D.C. Office Market Worsened Again In Q1, But Signs Of Recovery Starting To Emerge
The D.C. office market continues to suffer from stagnant demand and rising vacancy, shifting dynamics even further in tenants' favor, but experts are starting to see some signs of a recovery on the horizon.
These metrics reveal the devastating impact the coronavirus pandemic has had on the office market, as the shift to remote work has led tenants to put millions of square feet on the sublease market and to shy away from signing new long-term deals.
But while the researchers who author the reports saw little sign of recovery at the end of Q4, they now see several new reasons for optimism in the D.C. market.
The amount of sublease space hitting the market reached its peak in Q4 and has begun to decrease, the reports showed. Brokers are reporting a significant uptick in touring activity over the past two months as the vaccine rollout has given tenants more confidence. A slowdown in new office development will reduce supply pressures on the market, and experts see increased federal spending as a potential boost for the D.C. market.
More Records Broken — Not The Good Kind
The D.C. Metro area recorded negative net absorption of 4.2M SF in Q1, according to JLL, and the region's vacancy rate increased from 18.7% to 20.3%.
"Tenants are continuing to shed excess space, hit pause on new leases and still think through what their best decision needs to be for their space footprint," JLL Senior Research Director Michael Hartnett said. "In general, it's this cautious view still, and as they give back space, there's nothing to counterbalance it with net new demand coming in."
The District has been the hardest hit of the three jurisdictions in the region, according to CBRE. The firm's report found negative absorption of 1.1M SF in D.C. last quarter, and it pegged D.C.'s vacancy rate at a record 17.4%, up from Q4's then-record rate of 15.9%.
"D.C. has certainly been the hardest hit," CBRE Research Director Wei Xie said. "Looking back a few years ago when vacancy was at 12% to 13%, it was hard to imagine we'd be above 17% by 2021."
The lack of new leasing activity isn't the only reason for the rising vacancy, Xie said; it is also being exacerbated by the continued delivery of office projects that broke ground prior to the pandemic and still have large blocks of available space.
"A lot of that is supply-driven, a lot of the new product that has come online because of the construction boom that started in 2015 and 2016 has delivered around this time," Xie said. "We do still have 2.2M SF under construction, and that's going to deliver some vacant space by the end of next year, so we think the vacancy rate will go up a little more before it starts to come down."
The pullback of the coworking sector has contributed to D.C.'s negative office demand. According to Cushman & Wakefield, which pegged the District's Q1 absorption at negative 657K SF, coworking providers gave back 120K SF in the quarter.
"Coworking providers continue to shed some of their noncore locations, giving them back to the landlord," Cushman & Wakefield Vice President of Research Nate Edwards said. "On the demand side, it is a huge hit because it was the one sector that was really growing."
The continued decline of office demand has made the battle for tenants even more competitive, with landlords increasing concessions to record levels.
Savills, a tenant rep firm that describes the vacancy rate as the availability rate, pegged the metric at 20.4%, the highest in at least three decades. And it found that D.C.'s concessions have increased 25% since the start of the pandemic, with Class-A tenants now receiving an average of $260 per SF between tenant improvement allowances and free rent.
"It was already a tenant-favorable market for about a decade before the pandemic hit, and it's only become more so," Savills Research Manager Devon Munos said. "Landlords are competing heavily, and they're offering incredibly generous concessions."
Boosts In The 'Burbs
Northern Virginia also experienced negative absorption last quarter, but experts say it has a more promising outlook than D.C. because of big tech companies like Amazon, Microsoft and Google growing their footprints.
Newmark reported negative 660K SF of office absorption in Northern Virginia during Q1, compared to negative 419K SF in the District and positive absorption of 415K SF in suburban Maryland. The firm pegged Northern Virginia's office vacancy at 19.6%, the highest of the three, but Newmark Senior Managing Director of National Research Sandy Paul said Northern Virginia still has the strongest fundamentals.
"I think Northern Virginia is the best-positioned of the three going forward because of the mix of industries it can boast," Paul said. "It has a lot of reasons for optimism that tech is going to continue to drive office demand."
Suburban Maryland was the only part of the region to experience positive net absorption in Q1, according to the reports.
This was in part because the U.S. Citizenship and Immigration Services took occupancy in its new Prince George's County headquarters, a move that has been planned for several years. But Maryland has had less new office construction than D.C. and Virginia, and its demand has been bolstered by the life sciences sector in Montgomery County.
