D.C. Office Market Posts Strong Q3 With Rising Demand, Slowing Construction
The office market in the District is showing positive signs with strong leasing activity, driven by government and coworking tenants, and a slowdown in the pipeline of new construction.
Leasing activity in D.C. proper totaled 3.6M SF in Q3, the best quarter in over two years, according to CBRE's quarterly report. That activity was driven largely by relocations and renewals, but the District still recorded 843K SF of positive net absorption, CBRE found, bringing the 2018 total to 2.2M SF.
This demand growth, coupled with a slowdown of new office deliveries, helped decrease the office vacancy rate in the District to 13.2%, according to CBRE, down from 13.7% last quarter. This comes after five major office developments delivered 2.1M SF of office space in Q2, pushing D.C.'s vacancy rate to its highest point in five years.
Public sector leasing activity picked up significantly in Q3, with five 100K-plus SF leases from the General Services Administration or D.C. government tenants in the quarter, according to CBRE. Government leases account for 41% of gross leasing activity in 2018, CBRE Research Manager Wei Xie said, and those tenants are not shrinking their footprints as much as they did in past years.
"The government sector had a very active quarter," Xie said. "We're not seeing a ton of contraction in the government sector, it's remaining stable. I think government leasing right now has stabilized and the degree of contraction we were seeing a few years ago has really slowed down."
The office sector driving the most net growth in the market continues to be coworking. Six new coworking leases were signed in the D.C. metro area in Q3 totaling 178K SF, according to CBRE.
"A lot of what we see in the D.C. area is musical chairs where tenants move from one location to another and oftentimes densifying their footprint," Xie said. "In terms of pure organic net growth, coworking is the one sector to highlight for D.C., and that continues to be the case quarter after quarter."
The single deal that had the most impact on the D.C. office market was the former Intelsat Building, a vacant 600K SF Northwest D.C. office building, being turned into a private school. CBRE recorded this as an office lease that contributed to the net absorption total. Another report released Monday from Newmark Knight Frank recorded the deal as a conversion to another use that took the office space out of the market inventory.
In either case, the deal contributed to the health of the D.C. office market and pushed down its vacancy rate.
Newmark Knight Frank's report pegged D.C.'s vacancy rate at 12.2%, down from 12.7% the prior quarter. The tightening vacancy helped push up asking rents by 0.7% to $55.32/SF, NKF found. With an abundance of older, vacant office stock in D.C., more conversions of buildings like Intelsat to other uses could help improve the market's fundamentals, NKF Associate Director Bethany Schneider said.
"The product in the middle that's not trophy and not Class-B is going to continue to struggle, and where it makes sense converting to some other use is definitely a next natural progression," Schneider said.
In another positive sign for D.C.'s office market, it appears that the massive pipeline of new construction that has kept vacancy high in recent years is beginning to slow down. The District currently has 4M SF of office space under construction, down from 5.4M SF at this time last year, according to NKF.
"It seems like it has kind of peaked," Schneider said. "It's definitely not going to drop off, there's a lot still in the proposed pipeline and it seems like some projects are deciding whether to go ahead or not, so it peaked, but it's still really high. I think it will taper but really gradually."
CBRE also identified a slowdown in office construction. D.C. is on pace to finish the year with the total square footage of new office groundbreakings down 30% from last year and 50% from 2016, according to CBRE. Xie said that should help improve the market conditions for developers looking to lease their space.
"With a tightening supply pipeline, that will definitely help balance supply and demand," Xie said.
Even with a modest slowdown in supply, researchers still expect the D.C. market will remain in the tenant's favor for the foreseeable future. The one event that could fundamentally change that dynamic is if Amazon picks D.C. for its second headquarters, an announcement CEO Jeff Bezos says will come before year-end. Schneider said NKF doesn't have any inside knowledge on Amazon's plans, but is optimistic about D.C.'s chances based on public reports.
"We're pretty confident that the D.C. region will be selected," Schneider said. "So far we haven't seen a lot of signs of any office owners or businesses in the area depending on that ... everyone is business as usual, and if it happens, that would be a huge boost over the long term, but I don't think anyone's counting their chickens before they hatch."