The tone was downbeat at a recent statewide commercial real estate conference in Richmond. Report after report noted high vacancy rates and tenant defaults following the bursting of the high tech bubble two years ago. But when J. Scott Adams of CB Richard Ellis and R. Clay Culbreth of Advantis Real Estate Services Co. ended their sober presentation on the Hampton Roads market, they broke into comedy to liven things up. Donning wigs, they launched into their interpretation of Sonny and Cher's signature song from the 1960s, rewritten as "We've Got Space, Babe!"

The duo drew hearty laughs, but many of the brokers who attended the Certified Commercial Investment Members (CCIM) confab remain wary. It's been a decade since the office market has been glutted with so much space. "For lease" signs are out in force. Hardest hit are high technology firms, especially telecommunications companies, which saw few limits to their growth in the late 1990s. Vacancies are worst in the high-tech corridors of Northern Virginia, which has seen the implosion of attention-grabbing tech firms such as Teligent, PSINet and XO Communications. At the end of the first quarter, the rate for office vacancies was 25 percent in Herndon and 17 percent at Tysons Corner.

Taking a cue from Adams' and Culbreth's zaniness, the Virginia commercial real estate industry is regrouping by coming up with imaginative new ways to lease or sell space. They're handing out goodies that haven't been seen in years to brokers and leasers alike. Closing a deal can bring a bonus, commissions, a trip to the Bahamas or a Rolex watch. "If you do a big deal you can get a Porsche in addition to your commission," says one Richmond area broker. Open houses for brokers, which many in the industry thought were disappearing, are coming back as a way to boost traffic. Many of these feature raffles for even more dinners, trips and goodies.

Such incentives, including bonus commissions, which can raise a broker's 3 percent commission to as high as 6 percent, are not isolated to Northern Virginia, where conditions are the worst. Even in Innsbrook, one of the tighter markets in Richmond, there are deals to be had. After incentives are thrown in, rents may be discounted by as much as 10 percent to 20 percent, says broker Mark Douglas of Insignia Thalhimer in Richmond. As a recent CB Richard Ellis flier for Innsbrook's HRH building advised, "We are offering $100 cash to any broker who brings a client that needs 10,000 square feet or greater through for a tour of the building." Each time brokers show the site, they are also entered into a raffle for a Bahamas trip for two. Previous offers included a two-year lease on a BMW 23 and a trip to Europe.

In many markets, the oversupply of office space means lower rents. Before the glut, space that was going for $30 a square foot now rents for $20 a square foot, says Chip Ryan, executive director of Cushman & Wakefield, a real estate firm in Tysons Corner. Yet unlike the last real estate bust in the late 1980s and early '90s when developers overbuilt, tenants drive the problem this time. Thinking big and outside of the box, Internet and telecommunication companies drove up demand for office space in the late 1990s. By the time the party was over in mid-2000, many didn't have the business to support big leases. Business failures dumped a lot of space back on the market. It's the major reason for Northern Virginia's overall vacancy rate of 13.6 percent at the end of this year's first quarter, up from 11.9 percent in 2001. Currently, the region has more than 19 million square feet of available office space, including more than 7 million of vacant sublet space.

Lease and sublease activity picked up during the first half of the year, but it's nowhere close to what the sector needs to support itself heading into the slower summer months. Fortunately, though, for Northern Virginia, federal agencies and government contractors are scouting for space as a result of increased defense and security spending. The government's presence and other well-entrenched businesses have the ability to weather the current economy. Much of the activity is close in to Washington around Rosslyn, Crystal City and Ballston.

Another positive sign that things are picking up: Sublease space for the region actually declined by 208,808 square feet by the first quarter's end. Recent deals include the Office of Navy Research taking 311,000 square feet, the Department of Labor, 85,000 square feet, and SRI International 60,000 square feet in the Rosslyn/Ballston area. Microsoft is moving workers from the District to 50,000 square feet at Reston Towne Center and will create new jobs at a 100,000-square-foot sublease site in Ashburn. In one of the first quarter's largest transactions, IBM Corp. is subleasing 110,000 square feet in Reston for an expansion of its government services group. VeriSign is leasing 400,000 square feet of space in Herndon in what was formerly the home of Winstar, a telecommunications company that went bankrupt and was acquired by another firm. And Rosslyn's Twin Towers, the home of Gannett and USA Today until they relocated to a new Tysons Corner corporate campus, has been fully leased. Among the tenants is WJLA-TV, which moved from the District and leased 84,000 square feet.

Many real estate executives say they believe the market is bottoming out or close to it. Yet many of the same people have been saying the same thing since last summer. "It's a safe thing to say," says Mark C. Larsen, president of Larsen Commercial Real Estate Services in Reston. "I think we're closer to the bottom than we were six months ago," he says. Other brokers suggest some markets could have an inventory of available space for a year or so.

