D.C. Office Vacancy Hits All-Time High As It Falls Behind Suburbs In Q2

The coronavirus is beginning to take its toll on a D.C. office market that was already struggling with high vacancy and an oversupply of new space. Experts say it is going to get worse before it gets better.

The vacancy rate in the District reached an all-time high of 15.2% in the second quarter, according to CBRE's market report, surpassing the 15% mark for the first time on record.

Developers delivered several new office buildings in the second quarter with large blocks of available space, and the demand picture continues to worsen. D.C. posted 300K SF of occupancy loss in the second quarter, according to CBRE. 

"This is going to be a marathon, not a sprint," CBRE Associate Director Wei Xie said. "We are in the first quarter of a new situation that could unfold over the next 12 months."

Some bright spots did appear in the second quarter's market data, including new leases from government, technology and healthcare tenants, a trio of sectors that experts say should help keep the D.C. market from falling as far as other cities.

Dropping Demand

While some new leases were signed last quarter, experts saw a trend toward renewals rather than relocations, and those tenants that did change addresses largely reduced the size of their office footprint. 

"Leasing activity was sustained by the government and its related sectors, and while that was great for the market, it's not expected to be enough to keep the market from weakening further in the months ahead," Savills Research Manager Devon Munos said.

Savills, a tenant representation firm that describes the vacancy level as the availability rate, pegged that metric at 17.6% at the end of Q2. That number was up from 15.9% at the same time last year, and it represents the highest level of availability Savills has recorded since 2009. 

The economic shutdown caused by the coronavirus lowered deal volume in the market, with larger firms putting off leasing decisions and smaller tenants inking short-term renewals to push off their expiration dates. Cushman & Wakefield Senior Director of Research Nate Edwards said the number of leases recorded in Q2 was 100 fewer than the same quarter last year. 

"You can see how uncertainty and a lack of clarity about how this continues to go through the cycle is affecting the amount of deals happening today," Edwards said. 

Cushman & Wakefield, which pegged D.C.'s vacancy rate at 16.3%, attributed it in part to tenants putting more sublease space on the market. Edwards said there is 2.8M SF available on D.C.'s sublease market as of this week, compared to 2.2M SF at this time last year and 1.6M SF in 2018.

"That has definitely ticked up, and we think once people get back to the office and start evaluating how this plays out with working from home, we do expect another uptick in the amount of sublease space on the market," Edwards said. 

JLL, which pegged the District's vacancy rate at an all-time high of 14.5%, found that Q2 leasing velocity was down 73% from last year. Lease renewals accounted for 59% of the leasing activity, JLL found, compared to 29% before the coronavirus.

"The reason we've seen velocity has dropped so much is a lot of tenants are taking a wait-and-see approach," JLL Senior Research Director Michael Hartnett said. "With aversion to public transit and work-from-home policies, they're all waiting a little bit to see how the rest of the year looks before they decide to do that deal."

Much of the leasing activity in Q2 came from the market's most reliable sectors, the federal government and law firms, and experts say those sectors should help D.C.'s economy be more resilient than other markets. But while these tenants may keep some activity going, they do not contribute net growth to the market. 

The District's net absorption was negative in part because of new leases that represented a loss of occupancy, such as Wiley Rein's 166K SF deal at 2050 M St. NW. The firm previously occupied more than 300K SF of space across two K Street buildings, according to CBRE.

"In most pre-leases, we observed some sort of densification effort along with a relocation," Xie said. 

Surging Supply

The drop in demand comes at a bad time for the D.C. office market. 

Even before the crisis began, researchers were predicting a rise in vacancy because of the large amount of new office space under construction with sizable blocks of unleased space. 

Five buildings totaling 832K SF delivered in the second quarter, according to CBRE. The Meridian Group's 1901 L St. NW delivered 72% leased and Akridge's 2100 L St. NW delivered 54% leased. The National Association of Broadcasters completed its 1 M St. SE headquarters, and it is occupying 67K SF of the 118K SF building, with the rest still available.

Two additional deliveries, 1400 L St. NW and 1050 17th St. NW, brought a combined 315K SF of vacant space to the market, according to CBRE.

Construction will likely slow down in the coming years, but projects underway are still set to deliver another 2.7M SF to the market, according to CBRE. Roughly 586K SF of office buildings are set to deliver by year-end, and less than a third of that space is pre-leased. 

The submarkets with the most space under construction are the central business district with 759K SF, the East End with 675K SF and the Capitol Hill-NoMa area with 129K SF, according to Cushman & Wakefield. 

"The timing of the crisis coming in conjunction with a lot of buildings delivering and continuing to be under construction, that's pretty difficult," Edwards said. 

New deliveries will eventually slow down as developers stop speculative construction in response to the worsening economic conditions, but researchers say that may not impact the market dynamics until 2022. 

