D.C. Office Market Picking Up Steam, But Vacancy Keeps Hitting New Highs
Deal-making activity has begun to ramp up in the D.C. office market, with several major leases signed last quarter, but the market hasn't received enough overall demand growth to bring down its record-high vacancy.
Office leasing activity in the District last quarter totaled 1.8M SF, including new leases and renewals, a 62% increase from the prior quarter, according to CBRE's Q2 office market report.
While deal closings were up, they didn't prevent D.C. from recording its seventh consecutive quarter of occupancy loss, according to CBRE, which pegged the city's Q2 net absorption at negative 472K SF.
"For a year and then some, it was pretty much a deep freeze, so a lot of pent-up demand is now coming out as the restrictions are being lifted," CBRE Research Director Wei Xie said. "On a net basis that improvement in activity hasn't translated to positive absorption or a decreasing vacancy rate. That part is going to take much longer to be addressed."
The vacancy rate last quarter rose to 17.8%, according to CBRE, up from 17.4% in Q1.
Two of the main drivers of occupancy loss were the General Services Administration, which has consolidated some leased offices into owned buildings, and law firms, which have continued to shrink their footprints. But Xie said that more than 90% of the large law firms in D.C. have now executed a space reduction, and some have already added back space after realizing the cuts went too far.
"I think we're at the tail end of the densification cycle, there's only so much you can contract," she said. "We looked at law firm relocations of size in recent years. While most contracted, many of them subsequently expanded because they cut too deep initially and needed more space."
Xie said CBRE's Q2 research shows that the fears of mass footprint reductions across the office market have been largely unfounded. The number of companies expanding their footprint last quarter eclipsed the number of those that shrunk it, she said, but the total square footages of the cuts were larger, leading to the negative absorption.
"On an aggregate level, the myth that all companies are just going to give back 20% of their space absolutely has not been true for the D.C. region," Xie said. "We are actually seeing more tenants expanding."
An example of a growing tenant last quarter was Enovational, which leased 97K SF at Meridian Group's 1400 L St. NW. That represented an expansion of 74K SF from its previous office, according to CBRE, which represented the landlord in the deal.
Other leases signed last quarter include Boston Consulting Group's 98K SF relocation deal Bisnow first reported; a move from Bethesda to Downtown D.C.'s Metropolitan Square; and two deals at Meridian Group's 1333 New Hampshire building: a 96K SF lease with the Patient-Centered Outcomes Research Institute and an 87K SF lease with the American Bankers Association.
While the District continues to lose occupancy on a market-wide level, the dynamic isn't the same across all classes of office space.
Newmark's Q2 office market report said the District recorded negative absorption of 837K SF and its overall vacancy rate rose from 15.9% to 16.6%. But it found that the Class-A vacancy rate was 15.3%, while Class-B vacancy was 19.2%.
JLL's Q2 office market report pegged D.C.'s total net absorption at more than 500K SF, but it noted that the performance wasn't bad across all market segments. While the Class-B market experienced 560K SF of occupancy loss, the trophy segment experienced positive absorption of 315K SF.
The vacancy rate in D.C.'s trophy segment dropped below 10% last quarter, according to JLL, which pegged the city's overall vacancy rate at 18.4%.
JLL Research Director Lauren Grass said this dynamic has occurred because tenants have continued to leave older buildings for newly developed offices, benefiting the developers of those projects but not the market overall.
"It's this idea that we're referring to as 'tenant musical chairs,'" Grass said. "Tenants have great options, and certainly now with the concessions and the new supply coming on and the real push toward amenities, that was something we saw pre-Covid, and I think it's going to be more important in the post-Covid time frame. But without that demand to backfill, it's going to be tenants moving around and keeping that vacancy elevated."
Grass said D.C. has struggled for years to find drivers of net new office demand, and she doesn't foresee that situation improving this year. But she did point to one promising Q2 metric for the market: sublease availability.
Tenants put millions of square feet of sublease space on the market after the coronavirus pandemic began, and while that inventory is still 30% higher than Q1 2020, JLL found that tenants removed nearly 1.4M SF of sublease space from the market in Q2.
"We think that there was a lot of overreacting, and now we're correcting back," Grass said. "As tenants get more clarity and understand what their needs are going to be and feel more comfortable and confident making those decisions, they actually want that space back."
Savills, a tenant representation firm, found that 7.8% of the sublease space that was added to the market since the start of the pandemic has been withdrawn. Savills Head of Americas Research Sarah Dreyer said that metric reflects spaces that were leased to subtenants and spaces that were reoccupied by the original tenant, but the latter accounted for the bulk of the withdrawals.
"What we're seeing, in other markets as well as D.C., is now that more of the population is fully vaccinated, companies are beginning to enact their return-to-work plans, and people are beginning to occupy those spaces," Dreyer said. "I'm almost certain that a majority of that is from companies reoccupying their spaces."
Savills also found a sharp increase in leasing volume from Q1 to Q2, but the availability rate, Savills' metric for vacancy, rose to a record high 21.1%. The high amount of available space has allowed tenants to secure favorable deals, with concession packages in D.C. up 30.9% since the start of the pandemic, according to Savills.
"For the availability to be over 21% across the market, that results in a huge amount of options for tenants," Dreyer said. "D.C. already had the most tenant-favorable concession offerings in the nation pre-pandemic, and it's continuing to track that way."
Northern Virginia hasn't had the same positive signs in the sublease market that researchers have seen in D.C. this year. According to CBRE, D.C.'s sublease availability last month was down 12% from the peak, but Northern Virginia's availability has continued to increase, with 1.2M SF added last quarter.
"We think part of the reason is that in Northern Virginia, many tenants have multiple locations, they could have two in the same submarket with a lot of the government contractors, so they're able to reconcile their footprints into one location, since there will be people working from home," Xie said. "That attribute of the market is a disadvantage."
Leasing activity also increased in Northern Virginia last quarter, growing 62% to 2.1M SF, according to CBRE. But it experienced the same dynamic as D.C., recording negative absorption of 604K SF.
Newmark's Q2 report found that Northern Virginia recorded 824K SF of negative absorption in Q2, and its vacancy rate rose from 19.9% to 20.4%.
One advantage that Northern Virginia has over the District is the amount of available space under construction. Northern Virginia has 1.7M SF of office under construction at the end of Q2, with 1.2M SF of that space pre-leased. D.C. has 2.1M SF under construction, and 51% of that is pre-leased.
The nature of construction timelines means that projects that broke ground before Covid will continue to deliver throughout this year and next year, but after that, the market could start to benefit from the pause on development that the pandemic created.
CBRE hasn't tracked any new office projects that have broken ground in D.C. with plans to deliver after 2022, Xie said. Some projects have gone through the planning stages that could break ground, but market conditions have made developers less likely to pursue speculative office construction.
"The construction boom is ending, and that is good because there is less new supply coming online," Xie said. "We still have a couple million square feet of what has delivered and what's going to deliver by the end of next year that's still on the market, so it's going to take a while for the rebalance to kick in, but it's heading in the right direction."