Washington, D.C. owes its status as the nation's tightest office market to a vibrant local job market. The metro area produced nearly 37,000 new jobs in 2003, many of them within its thriving legal and governmental arenas. That, in turn, helped to drive down the office vacancy rate to an enviable 8% by year's end, reports Grubb & Ellis.

The mix of low vacancies and new jobs has proven to be too tempting for office developers to resist. Indeed, roughly 5 million sq. ft. of office space is under construction today in downtown D.C., and a full 3.1 million sq. ft. of that is speculative.

That begs a question: Can the market absorb so much space? The consensus among industry experts is a resounding “yes,” but there's a growing concern that the movement of existing tenants into this new stock of Class-A space could increase vacancy within the area's older stock of buildings.

“We're setting ourselves up for a lot of competition in the trophy market, which will give those tenants seeking the best space lots of options,” says Randy Harrell, senior vice president at Grubb & Ellis' Washington, D.C. office. Not only is there a strong chance that fresh Class-A space will draw well-heeled tenants from the best Class-B buildings, it will also force the city's Class-B owners to engage in cutthroat battles for these tenants.

Harrell, for his part, doesn't believe that this new space will cripple the market. “Washington is a market with deep roots. Defense spending and the legal sector have fueled leasing demand here and will likely continue to do so,” says the broker.

Local economists predict that the D.C. metro area will add 160,000 new jobs over the next two years. Historically, 55% of all new jobs in this market require office space, according to Advantis Real Estate Services. So with an average of 250 sq. ft. per employee, the D.C. metro market is poised to generate 22 million sq. ft. of net absorption over the next three years.

“The new supply does present some risks. But assuming that leasing demand by the government remains strong, we think that vacancy should stay in the single digits,” says Jim Costello, a senior economist at Boston-based Torto Wheaton Research.

On the supply side, downtown Washington, D.C. will see 3 million sq. ft. of new office space delivered this year alone. Another 1.3 million sq. ft. of space will come on line in 2005. Brokers suspect that vacancy rates will tick up this year as many existing tenants move into pre-leased, brand new space. The space that they vacate, of course, will ultimately need to be backfilled.

Class-B office vacancy in the metro market jumped 40 basis points between the beginning and the end of the first quarter to 9.2%. What's even more distressing for owners of Class-B or older Class-A properties is the Grubb & Ellis projection that a full 15% of all downtown office buildings will be less than three years old by 2005. Meanwhile, Class-A inventory is expected to grow by 5.7% this year alone, which would follow the 6.3% increase in 2003. All of this adds up to heated competition between Class-A owners for large tenants.

Despite the spike in new Class-A space, Harrell doesn't seem too worried about droves of tenants fleeing Class-B office buildings. The reason, he says, is pure economics: “There's still a $20 per sq. ft. delta between Class-A and Class-B space,” he says. At the end of the first quarter, Class-A space in the CBD cost roughly $42 per sq. ft. Doing Harrell's math, that makes Class-B rental rates in the CBD somewhere around $22 per sq. ft. “And that's enough of a spread to avoid a tremendous flight to quality.”

WASHINGTON, D.C.: HUB OF OFFICE DEVELOPMENT

Washington, D.C. trails New York City in the amount of new downtown office space under construction, but the nation's capital has the highest percentage of office space under construction relative to its existing stock.

Total Inventory* Total Sq. Ft. Under Construction* % of Stock
Washington, D.C. 85.2 million sq. ft. 4.9 million sq. ft 5.9%
Chicago 120 million sq. ft. 3.9 million sq. ft 3.2%
New York City 346 million sq. ft. 6.3 million sq. ft 1.8%
*Downtown areas only.
Source: Torto Wheaton Research