GOP Losses May Slow Market For Office Space in Washington

By Jennifer S. Forsyth
From

Republicans aren't the only casualties of last week's election: The Washington, D.C., office market is also likely to take a fall. Like most things in Washington, it will be mostly about politics.

Market experts warn there could be a kind of real-estate gridlock because spending programs may get hung up in power struggles between the Republican administration and the new Democratic-controlled Congress. They predict the resulting uncertainty and delay will curtail the signing of new leases by federal agencies and, more importantly, cause federal contractors to put off leasing. The upshot: One of the nation's most robust office markets could slow sharply starting next summer and remain in a swoon through the 2008 election cycle, says Joe Delogu, a Washington-based managing principal at real-estate brokerage house Jones Lang LaSalle.

Through leases and direct ownership of buildings, the federal government controls fully half of all office space in a market spanning two states and the District of Columbia. The District houses lobbyists, law firms and think tanks. Close-in Virginia near the Pentagon has traditionally been home to defense and intelligence contractors, and suburban Maryland has attracted life-science companies because it's close to the National Institutes of Health.

If defense spending slows, the biggest loser could be northern Virginia, which has benefited tremendously from the Bush administration's policies since the terrorist attacks of Sept. 11, 2001. The Maryland market may fare somewhat better if Democrats pass some health-related items on their to-do list, including a biotechnology bill that would encourage the development of new vaccines and treatment for possible bioweapons such as anthrax and smallpox.

Still, the blizzard of new offices due to come on line will hurt developers' prospects in the overall Washington market. More than 16 million square feet of office space is under construction in the area, with some of it expected to be ready by mid-2007, according to Stephen Fuller, director of George Mason School of Public Policy's Center for Regional Analysis. Tenants will lease only about four million of that this year, he predicts. "Everybody is building and very little of it is preleased," Dr. Fuller says.

Driving the construction has been a surge in federal procurements for everything from pencils to space vehicles. They were up 16.9% in 2003 and 19% in 2004, according to an analysis by Dr. Fuller in September. The commercial real-estate market followed in lock step due to the accompanying job growth. At the end of September, the District had the lowest vacancy rate in the nation at 6.8%, according to Reis Inc., a real-estate research firm. Landlords got big rent increases, and sale prices for buildings spiraled upward as investors elbowed to get in.

The government's spending pace has already slowed. While procurement numbers for 2005 still aren't complete, Dr. Fuller predicts the increase will be below the decade average of 8.8% and expects the rate to stay low in the next two years. Anthony Costa, the deputy commissioner for the General Services Administration's public buildings service, which serves as the federal government's leasing agent, says routine renewals of leases will occur, but he doesn't expect significant expansions.

The Democrats' big win -- and possible gridlock even though both parties have pledged to work together -- may exacerbate the situation. The only time that federal procurement flat-lined was in fiscal 1995, when the Newt Gingrich-led Republicans took over the House and battled a Democratic White House, though that freshman class came in with a mission to specifically cut spending. "Procurement contracting was held up by and large until about halfway through the fiscal year," Dr. Fuller says. "We got it all back finally, but it gave us about six months of slowdown."

Some developers remain bullish, particularly for the northern Virginia suburbs, where job growth remains strong. But with more than six million square feet under construction in northern Virginia and only about 25% of it leased, even the bulls expect some turbulence. "There may be some accommodation in the short term," says Kevin Dougherty, a managing partner of Crimson Partners, the developer of a $1 billion mixed-use project near Dulles International Airport that includes 1.5 million square feet of office space. He remains confident it will do well in the long term, along with other projects in desirable locations that are priced right.

Effective rental rates -- the price tenants pay after concessions -- have jumped 13% since the 2004 third quarter. Reis projects that rents will continue to climb over the next couple of years, but at a slower speed.

Even without gridlock, leasing around Washington tends to stall near the end of presidential terms. Top political appointees start to leave, and their posts may go unfilled pending the outcome of the election. And career federal employees become reluctant to make big decisions without the benefit of political cover.

When Robert Peck was the GSA's commissioner of public buildings from 1995 to 2001, he tried to push through a new headquarters for the Transportation Department. But as the end of President Clinton's second term approached, he sensed some reluctance. "People seemed to want to make sure that the next administration had the same view," says Mr. Peck. "Then, it was actually inked in the first few months of the Bush administration."

The controlling political party -- and its policies -- have long influenced Washington's suburban office market. During the early Clinton years, when health care and health-related spending was a top priority, tenants sucked up space in Maryland near the NIH. But the market slumped soon after President Bush was elected in 2000, in part because of the national recession but also because of a policy shift, says John Sikaitis, research manager in Washington for Jones Lang LaSalle.

The Maryland market has remained rather flat since then, but it could get a boost once again if the Democrats push through the biotechnology bill and succeed in passing federal funding for stem-cell research, a priority announced by California Rep. Nancy Pelosi, in line to become House Speaker, says Mr. Sikaitis.

Meanwhile, the recent elections, combined with so many new buildings under construction, may hurt the market in northern Virginia. Military spending, particularly on big-ticket weaponry, may slow, squelching the need for contractors to get bigger offices. Even if some sizable contracts continue to be awarded, brokers say that many defense contractors won't need more space because they leased extra square footage in the past few years to accommodate future growth. "They've already anticipated it," says Mr. Peck, now a senior vice president for Staubach Co., which has a contract to represent the GSA as a broker.

Furthermore, a senior Pentagon official says there's likely to be a reduction in new leasing close to Washington as the Defense Department begins to implement recommendations of the Base Realignment and Closure Commission. The Pentagon plans to move some offices to more secure military bases by November 2011. The recommendations, if implemented, would mean a shift of 22,000 jobs and empty out 4.5 million square feet. Defense-related companies will probably wait to see how the recommendations play out, and make their real-estate decisions accordingly.

The Democrats' win may not be all bad news for landlords in northern Virginia, where the Central Intelligence Agency and a number of intelligence contractors are concentrated. Some Democrats are urging more spending on intelligence, even if they oppose the war. Problem is, it's hard for developers to count on those leases because they are often cloaked in secrecy. Says Jones Lang LaSalle's Mr. Delogu, "the intelligence agencies are not going to write you a letter telling you they've just acquired one million or two million feet."

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