Washington, D.C., has historically been a strong market for commercial real estate, and local observers say the city is likely to keep enjoying that status in the long term—but not without first overcoming some short-term stagnation. For at least the coming year, Washington’s landlords and investors are likely to endure a period of flat activity as circumstances converge to create a paralyzing fog of uncertainty.

On top of a sluggish economy trying to find its footing, there are the political woes: the routine uncertainty caused by a presidential election, but also the likelihood that the federal government, one of the city’s largest tenants, will close and consolidate offices in coming years. In addition, the fractious battle in Congress over the budget and deficit reduction is spooking contractors, lobbyists and other professionals who depend on the government for their livelihoods, which is frustrating growth.

The current stasis is entrenched to a degree that’s unusual for Washington, says Scott Johnston, principal with New York-based Newmark Knight Frank. During past recessions, the government has often stepped up activity when the private sector has been hurting, Johnston says, and vice versa. “Now, unfortunately, we’re hitting where both sectors are falling below equilibrium,” he says. “It could be tougher than what Washington has seen.”

For a while, the outlook for Washington was a bit rosier. The anxiety of today follows a tide of growth that began in 2010, says John Germano, executive managing director of the Washington region for CB Richard Ellis. Back then, optimistic developers were building in the city while the rest of the country saw relatively little new activity. “All of a sudden, there was a tremendous investment appetite for all product types,” Germano says.

That changed last May with the escalation of the European debt crisis. “You put this level of uncertainty in the market, and it essentially paralyzed the market,” causing tenants to hunker down, Germano says. Few are making decisions about office spaces unless absolutely necessary. Meanwhile, fears about the federal government’s plans have prompted buyers to lower their bids: “Everything gets the hold button pushed on it.” Germano expects the uncertainty will persist for at least another 18 months.

“Anybody who is careful and who isn’t pressed to move is taking their time,” says Jeffrey Sussman, president of Property Group Partners (known as Louis Dreyfus Properties before December 2011).

A Cassidy Turley Office Market Confidence Index survey for the third quarter of 2011 confirmed the overwhelming attitude of hesitation. The survey of 82 respondents found that expectations for leasing activity continued a decline from the second to the third quarter. An indicator of current conditions for office sales did not increase for the first time since early 2009, and expectations for office sales dropped sharply, from an index of 75.4 to 47.3.

Meanwhile, vacancy rates in Washington began to rise in the third quarter of last year, to 11.5 percent, according to a study by the Greater Washington Commercial Association of Realtors. The quarter marked the first period of negative quarterly absorption since the first quarter of 2009. The overall average asking rent dropped by $0.47 to $49.17 per sq. ft.

Vacancy is likely to continue rising this year, says Paula Munger, director of research for the mid-Atlantic region for Cushman & Wakefield. Munger also expects rents to stay flat until 2014 at the earliest.

Spectre of budget cuts

Foremost among the discouraging factors affecting Washington are the government’s plans to reduce spending. With Congress mired in partisan posturing and bickering, the exact timing and nature of the cutbacks are not yet clear. But they’re likely to be of a sort that Washington has not previously experienced, says Jon Kaylor, a senior vice president at Boston Properties.

In the past, the government has sought to reduce spending by increasing outsourcing to the private sector, boosting growth in that area and keeping the Washington market on a more even keel. “But I don’t think that’s going to be the case this time,” Kaylor says. “It will be true downsizing in spending and staffing.”

Some observers play down the cause for alarm, arguing that Washington will be insulated in part from the impact of cuts because they will likely be made over a long period of time. “The federal government moves at a glacial pace,” says Scott Kubler, director of investment sales for NAI KLNB, based in Baltimore and the Washington area. “It ends up delaying the impact and spreading it out over a period of years. I expect it will give the area time to absorb that space and for private-sector hiring to offset that negative absorption.”

As leases expire, they may not be renewed,” says Germano of CBRE, summarizing the pace of change. “You won’t have this sort of tidal wave of vacancy that hits the market, like what happened in 2001, when the tech bust occurred.” At that time, 6 million sq. ft. re-entered the market “overnight.”

Germano and others say that contractors based in Washington’s suburbs will absorb the brunt of the impact of federal budget cuts, diluting the effects on those dependent on business within the city. Defense contractors in Northern Virginia in particular may be affected, Germano says, though over a period of several years.

The effect of cuts will also be mitigated by the cost of downsizing, says Munger of Cushman & Wakefield. “To downsize, you have to spend,” Munger says. “You have to move while space is being built out.” But the government has halted spending on anything to do with real estate. “The downsizing will happen, but it’s going to take a while.”

Law firms a bright point

Despite these setbacks, the city’s standing has still been relatively strong compared to elsewhere in the country, and some observers see reasons for cautious optimism. The city’s longtime durability has helped keep rental income relatively high even during the recession. According to a study by the Building Owners and Managers Association released on Dec. 7, total rental income in the city was $42.63 per sq. ft., second only to New York.

The sales market may continue to outperform leasing for at least part of the year, Johnston says, as low interest rates prompt investors to find a safe harbor for their funds. Buyers still see Washington as a desirable market, though the uncertainty of an election year may also end up putting a damper on their spending as well.

“Our levels of distress are nowhere near those of other urban areas that don’t have this federal government presence,” says Kubler of NAI KLNB. “Lenders have been a lot more patient with borrowers in our market. There’s more comfort that our leasing fundamentals are sound here.”

Some observers say IT companies may help take up slack left by the federal contraction. The city government is angling to draw Microsoft and other tech tenants to St. Elizabeth’s in the city’s southeast quarter as a campus of the hospital is redeveloped. MVM Technologies, a small ink-jet manufacturer based in San Clemente, Calif., has already announced plans to relocate to the site.

In addition, lobbyists and law firms still want to stay close to the action in Washington and continue to come to the area. Some small and midsized law firms have been opening new offices in the city in recent years. After adding attorneys last year, Stinson Morrison Hecker LLP relocated to a larger space in a recently renovated building two blocks from the White House. And Sterne Kessler Goldstein Fox will soon expand its offices at 1100 New York Avenue NW by 36,000 sq. ft.

A complication, however, is that some law firms are downsizing as their needs change. In some cases, attorneys now occupy offices that are all the same size, for example. And with technological advances, firms need less space for storing documents.

That’s a trend we’re seeing right now that will stabilize over the next couple of years, and when they bring in new people they’ll take additional space,” says Kaylor of Boston Properties. “Right now they’re right-sizing.”

“We in the development business are going to see a lot more of that, and the challenge is to build what they need,” says Sussman of Property Group Partners. PGP is looking mainly to law firms to occupy its Return to L’Enfant project, a 2.2 million-sq.-ft. project over Interstate 395 east of the city’s central business district.

Most commercial realtors agree that despite such trends in downsizing and the short-term federal gridlock, Washington will bounce back and remain a beacon for the usual buyers and tenants.

“The basics of the market are very appealing,” says John Germano of CBRE, citing the region’s high incomes, well-educated workers and competitive salaries. “When companies are looking globally at a labor market, the market in the metro D.C. area is better than almost every other market. Negatives are happening now, but still, so many positives are coming as well. I don’t see Armageddon coming.”