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D.C.'s Office Market Struggled In Q1, And It's Going To Get Worse

Before the coronavirus crisis began, the D.C. office market was already struggling with high vacancy and stagnant demand, and the freeze in economic activity is only going to make matters worse.

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The view from the penthouse level of Republic Properties' 1331 apartment project.

New Q1 data from several brokerage firms shows the District experienced falling office demand in the first three months of the year, and the market's vacancy rate remains at record-high levels. 

D.C. experienced negative net absorption of 200K SF in Q1, according to Cushman & Wakefield, which pegged the District's office vacancy rate at 15.8%. While some ongoing deals were able to close during the quarter, Cushman & Wakefield Regional Director of Research Nate Edwards said he is seeing a drop in new leasing activity. 

"Those deals that were in negotiation prior to recent months are moving forward," Edwards said. "The real hit in the near term has been to newer activity. Social distancing guidelines have made the touring process a little more difficult."

A landlord broker for one of the major firms, who asked to remain anonymous, said he typically conducts 10 to 12 tours with prospective tenants in a week. He said he had one tenant tour last week and as of Wednesday, he had zero scheduled for this week.

The office demand numbers varied among the market reports based on firms' calculation methods. JLL reported negative net absorption in the District of 399K SF and CBRE found 301K SF of occupancy loss. Newmark Knight Frank reported 134K SF of positive net absorption, though that was still down significantly from the same quarter last year. While the numbers may differ, experts agree that demand began to slow in recent weeks and will likely get worse. 

"Tenants that have an inflexible lease expiration date where they simply have to move soon have been moving forward with negotiating lease deals, but other then those tenants, the market has slowed substantially," NKF Senior Managing Director of National Research Sandy Paul said. "What you'll see over the next few months, perhaps the balance of 2020, is essentially no net new demand."

Savills, which calculates total leasing activity including renewals and relocations, found 1.8M SF of activity in D.C. last quarter, the lowest quarterly total since late 2017. In a typical quarter, Savills Head of Americas Research Sarah Dreyer said her team sees a string of deals close in the final days of a quarter, but the economic crisis changed that.

"This quarter was different, there wasn't that end-of-quarter rush of deals being signed," Dreyer said.

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The D.C. office market in Q1 experienced the lowest leasing activity since 2017, according to Savills' data.

A tenant-focused firm that refers to the market's vacancy as the availability rate, Savills pegged that figure at 16.6%, up from 15.9% in the first quarter of 2019. Dreyer said she expects the drop in demand to escalate as companies continue to work from home and delay key decisions. 

"I imagine people are hitting the pause button now, and I think Q2 leasing activity is going to drop below Q1, and probably Q3 as well," Dreyer said. "Given that everybody is in stay-at-home mode, I think they're going to push some of these decisions off until there's clarity around the market picture."

The office market sector that has driven net demand growth in recent years, coworking, is particularly vulnerable to this current crisis, experts say. WeWork had already stopped new leasing activity after its failed IPO last year, and Paul said he is now seeing it try to give back space.

"Coworking is definitely under pressure," Paul said. "WeWork is already seeking a reduction in lease liabilities, it is negotiating with landlords. But also for the industry at large, where a lot of coworking facilities have open office configurations, that environment is more prone to transmit disease."

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The second-floor common area in WeWork's 1701 Rhode Island Ave. NW space

In addition to the vulnerability of the shared office environment, coworking also faces a threat from its model of short-term membership agreements that give companies the ability to vacate quickly if they need to cut costs. Edwards said coworking providers may be able to hold onto their larger enterprise users, but he expects they will see a drop in occupancy from smaller companies.

"The real caution is their month-to-month business and their shorter-term contracts," Edwards said. "It's too easy for a user on a month-to-month deal to end its contract. That's where the real exposure is, and I'd say that's significant, especially for a segment of the market that has seen some volatility."

Coworking providers had been growing their footprints across the D.C. market and filling large vacancies in buildings in recent years, but that activity had already begun to slow. Four coworking leases have been signed in D.C. over the last two quarters, according to Cushman & Wakefield, and both of the Q1 leases were smaller than 15K SF. Edwards does not expect to see expansion from the coworking sector in the coming months. 

"My speculation would be they'd be in more of a holding pattern in the near-term until there is more certainty about when the economy can get up and running," Edwards said. 

While the coming months are expected to be a difficult period for the region's office market, researchers do see some reasons for optimism, from a slowing construction pipeline to the stability of the region's economy. 

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New construction has outpaced office demand in recent years, Cushman & Wakefield data shows.

Vacancy in the D.C. market has been pushed to record highs in large part because of a boom in new office development. But researchers expect the economic crisis will bring new construction starts to a halt in the coming months, potentially mitigating the future damage of decreasing demand on the market.

"One bright side in terms of the balance for the market is that because we're likely to see a significant slowdown in construction — we expect almost nothing to break ground for the balance of this year — that means we'll see a better balance than we were going to see otherwise from a supply standpoint," Paul said. "But demand will definitely be much reduced for 2020."

Another potential silver lining for the D.C. market is that it tends to be more resilient to recessions than other cities. Stable federal agencies make up a significant portion of its office stock, and increased government spending tends to boost other sectors of the region's economy. 

"Compared to our peer markets like New York, San Francisco, Boston, Chicago and Los Angeles, D.C. typically does OK because of the presence of the government and its propensity to spend its way out of a crisis, which we're definitely seeing right now," Edwards said. 

The parts of the region poised to benefit from government spending include the I-270 life sciences corridor in Montgomery County and the government contracting hubs in Northern Virginia, NKF Director of Research Bethany Schneider said. 

"We think those will be the areas of the region that see the recovery soonest and lead the way as the nation comes out of this," Schneider said.

Law firms and lobbying shops, two sectors with large concentrations in Downtown D.C., could also see increased businesses as companies look to navigate the crisis and compete for federal dollars, she added.

Northern Virginia's office market had been moving in a positive direction prior to the crisis, with its vacancy rate coming down as D.C.'s rose, and experts believe this trend could continue. In Q1, Northern Virginia experienced 638K SF of positive absorption, according to Cushman & Wakefield. 

"With its supply-demand dynamic, Northern Virginia is well-poised to continue to tighten," Edwards said. "There is not a lot of true speculative development going on, and the amount of large block users in the market is plentiful."

The sectors that have been driving Northern Virginia's demand growth, government contractors and technology companies like Amazon, are positioned to weather the coming storm better than other parts of the economy, Paul said. 

"In addition to government contracting in Northern Virginia, it has a very strong tech economy, and within the private sector, the tech sector is likely to be one of the economic drivers during this period," Paul said. "We're seeing greater demand than ever for data and the capacity to handle it."