As D.C.'s Construction Boom Continues, Experts Foresee Rising Office Vacancy, Falling Rents
For D.C.'s office sector, the second quarter of 2017 was marked by more construction starts that will bring additional empty space to the market. While there has been modest demand growth, experts view the market as oversupplied and expect rising vacancy rates and falling rents going forward.
The District has 9.6M SF of office space under construction or renovation, according to CBRE's Q2 office report, with much of that concentrated downtown.
Two new law firm leases signed this quarter in the central business district are kicking off construction starts on projects that researchers expected would come later, and the leases are taking up increasingly small portions of the buildings.
JBG signed Goodwin Procter for 80K SF at 1900 N, leading it to start construction on the 259K SF office building. Morrison & Foerster is in talks to lease four floors, roughly 80K SF, at its 2100 L development, a 190K SF office building.
With the previous wave of law firm movers, such as Venable taking 245K SF at 600 Mass and Arnold & Porter taking 375K SF at 601 Mass, the landlords had more than half of the buildings filled before breaking ground. But JLL senior research analyst Carl Caputo said this is no longer the case.
"With these projects, law firms are only taking 20% to 30% when you'd typically lease 40% to 50%," Caputo said. "A majority of the other blocks will probably sit vacant for 24 to 36 months, putting the market at a greater risk of oversupply."
There was some good news for D.C.'s office market in Q2. Thirteen different tenants signed leases to grow at least 5K SF, generating 250K SF of future occupancy gains, according to JLL's Q2 report. But Caputo said these gains will not move the needle much as the core downtown market prepares to add 7M SF of office space from new construction and renovations.
Once more of these projects deliver around the middle of 2018, JLL predicts Class-A rents will drop by 7% to 12%.
"Eventually somebody's going to give in and say, 'OK, let's drop rents,'" Caputo said. "At such a high price point you're not targeting a big enough demand pool. You're definitely going to see rents drop."
This supply-demand imbalance will also lead to a rise in D.C.'s vacancy rate, JLL predicts. For Class-A buildings in the CBD, Caputo said he expects vacancy to increase from 12.3% to as much as 18%. He also expects overall vacancy across the District to increase from roughly 12% to about 14%.
CBRE researchers said D.C.'s office market is oversupplied, but do not predict as sharp of an impact on rents. Research manager Wei Xie said the competition between landlords will be fierce, but she thinks rents will likely be the last metric to move.
"I think it may first manifest itself in way of concessions," she said. "They are already at an all-time high, and that may become more intensified with tenant improvements and abatement. I think the competition for the largest, highest-end will be very fierce in the next two years."
An additional factor that could harm the D.C. office market is slowing job growth. The region's job growth began to taper during the first half of 2017, according to Newmark Knight Frank's Q2 report. During the 12 months ending in April, the region added 38,000 jobs, NKF found, below the 20-year average of 44,200 annual jobs.
As with the previous stretch of rising job growth, the job numbers can take two or three years to register a noticeable effect with the office leasing market, NKF research manager Bethany Schneider said.
"Slowing job growth is certaintly a concern, but with the lag effect it won’t be an immediate concern," Schneider said.
With job growth slowing in cities around the country, NKF's report said the consensus of economists is that the nation will experience a significant economic downturn around the end of 2018 or in 2019. Schneider said this should not be a major cause of concern for those in the D.C. market, which has outperformed other cities during recent recessions.
Schneider also said the office market is oversupplied and thinks this will have an effect on rents and vacancy. She said there will be downward pressure on rents, but she does not expect a drastic drop.
NKF predicts metrowide vacancy will increase from 16.2% to more than 17% over the next two years. Still, some segments of the markets are performing well, Schneider said. Large blocks of Class-A space along the Dulles Toll Road have been filling up quickly, quality Class-B space has been performing well with value-conscious tenants, and trophy buildings near Metro stations are consistently outperforming other segments of the market, NKF found.