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New Leases Bring Signs Of Life For D.C.’s Scuffling Office Market

A string of new leases closing in December helped the D.C. office market end 2021 on a positive note, but its recovery could be complicated by the omicron variant, and experts say it could take at least another year before D.C.'s record-high vacancy rate begins to fall.

The Signal House office building at 1255 Union St. NE near Union Market.

The District's office market recorded positive net absorption of 93K SF last quarter, according to CBRE's Q4 market report, marking the first quarter of demand growth since Q3 2019. Gross leasing volume in the District totaled 2.3M SF in Q4, driven largely by the private sector, which CBRE said recorded its highest level of leasing since the pandemic began. 

"The private sector has strong foundations, especially in Downtown D.C., where almost half of all leases signed resulted in growth," CBRE Research Director Wei Xie said. "It was a surprising number of leases that represent net growth because their business is doing well, and they expect robust headcount growth."

Two of these private sector leases were signed at Signal House, the spec office project that Carr Properties delivered vacant last year. The developer signed a 50K SF lease with TikTok for the social media company's first D.C. office, Bisnow first reported last month. Carr also last month signed a 48K SF deal with nonprofit NeighborWorks, a previously unreported deal included in CBRE's report that a Carr spokesperson confirmed to Bisnow

Another two new deals were inked at the Warner Building, a downtown office asset at 1299 Pennsylvania Ave. NW owned by CBRE Investment Management and leased by CBRE. According to CBRE's report, the building landed a 54K SF lease with Deloitte and reached a 55K SF deal with Industrious, a coworking firm that often structures its deals as management agreements. 

Last quarter also featured a 54K SF deal at Capitol Crossing with Elias Law Group, with the new firm opening its first office, and law firm Katten Muchin Rosenman signed a 55K SF deal to relocate within D.C. to 1919 Pennsylvania Ave. NW. 

This growth in leasing demand crossed the river into Northern Virginia, where CBRE reported 76K SF of positive net absorption, ending a five-quarter streak of occupancy losses.

Northern Virginia's new leases last quarter included a 185K SF lease in Ballston from a group of nonprofits backed by Charles Koch, a 100K SF lease at Reston Town Center with IT firm Peraton and an 85K SF lease at Reston Station with software company Qualtrics International. 

Savills Q4 report found D.C. recorded 3M SF of leasing activity last quarter, a 52% increase from Q4 2020. Newmark's Q4 report found that D.C. recorded its first quarter of positive occupancy since Q2 2020, with 45K SF of positive net absorption.

A graph from Newmark's Q4 D.C. office report showing quarterly net absorption over the last five years.

Newmark found that D.C.'s demand growth was particularly strong in the Class-A segment of the market, which recorded positive net absorption of 242K SF in Q4. 

"In Q4 we saw a significant amount of leasing," Newmark Associate Director of Market Research Matt Kruczlnicki said. "You might attribute that to pent-up demand, which we’ve been following through the pandemic as leasing activity pretty much ground to a halt early in the pandemic. Eventually, these tenants have to make a decision."

The District's demand growth was still outpaced by the amount of new available supply hitting the market, leading its vacancy rate to reach another record high of 18.4%, according to CBRE's report. Newmark pegged the District's vacancy rate at 17.2%, up 170 basis points from a year ago. 

The positive leasing momentum in Q4 may be slowed by the omicron variant, which led to a record spike in Covid-19 cases in the final weeks of the year and has led many companies to delay their returns to the office. 

While Kruczlnicki said many companies with employees working remotely are still planning to return this year and some are touring offices ahead of lease expirations, he said the continued resurgence of the pandemic doesn't help the market's recovery. 

"Over the last six months since the onset of the delta variant, we’ve seen office market fundamentals are very closely tied to reboarding and the use and utility of office space, and office reboarding is highly correlated to the current public health conditions and the spread of variants," he said. "So long as variants are continuing to spread throughout the region, it's going to be a challenge to see a massive upswing in occupancy."

