developments in the market is the number of large tenants. It is unusual for so many large groups to be seeking space at the same time.”

Inside the Beltway, tenant base stability is a big help. According to Cushman & Wakefield, the federal government and legal sectors accounted for 1.5 million sq. ft. in leasing activity in the first half of 2001, or 38% of all leasing activity within the D.C. city limits.

Two recent transactions show the influence of the federal government and legal sectors. One was the lease by law firm Sidley Austin Brown & Wood of 190,000 sq. ft. in the 12-story Investment Building at 15th and K streets. The other was the Federal Reserve's purchase of its headquarters building at 1709 New York Avenue N.W. for $67 million from Cranford, N.J.-based Mack-Cali Realty Corp.

Even with downtown rents reaching all-time highs of $46 per sq. ft. to $63 per sq. ft., Washington, D.C., has successfully avoided the sharp rent spikes experienced in other markets during the past few years, said Thomas M. Fulcher Jr., senior vice president in the Washington, D.C., office of New York-based Julien J. Studley Inc. “In the future, I think we'll see rents in the main business districts continue to increase, but this growth will remain at a steady pace.”

Meanwhile, downtown has avoided fallout from the dot-com crash. That's because the area was never a hotbed of technology companies in the first place.

“A number of e-commerce groups did establish their offices in the downtown market, but never on the scale of other markets, such as Northern Virginia,” said Cramer. “Consequently, the downturn in this business sector has not affected the downtown market substantially.”

However, the suburban Washington, D.C., office markets have struggled with the effects of the technology fallout. This phenomenon shows in area statistics. According to Baltimore-based Reis Inc., the metropolitan D.C. office market experienced negative 485,000 sq. ft. of absorption and 1.1 million sq. ft. of new construction in the first half of this year. The last four years have seen the completions of new office projects increase.

“The most significant and obvious trend is negative absorption and flat/decreasing rents,” said Lloyd Lynford, founder and president of Reis. “Suffice to say, sublease space has become a very hot topic. We feel that while the overall real estate market hasn't been turned on its head, when the market begins to give back space that just 12 months ago it had been devouring, investors and other real estate professionals listen,” Lynford added.

Northern Virginia, one of the nation's most prominent technology sectors, has experienced negative absorption of 1.4 million sq. ft. in the first six months of 2001, according to Stout. Rents have fallen correspondingly, he added.

Approximately 44% of all the available office space in Northern Virginia is sublease space, and much of it is in new Class-A buildings, reports Grubb & Ellis.

According to Paul S. Schweitzer, executive vice president in Studley's Northern Virginia office, the Dulles Corridor had more than 6 million sq. ft. of space available at mid-year 2001, including sublease space, and posted an availability rate of 14%.

“With so much sublease space available in the Dulles Corridor, rents have hit a low not seen since 1999,” said Schweitzer. Herndon has taken the hardest hit of the Northern Virginia submarkets, with an availability rate of 18% in second-quarter 2001, he added.

“I think the market will be further impacted by the Winstar and PSINet bankruptcies, which may add another 500,000 sq. ft. to the market,” Schweitzer said.

Stout feels the worst could be over. “The good news is that most of the pain is probably behind us,” Stout said. “Unfortunately, a tremendous amount of space is expected to be completed in the second half of this year, and that should keep vacancies high. However, the supply pipeline will scale back dramatically next year.”

All of the available space is hurting the transaction market. “The biggest overall trend we have observed is a general lack of velocity in transaction volume,” Alexander said. “Through the first eight months of 2001, this trend can be observed across the entire region. It is particularly evident in the technology-driven submarkets such as Reston and Herndon in Northern Virginia.” In 2000, 66 sales transactions occurred in Northern Virginia, compared with 16 in the first six months of 2001, Alexander noted.

Joseph Callahan, area director in the Washington, D.C., office of Dallas-based Trammell Crow Co., said that given current conditions, many tenants are in a holding pattern. “Where possible, tenants have put their relocation decisions on hold as they reassess their future space needs, wait for landlords to lower rental rates or offer better amenity packages,” he said.

Despite the many machinations, rents are still holding up, say local observers. The metro area, with the exception of the technology-driven market stretching from Tysons Corner, Va., to Dulles Airport, has seen little to no decline in office rents. In the Tysons/Dulles Corridor, which encompasses Reston, Herndon, Route 28 North, and Route 28 South, rents have fallen 15% to 20% from their highs of last summer, according to Insignia/ESG.

