The close-in suburbs of Northern Virginia are seeing the most growth as the metro Washington, D.C., area emerges from the economic doldrums left by the recession of the late 1980s and early 1990s.

Overall vacancy rates for commercial office space in Northern Virginia dipped into the single digits, falling to approximately 9.2%, a decline of 52% since its peak in the spring of 1991. That's below the overall vacancy rate for commercial office space in Washington, D.C., which ended 1994 hovering around 11.8%. Suburban Maryland was even further behind with an overall vacancy rate of 18.3%, its highest level since -the first quarter of 1992.

"There has been a power shift be. tween the three jurisdictions," says Thomas G. Owens, executive vice president of Spaulding & Slye in Washington, D.C.

According to Owens, the District of Columbia is still suffering from a lack of faith in local government leadership as well as a fear among tenants that taxes will increase as the city at, tempts to deal with its deepening financial crisis.

The area is still feeling so%e of the residual effects of the dramatic over-building that occurred in the 1980s, but the lack of new development has helped to strengthen the market as it moves into the second quarter of 1995. This year saw the groundbreaking of a major speculative office project for the first time in five years; the Kaempfer Co.'s 1900 K Street, N.W. The 340,000 sq. ft. building, already 56% pre-leased by two law firms, is scheduled for completion in July 1996.

The District may have to rely on the strength of the private sector to recover completely, as the federal government continues on its course of reorganization and downsizing. Currently, the government occupies about 300 million sq. ft. of private office space in the region, according to Bruce R. Baschuk, senior vice president, corporate services, for the Washington-Baltimore Region of CB Commercial.

With 50% of the approximately 8 million sq. ft. of GSA leases in Washington, D.C., scheduled to expire between 1995 and 1998 - much of it in functionally obsolete office buildings requiring major renovations -- there's bound to be some jump in leasing activity by the public sector, according to Randolph C. Harrell, senior vice president and managing director of Smithy Braedon*Oncor.

From Submarket To Submarket

Although hopes were high that 1994 would end m a positive note for the D.C. office market, net absorption for the year was negative, with 44,000 sq. ft. of additional space returned to the market.

"Everyone thought that the vacancy rate was going to decline because there was no delivery of new product, but no one took demand into account," says T. Cristopher Roth, area managing director for the Mid-Atlantic Division of Trammell Crow.

Four of the District's seven submarkets ended the year with negative numbers, according to Carey Winston's Year-end Report, including the CBD, with a total negative net absorption of 352,000 sq. ft. at year's end.

The first quarter of 1995 has seen some renewed vigor in leasing activity in the CBD but the traditional heart for the city's business has not yet fully recovered.

According to the Carey Winston Report, the CBD experienced negative net absorption despite the fact that some of the largest lease transactions of the year were signed for buildings in this submarket. Currently, rental rates in the CBD, according to Carey Winston, are ranging from $27 to $39 per sq. ft. for Class-A, full-service; Class-B rental rates are ranging from $21 to $29 per sq. ft. These rates are second only to the East End, the only place in town where large blocks of contiguous space are still available.

"It's basically a two-tiered market in D.C. right now," notes Lance Ford, vice president of the Cafritz Co. "If you're a tenant tooking for more than 200,000 sq. ft., you might have two or three choices; but if you're a tenant looking for 5,000 sq. ft., you probably have 5,000 options," he said. "The East End has been the hot bed of activity because it's been the only place where new large blocks of space were available. Now what we're seeing are Class-B and -C buildings undergoing renovation to get larger blocks of space."

The East End

The East End finished 1994 with a positive absorption of 466,000 sq. ft., where current full-service rental rates are ranging from $28 to $42 per sq. ft. According to Carey Winston, 60% of all new office development in Washington since 1988 has been in the East End.

The fact that so little space exists for large users in Class-A buildings should help spur future development, although many in the industry contend this will mostly be build-to-suits or heavily preleased, rather than purely speculative deals. Larson, Ball & Gould Inc., reports in its 1995 First Quarter Overview, that the vacancy rate for new Class-A space in the District is down to 2.7%, decreasing by some 700,000 sq. ft. since the first quarter of last year. Larson, Ball & Gould also notes that developers and owners now seem a bit more aggressive in terms of speculative projects; in some cases they are accepting a 30% to 35% prelease commitment as viable rather than waiting for a 60% to 70% commitment.

News that the long-proposed sports and entertainment arena at Gallery Place in the East End may move forward is positive for the real estate industry. There are indications that groundbreaking on the complex could begin as early as the fourth quarter of this year.

"I really look to the arena as having a positive impact on the District," says Christopher R. Ludeman, executive vice president and regional manager of CB Commercial. "The view of D.C. will be greatly enhanced, and the downtown will improve. It should spur development and redevelopment in the areas due south of China Town, and just north of the Old Hecht's Department Store, a part of town that could use a shot in the arm."