Xie said that while the variants have impacted the market, she doesn't see a direct correlation between the percentage of people returning to offices and the amount of space being leased. And she said the effect that remote work has on companies downsizing footprints may be counteracted by companies increasing their headcounts as they grow. 

The trajectory of office demand this year remains uncertain because of the pandemic and remote work, but the picture for office supply is much clearer.

As the pandemic nears the two-year mark, many of the buildings that were already under construction in March 2020 have delivered, and the slowdown in new groundbreakings after that point is reducing the amount of space expected to hit the market in the coming years. 

The District's pipeline of under-construction office space at the end of the year totaled 1.4M SF, according to Newmark, the smallest construction pipeline it has measured since 2014. Newmark found only two office projects that broke ground in the District over the last year, totaling 306K SF, while before the pandemic annual construction starts typically surpassed 1M SF. 

"Throughout Covid, there have been very few speculative starts," Kruczlnicki said. "Developers are faced with future demand uncertainty, they’re faced with current pricing challenges with supply chain constraints and the cost to build, so a lot of projects will not break ground in the current environment unless they have a significant pre-lease, and those pre-leases have been few and far between over the last 18 months."

Some buildings that were under construction before the pandemic are still scheduled to deliver vacant space to the market this year, which could further increase the vacancy rate, Kruczlnicki said. But after 2022, he said this drop in supply should help tighten the market. 

"The fact that we’re not increasing our pipeline of deliveries in 2023, 2024 and 2025, that bodes well for future vacancy increases," he said. "Though we may be facing headwinds with vacancy increases over course of 2022 as a result of inventory expansion, the lack of new groundbreakings over the last 18 months at least will curb vacancy increases resulting from inventory expansions in subsequent years."

Xie noted that while D.C.'s office vacancy rate continued to increase over the course of last year, the pace of that increase has decelerated. She also said the slowdown in construction starts will help bring down the vacancy rate over time, but it may not happen immediately. 

"I’m not going to say vacancy has peaked; I’ve been wanting to say that for a few years now, but it keeps going up," Xie said. "We think the peak of the acceleration has passed. We think it's going to stabilize gradually as it has been throughout 2021. So in 2022, we definitely don’t see the rate of increase that we’ve seen over the past two years."

In addition to the slowing pipeline of new construction starts, the trend of older, vacant office buildings being converted to other uses could help reduce the market's available inventory and bring down the vacancy rate.

The vacant office building at 1125 15th St. NW.

The D.C. government is formulating a plan to incentivize office-to-residential conversions, and at least three such conversion projects are moving forward in Downtown D.C.

Lincoln Property Co. and Cadillac Fairview in 2020 acquired an office building at 1313 L St. NW that they are now converting to apartments, and last week the partnership closed on the acquisition of 1125 15th St. NW, which it also plans to convert to apartments. Foulger-Pratt last month acquired the vacant office building at 1425 New York Ave. NW and told Bisnow it plans to convert the 13-story building to 255 apartments. 

While these projects come with challenges, such as the larger floor plates of office buildings and the higher rents that office typically commands, Xie said the high vacancy rate for Class-B offices — CBRE pegs it at 23.7% in D.C. – makes these projects more feasible. 

"The Class-B product has a lot of vacancy and a lot of that product is in very good locations, so it's projects that are waiting to be reactivated and re-energized," Xie said. "Certainly the conversion is not easy and it’s not cheap, which is why it hasn’t happened at a large scale … but it seems like there’s a lot of discussion about it, and a focus from the public sector, so that could potentially be a great solution for both the oversupply of the office market and our housing needs."

Another type of conversion project, office-to-lab, could help improve the office market in suburban Maryland, which has experienced strong growth from the life sciences sector. Suburban Maryland's office market has a vacancy rate of 17%, down 10 basis points from the prior quarter, CBRE reported.

CBRE announced Monday it brokered the $45M sale of three flex-office properties on West Guide Drive in Rockville to Thor Equities, which CBRE said plans to convert them to life sciences space. 

"Suburban Maryland's vacancy rate actually declined slightly this quarter, and part of that was because of vacant buildings being removed from the office inventory because of life sciences conversions," Xie said.