Despite that fact, tenant improvement packages have held steady for both new and relet space over that same period. According to Alexander, average asking rents for office are $36.05 for the District of Columbia, $27.70 for suburban Maryland and $29.60 for Northern Virginia.

Retail: Getting noticed

Retailers have a renewed interest in the D.C. metro area. According to Richard Lake, managing principal of Washington, D.C.-based Madison Retail Group, retailers are looking at areas ranging from downtown all the way through the suburbs. Georgetown is one D.C. neighborhood that is enjoying tremendous new retail investment. “Our firm has leased over 100,000 sq. ft. of space in Georgetown in the last several years, primarily to national retailers,” Lake said.

“The focus of this reinvestment in urban areas is providing ‘building blocks’ of retail, chiefly grocery stores, hardware stores, and affordable apparel and houseware stores,” Lake said. Companies such as Landover, Md.-based Giant Food, Atlanta-based Home Depot and Troy, Mich.-based Kmart have announced the openings of their first stores within the D.C. city limits.

A development trend in Washington, D.C., is the emphasis on mixed-use properties, with residential, office, retail and hotel components. A prime example of this is Gallery Place, which features more than 500,000 sq. ft. of total development — 200,000 sq. ft. of office, 178 units of residential and nearly 200,000 sq. ft. of retail. Another example is 4500 Wisconsin Ave., the former Sears and Hechinger location in the upper Northwest market, which will be the new home of 200,000 sq. ft. of luxury residential and nearly 80,000 sq. ft. of retail space. Construction is slated to begin in second-quarter 2002.

Rising rents are the result of this beehive of activity, prompting owners to hold on to their retail investment properties. This price appreciation runs counter to the general slump in retail sales volume across the country.

“Owners in the D.C. market can sell their retail properties for strong gains, but they have decided not to,” said Bernie Haddigan, managing director of Encino, Calif.-based Marcus & Millichap's Retail Group. The area's high median incomes, particularly in the Northern Virginia market, have attracted retailers to the area, he added.

“In fact, every submarket of D.C., excluding the Capitol Hill-Eastern D.C. submarket, has a median household income in excess of the national average,” Haddigan said. “And continued job growth, although forecast to slow slightly this year, has allowed the region to maintain the solid demographics that keep retailers in the market.”

Recent events and the national economic slump should not greatly affect retail within the D.C. limits because of the city's limited amount of retail space and many residents' desire to move to the urban core, said Lake. Washington, D.C., proper has 9 sq. ft. of retail per resident, compared with 23 sq. ft. for suburban Maryland, and 27 sq. ft. for Northern Virginia, Lake noted, adding that the national average is 16 sq. ft. per resident.

“The potential for retail success in D.C. is quite strong,” Lake said. “Retailers of all types have recognized there is tremendous opportunity here to service this market.”

Haddigan echoes those sentiments. “Migration to urban areas has become increasingly popular over the past few years, a factor that has not gone unnoticed by retailers,” he said. “In other words, the current economic climate will affect some submarkets more than others, but the overall performance in the D.C. region should remain strong over the next 12 months.”

Leading the charge are grocery stores, apparel stores, restaurants and entertainment-style retail stores. On the grocery front, Austin, Texas-based Fresh Fields opened a 48,000 sq. ft. store at 14th & P streets, N.W., last fall. Pleasanton, Calif.-based Safeway also has had similar success with its store at the Good Hope Market Place in southeast D.C.

According to Marcus & Millichap, the average sales price of traditional and fast-food restaurants in 2001 is roughly $225 per sq. ft., which is up more than 17% from last year. Strip and neighborhood centers also have fared well this year, averaging $119 per sq. ft., up nearly 20% from a year ago.

Grocery-anchored strip centers, as well as other retail centers with a restaurant component, continue to garner investor interest and command higher prices. Residents of the region enjoy dining out, and the high disposable income of D.C. area housing residents should continue this trend.