Though space is clearly being absorbed in Northern Virginia, hundreds of thousands of square feet will come back on the market in the next year or so as new construction is completed. Freddie Mac is expected to move into its new 225,000-square- foot building next year in Herndon and will vacate a slightly smaller space. And Capital One Financial Corp. will give up several properties when it moves into its new McLean headquarters.

Filling any space is difficult, but none more so than in the sublease market. While prospective tenants can find some good deals, they also must worry whether their landlord will still be in business tomorrow. "Would you really want to lease space now from WorldCom? If they go out of business you don't have a lease," says Larsen.

The result is that some tenants are struggling to sublet sapce. Aether Systems in Tysons, for example, has been unsuccessful in subleasing 150,000 square feet. Instead, it has returned the property to the landlord and subsidized the rent for a new tenant. Rather than paying $35 per square foot, the new tenant may only pay $25, with Aether paying the $10 difference. Tenants are also paying for improvements to sublet space, commissions, legal fees and other costs just to close a deal on subleased space. "They'll pay all the differentials just to get the landlord to do the deal," says Larsen. Paying hefty fees to get out of leases is another popular ploy. Take Proxicom, which never moved into the Reston building it leased. The building sat empty for a year with Proxicom paying the rent. It eventually wrote the landlord a check reportedly worth one to two years' rent just to get off the hook. As costly as that transaction was, the company got out of a 10-year obligation.

Some firms are taking advantage of the market and good deals to cut their costs. Those in good financial shape are looking ahead and pressing landlords for longer-term leases to lock in savings. They're also taking prime space in areas such as the Dulles corridor.

But sublease isn't necessarily a dirty word these days. Unique spaces may not only pay for themselves but also generate a profit. Creative thinking by Advantis Real Estate Services brokers Jeff Ahearn and Charlie Polk in Richmond helped grocer SuperValu realize there was more money to be made in real estate than in selling green beans. An acquisition left SuperValu leasing 575,000 square feet of refrigerated space it didn't need. Now, it's making a profit subleasing 250,000 square feet of that space to Richmond Cold Storage, which is using the property to store tobacco for Philip Morris. "Their occupancy cost at the property is so low that it doesn't take a genius to figure out that you can go to the market and make a lot of money," says Ahearn, who is working on deals to sublease another 300,000 square feet.

Another tech bust that seems to be turning out well involves Atlanta-based Internet Service Provider iXL. Just two years ago, iXL Inc. was an icon of high-tech's go-go years. It spent $4 million on a new 60,000 square-foot Virginia headquarters in suburban Richmond's Innsbrook office park. The building went far beyond mere work cubicles, adding such accoutrements as a rock climbing wall, purple corridors and an aquarium to entice talented twenty-somethings to work there.

Just as the shiny new building was nearing completion, the downturn hit and iXL started handing out pink slips. The restructuring meant it didn't need a fancy new Richmond headquarters. So the Richmond office merged with another firm, Scient, and worked out of its space, before closing up shop here altogether. Today, the former iXL headquarters rents at full price - $19.50 per square foot. Leasing the unique space has not been difficult, says Paul Kreckman, president of the Richmond office of Highwoods Properties Inc. In fact, 40 percent of the space is leased and negotiations are underway for much of the remaining space. The site's peculiar perks, including the weight room, locker room and showers, external balconies and lots of pre-wiring for computer and phone systems, is actually drawing some clients. "Performance Food Group moved right into the old executive offices. They had an immediate need. They came in and said great,"says Kreckman. Retrofitting the site wasn't costly, he adds, since many of the changes requested by iXL were cosmetic and inexpensive to change. After a couple coats of paint, the purple lobby walls are now cream. "I don't know that the rock climbing wall is going to survive," he says.

Compared to the state's other major markets, Hampton Roads - with a smaller technology community - escaped a major dumping of space. The region's office vacancy rates were 11.8 percent for 2001, up from 9.7 percent in 2000, but still far below Northern Virginia. and the Roanoke Valley. Office vacancy rates for the valley's suburban market shot up to 13 percent last year, because a major tenant in the northern part of the market moved out of leased space into a facility it built, and a couple of technology tenants shut their offices down altogether.

From a landlord perspective, this downturn, the fourth in the last 20 years, has been the easiest, say Wayne Hoffman and Bill Rucker of West*Group in McLean. Even in Northern Virginia, where most West*Group holdings are located, most landlords continue to be paid monthly whether the space is being used or not.

The big question is how long tenants can continue to pay for space they're not using, or subsidize space someone else is using. And how long can real estate companies hold out with high vacancy rates and lower rents? "We're not dead yet," says B.K. Allen of B.K. Allen Real Estate in Reston. "I'm sometimes amazed that some people I know have not gone under. Everybody seems to be working things out." Besides things are looking up. Scott Price, director of research for Delta Associates, a real estate research firm in Alexandria, says the office market will continue to be soft over the next quarter or two. And then the sun will shine again. "By year end, with the market stabilizing and moving into 2003, we expect a gradual recovery."

Return to Virginia Business - June 2002