"The new supply really starts to burn off in 2022, and with the demand profile we're seeing between now and then, that's the real inflection point where the amount of vacancy we have peaks at that point and then comes back down," Edwards said. 

Xie also said she expects the vacancy rate will continue to rise for at least the next 18 months. 

"Between now and the end of 2021, we believe it's still going to trend up before it trends down," she said of the vacancy rate. "We know which projects are in the pipeline, and going spec from this point on is going to be unlikely. Construction will be reliant on a high rate of pre-leasing."

This imbalance of supply and demand is pushing the market even further into the tenants' favor. 

Cushman & Wakefield has seen an increase in tenant improvement allowances of $20 to $30 per SF since the crisis started, Edwards said. 

"We're seeing very high concessions, very high TI and free rent components," Edwards said. "What that telegraphs to me and our brokers is, even with the uncertainty of COVID, there's still a lack of confidence in the amount of larger tenants that will be executing leases in the next four years. The posture of investors is: Do whatever you can to keep the occupancy you have in your buildings, and do whatever you can to lease those buildings in the near-term."

JLL found that free rent concessions, which were already at a record high, increased by 21% in Q2 compared to last year. Hartnett attributed this to the imbalance of lackluster demand and surging supply. He added that one of the sectors that drove net growth in recent years, coworking, has halted new expansion activity. 

"It's the abundance of space under development that's available, it's the rise of sublet space, and on the demand side, our top growing sector was coworking and that creates a lot of exposure," Hartnett said. "Our lease expiration pipeline is pretty thin in the short term as well, so that creates an imbalance. The big question for D.C. is, 'where will the net new demand come from?'"

Stable Suburbs

While the office market in the District continues to worsen, the suburban jurisdictions appear better positioned with stable economic sectors such as technology, government contracting and healthcare, plus much less new, vacant construction. 

Northern Virginia's office market had begun to outperform the District's over the last two years, and that trend continued in Q2.

Major technology deals led Northern Virginia to record positive net absorption of 515K SF in Q2, according to CBRE.

Microsoft in May announced a 400K SF lease at Reston Town Center, with all of that space representing expansion in the region for the technology giant. Walmart Labs, the retail company's technology arm, in April leased 162K SF at 2245 Monroe St. in Herndon, the Washington Business Journal reported. CACI signed a new 135K SF lease at 12021 Sunset Hill Road in Reston, according to CBRE.

"Tech is actually doing really fabulous, especially for Northern Virginia," Xie said. "It has really been a key and sustaining driver for the office market."

These new leases come as Amazon continues to grow its presence in Arlington, announcing Tuesday its second headquarters had surpassed 1,000 employees. Munos said she sees Amazon as a catalyst that has attracted other tech firms to the area.

"Northern Virginia is very healthy right now," Munos said. "The tech sector is really well-positioned for growth, and the Northern Virginia market is a great place for that to happen because there is such a highly educated workforce. When Amazon selected National Landing for HQ2, giving that stamp of approval has made other tech companies interested in the area. I wouldn't be surprised if in the near to midterm we see a lot of new tech leases being signed."

Government contractors are also concentrated in Northern Virginia, and Edwards said that sector appears poised to grow in the coming months. 

"While other businesses are slowing down and taking a wait-and-see attitude, it's pretty apparent that government contractors are angling to take advantage of the increased spending environment that will come out of the stimulus," Edwards said. 

JLL identified $1.2B in federal government awards given to D.C.-area contractors directly related to the coronavirus response. It also found that the Dulles Toll Road area was the second-most-active submarket in the U.S. last quarter, behind Oakland. 

"It was a strong quarter for the Toll Road due to leasing activity that started pre-COVID and got to the finish line," Hartnett said. 

The suburban Maryland office market has a concentration of another sector that appears well-positioned to benefit from the crisis: healthcare and life sciences.

While much of Northern Virginia's leasing activity originated before the crisis, Hartnett said he is seeing a growing number of new lease requirements on Maryland's I-270 corridor. He said JLL identified nine suburban Maryland tenants that are working on coronavirus vaccines.

"We haven't seen across the region, except for I-270, any net new demand or requirements post-COVID," Hartnett said. "Maryland's demand is all life sciences driven. They have really risen to the occasion." 

Montgomery County posted occupancy gains of 24K SF in the second quarter, according to CBRE. The larger suburban Maryland market posted a slight occupancy loss of 1K SF, but its year-to-date absorption stands positive at 175K SF. The healthcare sector drove 48K SF of positive absorption in Q2 in suburban Maryland. 

The National Institutes of Health, the Food and Drug Administration, United Health Group, Children's Hospital and MD Oncology Hematology all signed leases, including renewals and relocations, in suburban Maryland last quarter, according to CBRE. 

"If you look at the suburban Maryland office market, we categorize it as 'steady Eddie,'" Xie said. "You look far back and that market does not have the major fluctuations of D.C., Virginia or other markets, and the heavy component of healthcare has to be a contributing factor."