D.C. Office Market Has No Clear Saviors As Record Vacancy Keeps Rising

The bleeding may be slowing in D.C.’s struggling office market, but another quarter of record-high vacancy suggests big structural questions about filling older buildings still haven't been answered.

The vacancy rate in the District hit an all-time high of 19.9% last quarter, according to a new market report from CBRE. A report from Colliers had D.C.'s vacancy rising to 17.8% and the market recording negative net absorption of 17K SF in Q2.

While those numbers are worrisome, absorption appears to be trending back toward the positive side as the new office pipeline thins, Colliers Senior Research Analyst Miles Rodnan said.

"The slowing of new construction, if that holds, will also help the market out, but I think we’ll be at pretty elevated vacancy rates for a little while," Rodnan said. "We will take what we can get in the market right now."

Class-A space has seen positive demand for three straight quarters in D.C., according to Colliers, indicating the bifurcation in demand for newer and older buildings has become further entrenched.

"Just generally, there’s pent-up demand, because there were so many deferrals or shelving of lease processes over the last couple of years," Randy Harrell, a vice chairman at CBRE, said. "I think we’re going to see a continued increase in leasing activity. What’s harder to predict is the net result of what that net activity is."

The quarter has seen some major leases in trophy spaces come to fruition, including law firm Williams & Connolly's 300K SF lease at two new buildings in The Wharf's second phase, which was agreed to in 2018.

According to CBRE, 71% of tenants who moved during the pandemic upgraded the class of space they occupied and moved to a building built or renovated in the last five years.

"It doesn’t necessarily mean trophy, but those trophy buildings and renovated Class-A buildings are really becoming the winners, even more so now than before," CBRE Research Manager Erin Janacek said.

Many of those relocations are for less space than companies' prior leases, and now the District's largest tenant class is starting to join that trend. The Department of Justice cut its footprint by 30% when it signed a lease for new digs at 555 Fourth St. NW, one of the first major relocation deals by a federal agency in the last two years.

That downsizing is likely to continue, Colliers Research Analyst Andrew Wellman said.

"I do think there are still tenants, either through becoming more efficient in buildings or hybrid work environment, I do think there’s still potential for tenants to downsize," Wellman said. "I do think we haven't hit the peak, or hit the bottom, just yet."

Federal government tenants tend to occupy lower-cost space than law firms or tech companies, which could mean more bad news for beleaguered owners of Class-B and C office buildings. Net absorption for the two building classes was negative 148K SF this past quarter, led by negative 208K SF of net absorption in the CBD alone, according to Colliers.

Office owners told Bisnow last month that they have been disappointed by the follow-through on the Biden administration's statement that a "vast majority" of federal workers would be back in the office this spring. The lack of office usage could presage a shift to smaller leases for federal agencies moving forward.

"Private sector-wise, maybe we’re probably getting to that point, but we’re still going to have federal downsizing for years to come," Wellman said. "As much as they downsize, there’s still a lot more to come, too, I think."

While big tenant relocations haven't been a boon for landlords, midsized and smaller tenants have been more active, Harrell said. He said many had "kicked the can down the road" for a new lease during the depths of the pandemic but are beginning to get a firmer grasp on their future space needs and are looking to sign in the next 12 to 24 months.

"In prior moments of surging market activity, they really hadn’t been active," Harrell said. "There’s swollen activity in that size range right now, and fortunately, they are moving through the process deliberately."

Coworking providers have been the District's top source of leasing demand this year, adding nearly 150K SF to the market. The sector was among the hardest hit in the early days of the pandemic — between July 2020 and January 2021, the overall occupancy of D.C.-area flexible office space providers declined by 879K SF, roughly 18% of their previous footprint, according to CBRE data at the time.

"Not only have we seen several coworking leases, but the health of existing coworking leases that I’m aware of has improved," Harrell said.

Still, there are long-term structural trends indicating vacancy will remain high. Besides the federal government's likely shrinkage, law firms, one of the largest tenant classes in the District, have been downsizing since before the pandemic as well, Harrell said.

But one of the biggest question marks for the D.C. office market going forward is the tech sector. The quarter has seen some notable highs, like Google's 130K SF sublease at 655 New York Ave., and lows, like Yelp announcing it would shutter its 52K SF office in Chinatown.

Despite signs that tech is now a prominent, permanent fixture of the D.C. business community, Wellman said he isn't yet convinced it will take enough space to compensate for the challenges that have built up in the D.C. office market over the past decade. 

"The tech industry is, I think, viewed a lot of times as maybe not a savior but as a real growth industry," Wellman said. “I think a lot of markets potentially could be saved by the growth in the tech sector. That may be the case here, but I don't think it's true in D.C. just yet."