Articles

Real Estate Best Practices: Interpreting Market Trends

By: Mike Norris of Scheer Partners, Inc.

You’ve seen it. You’ve read about it. The cranes are back again. Just five years after the last cycle’s oversupply of office space in the Dulles Corridor, developers have broken ground on nearly four million square feet of new office space in about forty buildings, and only 700,000 square feet (or 18%) is pre-leased. The Dulles Corridor historically registers one million square feet of net absorption (the difference between space that gets occupied and space that gets vacated) each year; at it’s peak, the market absorbs a net of 1.5 million square feet. Therefore, in addition to the 700,000 square feet that’s pre-leased, the market needs to lease another one million square feet in addition to the market average of two million square feet in the next two years just to maintain current market rates.

To give you a sense of what it takes to fill that much space, let’s assume you allocate 250 square feet per person (about average). You would need 13,200 net new jobs to absorb the new space and keep the existing space occupied at its current level (about 89%). Historically, Northern Virginia creates 35,000 new jobs each year; the area’s created closer to 50,000 new jobs over the past few years, so let’s use that number as the initial benchmark. Fairfax County is the rough equivalent of the sum of all other Northern Virginia jurisdictions, accounting for half of Northern Virginia’s new jobs each year and about a third of the Washington DC area’s job growth. Recent annual job growth in the county has been in line with these proportions, as approximately 25,000 new jobs have been created each year. The Dulles Corridor represents about half of the county’s office space, so let’s assume 12,500 new jobs are created in the corridor each of the next two years, so that’s 25,000 total. About three-quarters of these jobs are jobs requiring office space, so 18,500 new office jobs in the next two years is about what will be created when we only need about 13,200 new office jobs. Even if there’s a lot of shadow space (space companies are carrying in anticipation of hiring additional employees) out there, the market should remain stable, if Northern Virginia can keep creating 50,000 jobs each of the next two years.

Now let’s take a slightly less optimistic look. If we use the historical average, Northern Virginia will create 35,000 jobs each of the next two years, which translates into 12,950 new jobs in the Dulles Corridor-slightly less than what we need if there is no shadow space and not enough to prevent the new supply from adversely impacting the market if there is a statistically significant amount of such space. There are a couple of other potentially limiting factors to net absorption as well. You’ll notice that there are no projected space deliveries in the later half of 2008 and beyond; how many more proposed and approved buildings will break ground in the near future on a speculative basis? Also, telecom convergence is allowing us to work more efficiently and remotely; we’re seeing more technology companies replace the more traditional structured offices with more collaborative and hoteling space. Therefore, perhaps each new employee won’t need as much space.

Now let’s examine the threats to job growth. The most glaring is government spending not continuing at current levels. Procurement has risen exponentially over the last four years and the Dulles Corridor has been one of the most direct beneficiaries. Will government spending continue to grow at the same remarkable levels to yield enough jobs to offset it’s portion of the supply of new office space? Another potential threat to Dulles Corridor job growth is cost. Stabilizing the office market over the next two years would simply justify rents remaining at current market levels (about $26 per square foot for Class A office buildings)-not the kind of appreciating rents (closer to $28-30 per square foot) landlords that bought into this market over the last few years (or developers that are building within this market) will need to meet their pro formas and offset their construction/buildout costs. We’ve already seen some companies, once they grow to beyond a couple hundred employees, choose to expand in another market outside of the Dulles Corridor. Areas like Prince William, Stafford and Fredericksburg have become more popular for reasons such as Base Realignment And Closure, facility security requirements and lower cost ownership opportunities.

In interpreting this data, the Dulles Corridor’s current and prospective tenants facing near-term real estate decisions should surmise that if they don’t believe that we’ll achieve the required growth described, signing a 2-3 year lease is a better market strategy then signing for a longer term (say 5 years), notwithstanding any overriding business objectives that need to be met. Companies whose decisions are further out (1-2 years) should not rush into any real estate long-term real estate transactions either; rather, they should assemble a real estate team to relate their business priorities to current and projected future opportunities to determine the appropriate short and long term paths. They should not simply assume that market rents will continue to rise. Market rates are likely to increase as space is absorbed over the next two years, but at some point soon thereafter, we may be headed toward more of a “tenant’s market” in the Dulles Corridor. Historically, the market is stronger at any point ten years later then the reference year, but the market 3 years from now will need recent job growth levels to persist given what’s already in the development pipeline and what is projected to be when compared to projected demand. The challenge is that as the market has improved and tenant buildout costs have risen, more landlords are commanding at least a 5-year term to recoup transaction costs and stabilize their assets. This dynamic requires tenants-and their real estate advisers-to be more creative in formulating opportunities to achieve the most favorable market terms, while ensuring that transaction structure is in line with the company’s business goals.