Investment Activity

After several years of "vulture buying" in D.C. and its surrounding suburbs, prices have started to inch up as both institutional and foreign investors return to the market. In addition, almost all of the problem properties, many in the hands of banks and the Resolution Trust Corp., are no longer on the market.

Julian J. Studley reports that a number of Class-A buildings are actively being marketed, and several Class-B and -C buildings are under contract for closing later this year. Recent transactions include Hines Interests Limited Partnership's purchase of 370 L'Enfant Plaza for $78 million, and Starwood Capital's purchase of 1401 K Street for approximately $6 million.

The largest sale was in the East End, with the Government of Singapore's purchase of 901 E St., N.W., for $66 million, or $280 per sq. ft. According to Business Real Estate Information Corp., there were approximately 30 office building sales in the District in 1994, with an average sale price per sq. ft. of $108.

Although D.C. ranks among the top five markets for investor activity in 1995, according to Landauer Real Estate Counselors and the Real Estate Research Corp., there is still some resistance on the part of buyers to pay more than replacement costs, which are somewhere in the vicinity of $300 per sq. ft., according to John P. Kyle, senior managing director of the Washington region for Julian J. Studley.

"What tenants have done is trade up from Class-C buildings to Class-A without a substantial difference in rents," says Kyle, "and that has produced two phenomenons in Washington: the owners of the Class-A buildings aren't in a position to sell because of lower rents and lower cap rates, and the owners of older buildings either have to make the capital investment necessary to upgrade or do an arm's length transaction to a third party."

Ryan M. Lorey, senior vice president of investment sales for Barrueta, says that foreign and domestic groups still have strong confidence in the trophy buildings in downtown D.C., and that most foreign investment dollars come to urban, not suburban, markets.

Northern Virginia

The recent purchase of two office buildings totaling more than 500,000 sq. ft, and a parcel of land zoned for office development in Arlington by a Florida pension fund for $95.4 million has stirred hopes that the suburban Virginia market is getting tight enough to support new construction, with many larger users particularly considering the option of build-to-suit.

With a vacancy rate of 1.6%, Crystal City had the lowest overall vacancy rate in all of Northern Virginia at the end of the first quarter of 1995, according to Cushman Wakefield. This submarket was significantly helped by the Department of Defense's lease at Presidential Tower.

Tysons Comer also is a strong market right now, boasting a net gain of 673,206 sq. ft. for 1994, according to Smithy Braedon*Oncor's statistical data. Of note was America Online's leasing of 44,049 sq. ft. at the Westward Building VII.

America Online also helped to strengthen the Reston/Herndon market with its purchase of the 235,000 sq. ft. building that formerly housed Tandem Computers. The Herndon market saw its vacancy rate decrease by 45% in the last 12 months to 7.4%, says CB Commercial.

The northern Virginia market also showed significant strength on the industrial/flex side. According to Barrueta's Lorey, there was a surprisingly strong user market acquiring industrial/flex space in Northern Virginia. But what is most striking, he says, is the large volume of flex industrial sales. "We had in excess of 1 million sq. ft. of flex/industrial that closed during 1994," says Lorey.

Suburban Maryland

Like the office market, industrial/flex is recovering more slowly in Maryland than in Northern Virginia. In Prince George's County, where there was already significant overbuilding, the addition of a few large blocks of space, particularly in the Landover/Capital Heights area, has caused a lull in the flex/industrial market. Overall, however, both Prince George's and Montgomery counties' flex/industrial performance was not as disappointing as the office market.

During 1994, according to Tara K. Schneider, a senior market analyst for Smithy Braedon, suburban Maryland lost a net 624,807 sq. ft. of occupied office space, compared to 1993's year-end net gain of 3.6 million.

Montgomery County was particularly hurt by the addition of a significant amount of second-generation space on the market. Such large influxes of space dampened the market, despite some significant lease signings: Martin-Marietta and New York Life committed to more than 70,000 sq. ft. and 23,000 sq. ft., respectively, in North Bethesda.

Hospitality

In 1994, the hotel market in the metropolitan area continued its recovery from the low points of 1991 and 1992, with both occupancy and average daily rate increasing in almost all submarkets. In addition, the first quarter of 1995 has seen a flurry of renovation activity, especially among the higher-end properties.

"The suburban markets, with the exception of Prince George's County, have done better in percentage increases compared to D.C., but the whole region is emerging from the slump of previous years," says Robert T. Koger, vice president of C.J. Molinaro & Associates, a hotel brokerage company in Fairfax, Va.

