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D.C. Office Market Worsens As Vacancy Hits Another Record High

The coronavirus pandemic is continuing to hurt the office market in the nation's capital, with demand for office shrinking, a host of sublease space becoming available and vacancy reaching another all-time high.

The available 11th-floor office space in the newly delivered 909 Rose building.

Newly released Q3 data from multiple brokerage firms shows the D.C. office market experienced negative absorption and rising vacancy. The market is being hurt by a lack of new leasing activity as companies delay major decisions on their future office space needs. 

"The economic hardship makes it difficult, and the uncertainty around when employees will return to the office, how many of them will return, and how their future office space should be reconfigured, all of that is raising a lot of questions," CBRE Associate Director of Mid-Atlantic Research Wei Xie said. "Anybody who has the luxury of waiting a little longer is not in a hurry to make a decision."

CBRE's report found negative net absorption of 177K SF in the District, bringing the year-to-date occupancy loss to 780K SF. It pegged D.C.'s vacancy rate at 15.4%, a new record high for the market. 

While the market challenges in Q3 were similar to the previous quarter, Xie said Q2 was bolstered by the closing of deals that had begun before the pandemic, and those deals are beginning to disappear. 

"There was not a fundamental change in the nature of the marketplace, but what helped in Q2 was more hangover deals that we're starting to see less and less," Xie said. 

The federal government has continued to lease space and bring activity to the market, but its overall impact on absorption has been negative as agencies continue to downsize. Law firms have also continued to downsize their footprint, and Xie said because they typically sign leases multiple years in advance, many have been able to delay their deals while they evaluate their space needs. 

The sectors that have experienced occupancy growth in D.C. this year are technology, business services and nonprofits, but those gains have been far outpaced by the negative absorption in other sectors. 

A CBRE chart showing which sectors have grown and shrunk their office footprints in D.C. this year.

The pipeline of companies looking to sign long-term leases has decreased significantly, experts said. There has been an increase in short-term renewals as tenants with expiring leases don't feel enough certainty to make longer commitments. 

Renewals comprised 29% of leasing activity before the pandemic, and in Q3 they comprised 60%, according to JLL. The firm's report said the District recorded 603K SF of negative absorption in Q3 and that vacancy hit a record high of 15.1%. 

"Many tenants are trying to delay decisions if they have a lease coming up," JLL Senior Research Director Michael Hartnett said. "They're trying to delay decisions until they have a better sense of their future work-from-home policies and space strategy."

Savills Research Manager Devon Munos said she doesn't see much new demand from tenants on the market. Savills, a tenant rep firm that defines vacancy as the availability rate, pegged D.C.'s rate at 18.1%. 

"I think that in the coming quarters we're going to see demand significantly drop," Munos said. "There's really just fewer and fewer tenants willing to start the leasing process unless they're forced to by an imminent lease expiration."

Surge In Sublease Space 

The harmful effects of the slow leasing demand on landlords are being compounded by the amount of space that tenants themselves are marketing for sublease. 

Tenants have put roughly 500K SF of sublease space on the market since March, according to Savills, bringing the total amount on the market to nearly 3M SF. D.C.'s sublease availability today is the highest ever recorded, according to Savills, surpassing the previous high in 2013 after the Base Realignment and Closure Act and surpassing the Great Recession

"A lot of companies right now have decided their need is to shed extra office space, so these companies are looking to just reduce their real estate costs and are considering shifting to remote work permanently," Munos said. 

Companies looking to cut costs by subleasing space still need to find a tenant to take that space before they can save any money, and Hartnett said that is proving difficult. 

"We think that sublease availability will continue to increase moving into the rest of this year and next year," Hartnett said. "And on the demand side, it's low ... We're not seeing a lot of velocity in terms of tenants in the market looking for sublease space."

Hartnett said there has been limited tenant interest in sublease space in part because the rent discounts are not substantial enough. He said the discount between direct leased space and sublease space in D.C. has remained steady at around 28%.

"If sublease space starts to come down in price more, you could see demand pick up, but right now it doesn't feel like that discount is enough to swing things," Hartnett said. 

While the surge in sublease space is hurting D.C.'s market fundamentals, it is still relatively low compared to what other cities are experiencing.

Sublease space in D.C. accounts for roughly 13% of all available space, according to Savills, but in other major markets that number is above 25% or even 50%. Munos said this is because of the large presence of the federal government and other stable tenants such as law firms and nonprofits. 

