Despite a general slowdown in leasing activity among most asset classes in the Metropolitan Washington region, and rising concerns over the health of the national economy, fundamentals in the D.C. Trophy office market remained strong and many key indicators improved throughout the past two quarters.
Direct vacancy rates plunged to record lows, and rental rates soared to unprecedented highs, as Washington’s Trophy office market continued to outperform all other segments of the local commercial real estate market. Trophy properties recorded positive net absorption of 598,362 square feet in 2
007, compared with negative net absorption of all other asset classes in Washington, D.C.
With just one block of contiguous available space greater than 25,000 square feet in the Trophy market’s 11.1 million square foot existing inventory, direct vacancy plummeted to an all-time low of 0.4% at the end of 2007. These tight market conditions made leasing activity at existing buildings nearly impossible, and ignited abundant preleasing at under-construction buildings.
Supply
The inventory of Trophy office space in Washington, D.C. increased 3.0% over the past year to 11.1 million square feet, extending a supply-demand imbalance that has persisted in the market over the past several years.
Existing Trophy supply spanned 32 buildings, with another 2.1 million square feet under construction across eight buildings. This segment of well-located, premium product accounted for 10.8% of the overall inventory within the District’s 102.4 million square feet of commercial office space.
Only one block of direct space above 25,000 square feet remained on the market in existing buildings, a 27,924 square foot vacancy at 1301 K Street, NW. These tight conditions required tenants in the market to begin space planning far in advance of lease expirations at costlier under construction product, over a third of which was already preleased.
Vacancy rates maintained their consistent downward trend over the past several years in the Trophy market, and ended 2007 with rates 3.4% below winter 2006, from an already low rate of 3.8%. The prime vacancy rate among Trophy properties ended the year
at a record-low 0.4%; the addition of sublease space lifted the total vacancy to just 1.6%. Net absorption in 2007 was down across all asset classes in Washington, D.C., although the Trophy market’s share of net absorption reached its highest point in over a decade.
Demand
Comprising just 10.8% of the city’s total inventory, the Trophy market absorbed more space than all other asset classes combined, with gains coming despite exceptionally limited vacancy. Large tenants demonstrated a propensity to sign commitments 24 to 36 months in front of their lease expiration, which created backlog of demand in the market.
Leasing activity in the Trophy market during the past six months was heavily influenced by law firms and corporate government affairs offices. The 242,000 square foot lease by Mayer, Brown, Rowe & Maw, LLP at the under-construction 1999 K Street, NW, was the largest deal signed, but nine other leases over 10,000 square feet were also executed in D.C. Trophy buildings over the past six months. McKinsey’s 76,000 square foot lease at 1200 19th Street, NW, was the largest non-legal transaction.
Trophy net absorption totaled 377,529 square feet during the final six months of 2007, a 71.0% increase over the first six months of the year. The 598,362 square feet of positive net absorption in 2007 fell short of the 848,626 square feet of positive net absorption experienced in the previous 12 month period ending in the second quarter of 2007, and even further behind the 1,246,044 square feet of positive net absorption recorded in 2006.
The decline in net absorption was largely attributed to tight market conditions and a lack of available space. While the market averaged over one million square feet of positive annual net absorption over the past three years, that was virtually unachievable over the past 12 months based on the amount of space available in the market and the pace of new construction. The shortage of supply will continue to cause the majority of absorption to occur in under construction buildings, which remain the sole source of large blocks of contiguous available space.
Rental Rates
With available Trophy space at an absolute minimum, space continued to command a premium. Overall asking rents soared 5.0% from mid-year and 12.0% since year-end 2006 to an average of $55.11 NNN per square foot for existing and under construction product. Asking rates at sele
ct new developments approached $70.00 NNN per square foot, which brought D.C. closer to eclipsing the $100 full service per square foot barrier already prevalent in other major cities across the globe, including London, Tokyo, Midtown Manhattan, Hong Kong and Paris.
D.C. Trophy properties commanded a 59.1% premium to the overall D.C. office market, and the existing Trophy market’s 12.0% rental rate growth over the past 12 months far surpassed the 7.5% rate of increase of the broader market. While rents have soared in the Trophy market, concession packages have also become increasingly generous, with tenant improvement allowances for large deals averaging $65 per square and several months of free rent becoming the norm for large transactions.
Development
One property delivered to the Trophy market during 2007, the fully-leased 505 9th Street, NW. Law firms DLA Piper and Duane Morris took the bulk of the 322,668 square feet at the location, with two smaller tenants leasing the remaining space at the East End building.
Just two properties were slated to deliver in 2008: 1099 New York Avenue, NW, and 1155 F Street, NW, both of which have already secured partial tenant commitments from Jenner & Block and Bryan Cave, respectively. Few new options will materialize for tenants until 2009 and 2010, when six additional buildings are expected to deliver. Space at the eight Trophy buildings under construction ended the year 33.6% preleased, with three buildings already more than 50% committed.
Investment Activity
Investment sales activity slowed to a standstill in the second half of 2007, influenced by widespread issues in the credit markets. Over the past year, just one Trophy building traded hands, Franklin Tower at 1401 Eye Street, NW, which sold for $150 million, or $658 per square foot.
Portfolio sales in early 2007 resulted in the trading of the Willard Office building at 1455 Pennsylvania Avenue, NW, along with Market Square East & West at 701-801 Pennsylvania Avenue, NW, however each of these transactions closed during the first half of the year, and sales activity has remained dormant since then.
Outlook
The general economic malaise sweeping other parts of the nation should be mitigated in the D.C. market due to the extensive spending and steady employment presence of the city’s anchor tenant, the federal government.
Proximity to federal agencies and institutions, as well as access to key decision-makers and a network of business services professionals, makes well-located product in D.C. essential to government affairs and lobbying firms, whose demand for high-quality space and willingness to pay a premium for luxury building finishes continues to drive prices in the market.
Since corporate office space remains an important factor in conducing business and attracting and retaining personnel in the legal, government affairs and professional services sectors, demand should continue to thrive in the D.C. Trophy market among that tenant base.
In the months ahead, the District’s niche strength in government-oriented services and virtually recession-proof economy should provide sufficient stimulus and stability to deliver occupancy gains and rent increases to the Trophy market despite any potential challenges in the broader economy.
Contacts:
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