While life sciences firms primarily lease lab space, a property type that isn't included in the office demand metrics, the booming sector can also have a positive effect on the area's office market. Some firms lease offices to service the labs, and developers have converted vacant office buildings to lab space, taking that empty inventory off the market.
"There is still a need for office space when biotech firms decide to expand their operations here or move their headquarters here," Paul said. "Some of the work being done on vaccine candidates was being done in suburban Maryland, and that is likely to draw other companies in that industry to the market because they know there is a capable workforce there."
'It Definitely Seems Like Things Are Accelerating'
The long-term outlook that experts have for the D.C. office market has improved over the last few months as they see signs of demand recovering and supply slowing down.
The sharp rise in sublease space last year was an immediate indicator that the office market was in trouble, but that increase appears to have slowed. CBRE found that new sublease listings peaked in October, when 310K SF was added to the market, and it has since decelerated, with less than 100K SF added in March.
"We see that as a promising sign because sublease addition is a sign of stress," Xie said. "There was probably a lot of knee-jerk reaction, 'We're working from home, so we'll just put space on the market and see what happens.' That really has slowed down a bit."
Researchers all said their brokers reported a notable increase in tours during February and March, a sign that tenants are on the market looking for space more than they were last year. Cushman & Wakefield found that touring activity in March was about 50% higher than in Q4, Edwards said.
While the period of time from touring to finalizing a lease deal can take months, or even more than a year, Edwards said he thinks companies may accelerate the process this time around.
"It's very clear at this point in using some of our tracking tools that tour activity is really starting to come back," Edwards said. "Because of the pandemic, a lot of people put touring and getting into the market on hold, so I think some of the timeline in the lease process has been compressed for a lot of users."
Xie said CBRE has been tracking touring activity every month and saw a "pretty notable uptick" in touring activity in February and March.
"There has been a decided improvement, not only in terms of the numbers of tours taking place but also the quality of tours," Xie said. "What we're hearing from our landlord brokers is the tenants active now are really engaged, deliberate and ready to go. It's definitely painting a picture of better days to come."
Marx Realty CEO Craig Deitelzweig, who is working to lease up a vacant office building it renovated in Downtown D.C., said he has seen a noticeable increase in tours over the last month, and most of the prospective tenants ask for lease proposals. He said his team has sent out four lease proposals over the last three weeks.
The developer also announced Thursday it entered into a partnership with Invesco Real Estate to invest in the project, a transformation of the Herald office building at 1307 New York Ave. NW.
"It's been feeling really good," Deitzelweig said. "It definitely seems like things are accelerating."
The federal government has continued to provide a backbone to D.C.'s office market, with the General Services Administration accounting for many of the major leases over the last year, and experts see promising signs for federal leasing going forward.
Paul said he thinks the stimulus bills passed in December and March that totaled roughly $2.8 trillion in spending, plus the $2 trillion infrastructure plan President Joe Biden proposed this week, could benefit D.C.'s office market.
While much of the spending has gone directly to individuals and small businesses, rather than to agencies and contractors that lease D.C.-area office space, Paul said there will still be a need for government personnel to oversee the massive amounts of spending, and the bills could give confidence to private sector tenants.
"Any time there is a significant amount of additional federal spending, there's the need to monitor it, so we're going to probably see some spending on the part of government agencies to track all the spending over the next few years," Paul said. "Also more broadly, the fact that spending is likely to dramatically accelerate the regional economic recovery and national recovery means the private sector will gain confidence and be more likely to take space."
The increases in touring activity and federal spending could translate into new office leases and higher demand later this year, and that will likely be followed by a drop in supply that could help bring down D.C.'s vacancy rate.
The pandemic has led to a slowdown in construction starts as developers are more hesitant to break ground on new office projects. Newmark found 5.3M SF of office space is currently under construction across the D.C. Metro area compared to 7.5M SF at this time last year. That 5.3M SF is roughly 66.5% pre-leased, it found.
"We've been seeing deliveries but not a lot of starts," Paul said. "That is going to help gradually bolster or tighten the market over the next couple of years."
The timeline of construction projects means projects that broke ground before the pandemic will continue delivering for around two more years, but after that, the deliveries are expected to drop dramatically. Cushman & Wakefield is expecting less than 100K SF of office space to deliver in the District in 2023, compared to 1.5M SF last year.
"That's going to be the real game-changer in the next 36 months is the amount of new supply," Edwards said. "It is dropping off very rapidly, and that's good for the overall market."