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Tale Of Two Cities: D.C.’s Core Office Market Struggles As Emerging Areas Strengthen

The core downtown office market in D.C., comprising the central business district and East End submarkets, is suffering from oversupply and stagnant demand, with some experts predicting a double-digit percentage drop in rents. Meanwhile, emerging submarkets like NoMa, Southwest D.C. and the Capitol Riverfront have captured strong leasing activity and outperformed the District's traditional office environs. 

Washington D.C.

These three emerging submarkets, which comprise 21% of the city's office stock, claimed 43% of all leasing volume in Q3, according to CBRE's Q3 office market report. The vacancy rates in these submarkets have dipped into single digits, sitting at 9.9%, compared to 13.2% in the downtown core. 

The supply-demand dynamics in D.C.'s core office market appear to be out of whack. In the CBD and East End, a total of 4M SF of office is under construction, according to JLL's Q3 report, more than the rest of the city combined. But, through the first nine months of 2017, these submarkets have experienced negative absorption, losing a net total of 59K SF of occupied space. 

"The issue with the overall market is downtown and the amount of space under construction," JLL Managing Director of Research John Sikaitis said. "You have flat demand levels and millions of square feet under construction with the vast majority of that unleased."

JLL's John Sikaitis and HOK's Vincent Ng
HOK's Vincent Ng and JLL's John Sikaitis at Bisnow's D.C. State of Office

These dynamics are worst in the trophy and Class-A segment of the market, with most of the construction either ground-up trophy development or renovations of old Class-B buildings into Class-A product. But the number of tenants on the market for high-end space is shrinking, Sikaitis said, with most law firms that have upcoming lease expirations already signed, and much of the new demand coming from value-conscious tenants. 

This has created sharp competition among downtown landlords in the top segment of the market. Up until now, this competition has manifested itself in concession packages such as tenant improvements and months of free rent, but it appears asking rents are starting to give. 

"This was the first quarter that we've seen, in lease proposals, landlords are starting to drop rates," Sikaitis said.

JLL expects this drop to continue, projecting a 12% to 15% decline in downtown trophy and Class-A office rents through the end of 2019. 

Newmark Knight Frank Senior Managing Director Sandy Paul said some owners of downtown commodity Class-A buildings have reluctantly begun to bring rents down to Class-B levels to help fill vacant space. 

"For some product, it comes down to a choice between accepting lower rents and increasing occupancy, or continuing to have high vacancy," Paul said. 

Tale Of Two Cities: D.C.’s Core Office Market Struggles As Emerging Areas Strengthen
A rendering of Skanska's spec office project at 99 M St. SE

Meanwhile, emerging markets outside of the downtown core have trended in the opposite direction. Vacancy in these markets has been cut in half since 2009, according to JLL, and rents have increased and are expected to soon surpass an average of $50/SF.  

The Wharf, the $1.5B Southwest Waterfront development opening next week, has drawn tenants such as law firms, lobbying groups and nonprofits away from the CBD. Leasing activity has also picked up in the Capitol Riverfront, with office projects such as Skanska's 99 M spec building starting to build momentum. The NoMa submarket has continued to lure large government tenants away from more traditional office areas.

These three submarkets have combined for 236K SF of net absorption so far in 2017, according to JLL. This has created an environment that favors landlords in these areas much more than the downtown submarkets. Rents in emerging markets like Capitol Riverfront and NoMa have grown more than 15% since 2015, Sikaitis said, adding that The Wharf has experienced a 30% price increase since it began leasing. 

"These parts of the market are seeing rents increase, concessions decline, vacancy decline and activity diversify," Sikaitis said. "These markets are challenging for tenants and more opportunistic for landlords." 

Tale Of Two Cities: D.C.’s Core Office Market Struggles As Emerging Areas Strengthen
The First Street NE and L Street intersection in the NoMa neighborhood, with Tishman Speyer's Mathematica-anchored office building on the left

CBRE Research Manager Wei Xie attributes the strong performance of these emerging markets partially to tenants seeking a value play, with the ability to get the same quality of space as downtown Class-A product but only pay Class-B level rents. She also said the way these neighborhoods have been designed plays a big role. 

"The developers in those secondary markets are very conscious about adding amenities," Xie said. "The BIDs are very focused on making sure they have a great retail mix, residential space, and some of the features like waterfront parks that you don't see in the core market." 

Unlike the downtown market, where office buildings make up 80% to 90% of the space in some areas, Sikaitis said secondary markets are much more diverse, mixed-use environments. Neighborhoods like Capitol Riverfront began with strong multifamily and retail, with the growing number of residents supporting the new stores and restaurants. Then as the neighborhood became a more vibrant and enjoyable place to be, developers bet that some companies would choose to work there and began to build office. He sees this trend also taking shape in Northeast D.C. submarkets.

"The Ballpark area is a case study for what will happen in markets like H Street and Union Market, and even beyond east, in later years," Sikaitis said. "These emerging markets didn't have office product because there was never a residential base that demanded it. Now as the residential base increases, there is going to be a need for office."