While market conditions slowed to a standstill as conservatism swept through the office market, job growth in the region was resilient. Although the country has lost 760,000 over the past nine months, job growth in the DC region has actually increased from several months ago as the cushion of the government and its contractor base allowed the Metro DC economy to add 44,600 jobs in the 12 months ending August 2008. Additionally, unemployment remained two full percentage points below the national average at 4.1%. Over the past six months, as the national economy slowed, Metro DC's job growth accelerated, nearly doubling the 22,000 jobs created in the twelve months ending March 2008 by reaching its current level of 44,600 jobs. The job creation should fuel additional office sector requirements in the first half of 2009 even as most metropolitan areas around the country have recently experienced contracting payrolls and occupancy declines.

Despite significant job creation, an aggressive development cycle in all three jurisdictions coincided with the slowdown in demand, shifting leverage to tenants in the vast majority of product types and locations over the past few quarters, which will undoubtedly linger for the coming quarters into the latter part of 2009, at a minimum.

In the third quarter of 2008, the metro DC marketed posted a decline in overall occupancy for only the second time in the past six years. Occupancy declines largely stemmed from the addition of sublease space from financial-related companies in Chevy Chase, Silver Spring, and Bethesda, along with Tysons Corner and Fairfax Center in Northern Virginia, as well as government contractor space coming back to the market in Northern Virginia. In total, the metro DC office market posted negative net absorption of 198,503 square feet in the third quarter, shifting occupancy gains throughout 2008 down to 1.8 million square feet.

As occupancy has stalled or grown at slower levels, supply has increased substantially due to increased development activity. New supply has outpaced occupancy gains by a four to one ratio in 2008 as 7.2 million square feet have been added to the market in 2008. Since the beginning of 2007, the same trend illustrated that 12.1 million square feet of new supply has been added to the market, while tenant demand has driven only 3.1 million square feet of occupancy gains. As a result of this stretched supply-demand imbalance, tenant's available space options have skyrocketed 34.5% since the beginning of 2007. From the vacancy perspective, vacancy rates region-wide have shifted up from 8.1% at the beginning of 2007 to 10.5% at the end of the third quarter of 2008. When tacking on sublease space, total vacancy rates shifted up from 9.5% at the beginning of 2006 to 12% at the end of the third quarter.

Rental rates, which have grown over the past five years, have begun to demonstrate signs of softening in certain markets, while flat out declining in markets where new supply issues have altered market dynamics greatest. Overall, the metro DC average rent decreased slightly in the third quarter from $35.06 per square foot in the second quarter to $34.96 per square foot in the third quarter. While asking rents remained only slightly depressed, net effective rents were down more than three to five percent, depending on the product and location type. The greatest net effective declines have been realized in the Toll Road markets in Northern Virginia and the I-270 Corridor in Suburban Maryland, where tenant improvement packages and free rent in new developments have eclipsed $65 per square foot and six to 12 months of free, respectively, at a minimum. Significant softening in net effective rents was also evidenced in the Commodity Class A market in the core markets of the CBD and East End, where numerous additional options have delivered or will deliver to the market over the coming quarters. As a result, the vast majority of these buildings, that were quoting $58 to $60 per square foot rents at the end of 2007, were marketing rents in the low to mid $50's per square foot at the end of 2008 with several months of free rent and a minimum tenant improvement allowance of $65 per square foot.

The District has been characterized by a tale of three markets... the core CBD and East End product, outlying core product and emerging market product with respect to both supply and demand market fundamentals. Trophy market dynamics remained very tight and were expected to maintain tightness due to the stable and growing tenant base of law firms, lobbying firms and government affairs offices. As a result, vacancy measured 1.7% with rents growing marginally at 3%.

However, Commodity Class A space continued to flood the market within the CBD and East End, leaving vacancy at the end of the third quarter hovering near 13%, offering tenants an abundance of large and small options. Finally, the Southwest, NoMa, and Southeast continued to reel from lack of demand and an exorbitant amount of new supply hitting the market with minimal preleasing to date.

As a result, vacancies in these submarkets finished the quarter in the double digits and could realistically double over the next 24 months with more than six million square feet under construction and minimal preleasing to date. In square feet under construction with just 24% of the space preleased, which will lead to record high vacancy levels over the short-term and downward pressure on rents.

In Northern Virginia, net absorption tailed off after a gain of 1.8 million square feet during the first half of the year. 418,337 square feet of negative net absorption during the third quarter resulted primarily from outflows in Fairfax County, where Merrifield, Route 28 South, Reston, and Herndon registered the most significant losses. Vacancy increase and negative net absorption outside the Beltway was fueled by consolidations, downsizings and an increase in sublease space. 2.3 million square feet were available for sublease in Northern Virginia at the end of the third quarter, an increase of 6.0% over the past three months.

As a result, vacancy rates continued to rise in outlying markets, particularly the Toll Road and Route 28 Corridor, where new construction activity has exceeded tenant demand. However, dynamics inside the Beltway remained tight, with Alexandria and Arlington County still supply-constrained. These two jurisdictions had direct vacancy rates of 7.6% at the end of the third quarter as premium locations and Trophy buildings continued to outperform the broader market, with Reston Town Center, the Rosslyn-Ballston Corridor, and Tysons Trophy assets garnering the highest rents and lowest vacancy rates across the region. In comparison, other parts of Fairfax, Loudoun, and Prince William Counties displayed vacancy levels of 13.7%.

New supply will continue to remain in an issue going forward as planned fourth quarter 2008 deliveries totaled 923,401 square feet, and were just 9.5% preleased.

The full pipeline through 2011 totaled 3.0 million square feet, of which 19.9% was preleased Suburban Maryland's market remained slow with demand concentrated in the urban markets of Chevy Chase, Bethesda, and Silver Spring, where market fundamentals remained tight. However, along the I-270 Corridor, Rockville Pike and in Prince George's County, demand levels remained depressed, while new supply continued to deliver to the market. As a result, rents levels have declined and space options continued to jump. A promise of increased life science dollars in 2009 and 2010 are now unlikely as well as the vast majority of federal spending initiatives is likely to be funneled to the Treasury, SEC, and FDIC, agencies located in the CBD, NoMa, and the RB Corridor, respectively.

Unlike most office markets around the country, which are preparing for significant amounts of disposition space to be returned to the market, or at the very least, a substantial reduction in tenant demand, the Metropolitan Washington, DC dynamic is different. Times of peril precipitate a renewed focus on oversight and governance, as the nation turns to the federal government for solutions and safeguards. Government grows in times of crisis.

There was a reason why in the last economic downturn, the Metro DC economy continued to grow, while other metropolitan areas experienced significant job losses. The infusion of federal procurement dollars into the local economy helped generate thousands of jobs across the region, and consistently kept unemployment rates between 1.6 and 2.0% lower than national averages.

Requirements that agencies like the FDIC, SEC, and Treasury are likely to generate as part of their enhanced role in financial oversight and regulation will provide a cushion to offset potential losses in other sectors. Organic growth among federal agencies themselves is likely to be augmented by requirements among government contractors and support service providers, similar to past expansions. While this scenario certainly provides a unique benefit to the region, it will not completely bail the region out of its current condition. Rather, a new equilibrium must be achieved based on Metro DC's unique supply and demand characteristics.