Significant overbuilding during the 1980s hurt the hospitality industry throughout the metropolitan area during the recession, and average daily rates suffered across the board. They have been rebounding this year, but no new construction is on the horizon. The $15 million renovation of a historic downtown office building will be the first new major hotel in the District since the Chevy Chase Pavilion opened in 1991.

Still, acquisitions were strong in 1994, compared with the prior two to three years. "In 1994, there were approximatety 20 hotel properties sold in the Washington metropolitan area," says Koger. "Most of the properties sold have been in the mid-market range, primarily because most of the hotels sold fall into that category. Properties at the four-star, full-service range are difficult to obtain in an improving market because sellers are more reluctant to sell those assets." One significant transaction was the sale of the Holiday Inn Crowne Plaza downtown, which was purchased by Marriott for $46.5 million and converted to a Marriott Hotel.

Multifamily

The multifamily industry in the Washington metropolitan area kicked off 1995 enjoying high occupancy numbers and rental increases after three years of enduring a totally flat market.

"The rental market has gotten consistently tighter in the last 12 months," notes Thomas Bozzuto, president of the Bozzuto Group, which manages 3,500 apartment units in the metropolitan area. "Concessions have basically gone away and we're seeing net rent increases across our portfolio averaging better than 5%." Bozzuto says that all of the submarkets in the area are enjoying higher occupancies, including Prince George's County and downtown Washington, particularly in the luxury properties. In fact, Bozzuto is involved in a joint venture that will open a high-end property called Westbrook at 22nd & N streets, N.W. - the first new project downtown in several years.

According to Delta Associates, because most submarkets are experiencing vacancy rates at or below 5%, and in the hottest submarkets in both Virginia and Maryland, vacancy has dipped to as low as 2%.

Delta reports that there are likely to be 3,631 Class-A garden and high-rise apartments delivered in Northern Virginia within the next 18 months. Of these, 1,387 units are currently under construction. Yet this may not be sufficient to satisfy current demand of 2,500 to 3,000 units annually, plus pent-up demand. Delta foresees that demand will continue into the 1995-97 period, translating into continued sharp rental rate increases over the near term.

There is also a lot of investor interest for multifamily in the Washington metropolitan area, according to Dick Michaux, chairman and CEO of Avalon Properties.

Financing for new development is becoming available now. "There is clearly still a requirement for equity greater than there was in the 1980s. The lending standards are tougher," says Michaux, "but this recent run-up in rents in some submarkets has created the economics that can attract the capital in a limited fashion."

Tom Bozzuto has a similar assessment. "Most of the people who are starting new projects are REITs but there are several of us getting financing from insurance companies and pension funds," he says, "and the banks are willing to make financing available if you have a lot of equity." He notes, however, that "one thing that has changed for the negative from last year is that the people looking to buy properties appear to be in the market with higher capitalization rates than a year ago; now it's in the 8 3/4% to 9% range, where a year ago it was 8 1/4%." Bozzuto attributes this change to the overall rise in interest rates that has put pressure on the REITs, who were among the biggest buyers last year. "From what I'm hearing the buyers in the market right now are pension funds and insurance companies," he says.

Retail

"The retail market is vibrant in Washington, D.C., not booming, but it's very vibrant," says Howard W. Mersky, vice president and director of retail services for Carey Winston.

Howard Biel, a partner with Faison Northeast Retail, agrees that the retail sector is strong in metro Washington, D.C. A key factor of the sector's strength, he says, is "The emergence of new box store players simultaneously attacking the market, such as Target, Kohl's, Dick's, Bob's and Homeplace."

The trend in suburban retail continues to be "bigger is better" says Steven Graul, CCIM, vice president of retail services for Barrueta. "There are more tenants looking for retail space right now than there is space available," says Graut.

Target is expected to open between 15 to 20 stores in the area, and Wal-Mart and Sam's are already midway through their program in this region. Super-style bookstores in the 25,000 sq. ft. range have also entered the market.

Mersky says, "These category killers are now beginning to look for sites aggressively in the central core of the city and into the more population-intensive and office building-intensive markets such as Bethesda and Chevy Chase. Such sites are hard to find so it's really creating the opportunity for brokers and developers."

One interesting trend is what Graul calls "a whole new generation of retail" that's about to occur nationally: the entertainment, specialty-themed retail project. One major mall in the Washington area, White Flint in Rockville, which struggled financially after the renovation of the nearby Montgomery Mall, has been retenanted and remerchandised.

The same type of remerchandizing is being done at the Tysons Galleria, an upscale mall owned and managed by Homart. Dan Foy, director of Tysons Galleria, says the mall has had double digit sales increases since its remerchandising program began. The mall is currently courting specialty tenants, restaurants and services, although Foy notes the Galleria's main emphasis will remain on shopping.