Hotels: A slightly slower pace

On the hospitality front, the big news is the construction of the $778 million Washington Convention Center. Groups are bidding to build an adjacent hotel. A request for proposals (RFP) over the summer brought in several bidders, and insiders say the advantage is with a group led by Washington, D.C.-based Gould Property, Marriott International and Washington, D.C.-based JBG Cos. The group is planning a 1,400-room hotel in the 900 block of Massachusetts Avenue N.W., which will cost an estimated $350 million. Final selection is scheduled for Dec. 19.

Overall, hotel development and sales activity are slower than in the past few years, but the industry still is moving along. An estimated 17 new hotels will open in the D.C. area this year, compared with more than 30 openings in 2000.

One recent hotel opening was a very splashy affair, when a new Ritz-Carlton, part of a $225 million mixed-use project by New York-based Millennium Partners and Washington, D.C.-based EastBanc, opened at 1150 22nd Street N.W.

Construction started in July on a 336-room Marriott hotel located in the Arlington Gateway Project in Ballston, Va. JBG is the developer. The $125 million first phase of the huge mixed-use project includes the hotel and a 412-unit apartment tower. Later phases will feature a 330,000 sq. ft. office tower and a new entrance to the Ballston Metro Station.

In another big project, JBG and Toronto-based TrizecHahn will break ground either later this year or in early 2002 on Waterview, a mixed-use project in Rosslyn, Va., that will include a 240-room hotel.

Renovations also are popular. The 73-year-old Hay-Adams Hotel, which will close in November to begin an extensive five-month, $14 million renovation, is typical. Developers have embraced adaptive reuse of office buildings, which increases the area's hotel inventory. For example, San Francisco-based Kimpton Hotel & Restaurant Group is developing the Hotel Monaco in the former Tariff Building. Completion of the $19 million project is slated for April 2002.

Hotel property sellers also have taken their cues to get out when the time is right, according to D.C. real estate observers. In one of the area's larger deals, Dallas-based Crow Holdings purchased the Wyndham Bristol Hotel at 2430 Pennsylvania Ave. for $32.2 million from Philadelphia-based Berwind Property Group.

Apartments: Still balanced

It's obvious the D.C. apartment sector is hot when traditional office developers start building apartments. Driven by demand from strong job growth, permits for more than 9,000 apartment units were issued in each of the past two years, according to Marcus & Millichap. But the good news is that developers actually are pulling back the reins on building activity.

“Even with these high levels, supply and demand appear to be relatively balanced,” said Linwood Thompson, national director of Marcus & Millichap's National Multi Housing Group in Dallas.

Approximately 96,000 new jobs were created in the D.C. metropolitan area in 2000, and the average number of persons per household is 2.5, according to Marcus & Millichap. Based on these figures, housing demand for these new residents would total about 38,000 units. Given that total housing permits in 2000 totaled approximately 39,000 units, the supply/demand equation looks fairly well-balanced, considering that not all projects for which building permits were issued actually began construction. Starts also are expected to taper off slightly this year to 8,500 new units, according to Marcus & Millichap.

Rents still are holding up well, with almost every submarket experiencing double-digit rent gains over the past year. “With the somewhat softer market expected over the next 12 months, rent growth will moderate from what has been experienced over the past several years,” Thompson said. Low vacancy levels will allow owners to raise rents by about 7% to 8%, a decrease from the intense spike in rents over the past few years, Thompson added.

The Washington, D.C., area is witnessing a population migration from the suburbs back toward urban areas, including the D.C. city limits. Consequently, developers with a history of building office product in the CBD have begun looking toward multifamily and single-family development, as well as mixed-use properties that combine office, retail and residential units, Thompson noted.

“The majority of the construction is high-end, Class-A apartments and condominiums. Conversions from office to residential uses also have become more common,” Thompson said. “This is the first time in its history that the CBD has had a strong residential presence, and the success of this type of development has been so great in other major metropolitan areas such as New York and Chicago that it appears to be a normal and obvious evolution.”

But even here, too, the slowing economy and decline in technology companies will eventually have an impact. “Declines in the tech sector will certainly impact the local apartment market, but the extent will be much less than in the more heavily weighted tech markets across the country,” Thompson said.

He admits that some submarkets will be affected more than others. For instance, Thompson predicts there will be a softening of rents in Dulles and Reston, as well as some areas of Loudoun County, Va. Nevertheless, Thompson predicts rent growth in the metropolitan D.C. area will remain above the national average.

Ben Johnson is an Atlanta-based writer.

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