Washington, D.C.'s troubled office market appears to be lagging behind its peer cities as public and private sector tenants shrink their footprints.

The District recorded 1.2M SF of negative net absorption last year, bringing the vacancy rate to 20.5%, according to CBRE's fourth-quarter market report. The vacancy rate rose 20 basis points in Q4, due in large part to a quiet quarter from the federal government, which only signed one 10K SF lease.

"Public sector leasing was down in the fourth quarter, notably. That's where we felt an overall decline," CBRE Mid-Atlantic Research Director Stephanie Jennings said.

The private sector had more leasing activity, Jennings said, but that activity didn't result in positive absorption as some firms contracted their footprints. One of those firms was Universal Service Administrative Co., which signed a lease renewal last week at 700 12th St. NW that will reduce its footprint by 48K SF.

CBRE Vice Chairman Randy Harrell, who represented the landlord in the deal, said the firm agreed to retain its 68K SF space on the building's ninth floor through 2038, but will give back the rest of its space in the building in April.

The tenant's previous lease was set to expire in 2024, but Harrell said the owner signed the smaller renewal lease now in order to stabilize the building's rent roll. The building is owned by Jamestown, property records show.

"I'm not predicting robust net absorption, nor robust gross leasing activity, so as a result, owners are going to have fewer at-bats to refill the space," Harrell said. "So they're playing the hand that they're dealt and taking a little bit of a haircut instead of a bigger loss."

Despite some activity from nonprofits and one major law firm, Harrell said market softness is likely to continue into 2023, with landlords having to work harder to convince tenants of their financial stability.

"We're preparing our owner clients for greater transparency of their capital stack," Harrell said. "Historically, owners have held their capital stacks relatively close to their vests. When money was free, it wasn't a problem. Well, money isn't free right now."

That warning comes as many capital markets observers expect a wave of office owners to relinquish their properties to lenders this year, crushed by mounting debt and rising vacancies.

D.C.'s office pipeline has atrophied in the face of those difficult conditions — seven buildings delivered in 2022 but just two are slated to deliver in 2023 and one in 2024.

The two largest D.C. deals to close in the fourth quarter saw tenants shrink their footprints. In addition to the Universal Service deal, law firm Orrick Herrington & Sutcliffe signed a lease at 2100 Pennsylvania Ave. NW for 77K SF, which CBRE's report said represented a contraction.

Landlords looking to lock in existing tenants with reduced footprints rather than seeing valuable occupants depart will likely drive much of the activity in office leasing this year, Jennings said.

Jennings also noted that with the labor market shifting back in employers' favor, tenants may begin getting a better sense of the headcount they're looking to accommodate in future leases.

But D.C.'s largest tenant base, the federal government, has yet to make a firm commitment on remote work, and is dragging down transaction activity for the market as a whole, Jennings said.

That has become a bigger problem as other sectors have adjusted to post-vaccine realities. Most of the American Law 100 firms with office leases in D.C. that would have expired in the next 24 months have already signed deals, Harrell said. The closure of three WeWork locations, meanwhile, turned the coworking sector from a demand driver earlier in the year into a source of occupancy loss by the close of 2022.

Jennings said the peak of large lease expirations in D.C. over the next five years is in 2026. That "bodes well" for the market, Jennings said, as proactive tenants looking to get ahead of their lease expiration keep the office market from grinding to a halt.

"The larger the tenant, the sooner they have to engage the market," Jennings said. "It's a good thing for us that large tenant lease expirations are occurring sooner rather than later."