The D.C. Council last month passed a $15.5B budget including commercial property tax increases that developers have sharply criticized, and a new report highlights the massive implications it could have on the office market.

The report from JLL details how investment sales transactions have already become more difficult to close in D.C. this year, and it says the tax increases will cause sales activity to "grind to a halt."

The budget increases taxes on commercial properties over $10M by $0.04 per $100 of assessed value, a 2.2% increase. It also increases deed and recordation transfer taxes from 1.45% to 2.5%, a 72% increase that could have a significant impact on the investment sales market.

For the sale of a $200M office building, the deed and recordation transfer tax would go from $5.8M previously to $10M under the new policy, the report found.

"There is seldom legislation that impacts everyone in a detrimental way on the commercial side," JLL Managing Director of Research John Sikaitis said. "This does that pretty effectively."

The revenue created from the taxes would go toward affordable housing as part of D.C.'s efforts to address the housing affordability crisis. But the JLL report notes that if the increased tax rates cause the volume of investment sales to drop, which the researchers expect it will, then the policy could fail to bring in the revenue it seeks.

"These taxes shrink the common ground on which buyers and sellers can pencil out a deal so it works for both sides," JLL Senior Research Analyst John Andril said. "I’m certain we’re going to see additional failed sales."

The policy might work in a city with a red-hot investment sales market, Andril said, but D.C. has been anything but that so far this year.

The D.C. office leasing market has been soft in recent years, but prior to 2019 that had not translated to a weak investment sales market. Institutional and foreign investors were still hungry for D.C. office assets and willing to pay top dollar for them despite the underlying leasing performance. But Andril said that has begun to change.

"In 2019, we've finally started to see those weak leasing fundamentals catch up with the sales market, and it really dropped off sharply," Andril said. "You have all these [owners] with inflated price expectations bringing assets to market expecting high prices, and they’re just met with crickets."

That disconnect between seller expectations and buyer demand has led many D.C. office properties to hit the market and fail to sell. For the 12 months ending in April, the JLL report found nine D.C. office buildings with a combined value of $1.9B were pulled off the sales market after failing to attract buyers or find a price on which both sides could agree.

If that same level of buildings were to fail to transact in the 12 months after the D.C. tax increase goes into effect, the JLL report estimates it would result in $95M of lost tax revenue for the District, exceeding the $90.8M it expects to raise with the new taxes.

With the increased taxes on commercial property sales making deals harder to pencil in D.C., the JLL researchers expect investors will begin to look across the river. Northern Virginia has traditionally not been viewed as the same type of core market as D.C. in the eyes of outside investors, but an improving office market and expected growth from Amazon HQ2 has them taking a closer look.

"No one denies now that Arlington is a core market with a significant amount of future urban demand," Sikaitis said. "You're now seeing institutional investors start to look at Arlington from an investment perspective, which didn't happen 12 or 24 months ago. Their allocation to D.C. could be allocated to Arlington."

Similar effects are expected to take place in the office leasing market as higher property taxes are passed down to D.C. tenants in the form of rent increases, the JLL report found.

The effect on the leasing market is expected to be the greatest in D.C.'s Class-B segment, which has experienced a 2M SF decrease in supply since 2016 due to owners repositioning their properties.

Class-B office office rents in D.C. have increased 4.4% since 2016, the highest of any segment, making it harder for value-conscious tenants to afford to stay. If tax increases force rents up even more, Sikaitis said these tenants will increasingly look elsewhere for office space.

"The Class-B market is the one part that's moving along in a good state, and you're going to see further rent increases be imposed because of the legislation," Sikaitis said. "Then if you’re a tenant in D.C. you start to wonder, 'Could I cross the river for a more affordable price point?'"