"D.C. benefits from the fact we have that core tenant base and we're not shedding space at the rate of what's being experienced in other markets," Munos said. "New York, San Francisco and Chicago are some of the weakest markets."

The Government Safety Net

D.C.'s office market has been spared from the worst effects of the crisis because the federal government has provided a stable backbone to the leasing market. But while these leases have helped keep activity moving, many have still been downsizing moves that add vacancy to the market. 

Government leases accounted for 45% of all Q3 leasing activity in the District, according to CBRE. Many of these leases were renewals, including a 319K SF lease with the Federal Reserve at International Square and a 167K SF deal with the Internal Revenue Service in NoMa, according to CBRE. 

"The federal government has been adding jobs and has been active in transacting for office space when the private sector has slowed down," Xie said. "The federal government is a sustaining force for our region."

The International Square office and retail complex at 1850 K St. NW

Despite the new leasing activity, the General Services Administration is continuing with its effort to save taxpayer money by consolidating offices and reducing its real estate footprint, which results in negative absorption for the D.C. office market.

"The trend we've seen the past couple years of government downsizing is likely to continue, and that has contributed to increasing vacancy," Cushman & Wakefield Senior Director of D.C. Metro Research Nate Edwards said.

Additionally, the federal government has begun to relocate some agencies away from the D.C. region, including the Bureau of Land Management and the United States Department of Agriculture. 

"The fact they're moving some of these agencies and requirements outside of the national capital region is obviously a huge deal and is going to leave vacancy," Edwards said. He added that he still sees the government signing renewals and relocations within the D.C. area that are keeping market activity moving. 

"The government is a stabilizing factor and it definitely causes our highs to be less high but our lows are much less impactful than the big financial or tech markets like New York or San Francisco or even Boston," Edwards said. 

Rents Not Falling Yet, But Concessions Keep Rising

The decreased demand and increased office vacancy in D.C. are shifting the market to the tenants' favor, but that has yet to translate to a major drop in rents. 

Class-A office rents in the District declined by 1% last quarter, according to Savills, but it found concessions reached a new all-time high for the market. The combination of tenant improvement allowances and free rent averaged a record $238/SF in value, according to Savills. 

"Owners have really held firm on their pricing," Munos said. "I don't expect rents to significantly drop. Sure, there will be some decrease. Concessions will remain incredibly generous and overall there will be favorable terms within leases that are signed for tenants."

Edwards said that when you factor the value of concessions together with the base rents, it equates to the market being down roughly 10%, which is on par with previous recessions.

"The interesting thing in COVID is we've seen rents largely holding," Edwards said. "Rents are staying up, but how people are making up for the perceived weakness is we've seen a clear uptick in the amount of concessions ... so when we look at that, we're seeing at least a similar impact that we saw in the 2008-2009 crisis."

Northern Virginia Turns In The Wrong Direction

While the office market in the District had already been worsening before the pandemic, Northern Virginia had been trending in a positive direction that continued in Q2. But the market's fortunes changed in the third quarter. 

Northern Virginia recorded 1.4M SF of negative net absorption in Q3, according to JLL, nearly double the occupancy loss experienced in the District in all of 2020. 

Hartnett said Northern Virginia's market was hurt last quarter by an increase in large sublease spaces coming onto the market. Additionally, it didn't benefit from the government contractor leasing that is typically associated with increased federal spending. 

"Contracts being awarded by the federal government in the region are at a record high for this year; however, there's no correlation like we've historically seen to leasing activity based on award volume," Hartnett said. "What's happening is most major contractors are doing everything they can not to take net new space, given that they have excess availability in their portfolio due to work-from-home trends."

Northern Virginia's positive absorption in Q2 was primarily attributable to one big entrant to the market, a 400K SF lease with Microsoft. If that deal hadn't occurred, Xie said the negative trend the market saw in Q3 would have begun in the previous quarter. 

CBRE recorded 544K SF of occupancy loss for Northern Virginia last quarter, ending a stretch of 12 consecutive quarters with demand growth. It also found that Northern Virginia's overall leasing volume of 1.3M SF was the lowest since 2007. This led the area's vacancy to increase 30 basis points to 19.2%. 

"In the Northern Virginia market, there are a lot of midsized tenants that may have multiple locations throughout the region," Xie said. "That allows them to consolidate and be flexible with their space use as needed."