Record Influx Of New Office Deliveries Brings D.C.'s Vacancy Rate To Highest Point In 5 Years
D.C.'s office market recorded strong absorption in the second quarter, but demand growth was outpaced by the record amount of new supply that delivered, bringing the city's vacancy rate to its highest point in five years.
With several buildings bringing large blocks of new, vacant space to the markets, D.C.'s office dynamics could swing even further in tenants' favor as landlords compete to lease up projects.
Five new office developments delivered a total of 2.1M SF to the D.C. market last quarter, according to Newmark Knight Frank's Q2 report. Cushman & Wakefield's report, which observed roughly the same delivery total, noted that it represents the largest quarterly total of new deliveries in D.C. history, but nearly half of the space remains vacant.
Some of the new deliveries were anchored by large tenants like Fannie Mae at Midtown Center. Other deliveries were less than half filled upon delivery, such as Capitol Crossing's 200 Massachusetts Ave. NW and Skanska's 99 M. Skanska also delivered 2112 Pennsylvania Ave., which is anchored by Cleary Gottlieb but still has over 100K SF available. The Wharf's trophy office building at 1000 Maine delivered this quarter with tenants such as Fish & Richardson and Washington Gas, but about 40% of the building remains available, according to NKF.
"With these deliveries, the vast majority of the pre-leasing was in the top floors," NKF Associate Director Bethany Schneider said. "It's the lower floors of these buildings that are still available. Based on recent trends, it seems that it will continue to be a challenge for these owners to get the lower floors leased."
This onslaught of new vacant space has swung the market even further in the tenants' favor. D.C.'s vacancy rate rose from 11.4% in Q1 to 12.9% last quarter, according to NKF, its highest point in over five years. Cushman & Wakefield pegs D.C.'s vacancy rate at 14%, up from 12.3% at this time last year.
"There is a gluttony of space on the market," said Savills Studley Corporate Managing Director Jon Glass, who is currently representing a 50K SF law firm tenant and has identified over 60 Class-A options for its planned 2021 move.
Landlords in D.C. have already been offering record-high concessions to attract tenants while keeping rental rates steady, but Cushman & Wakefield Senior Director of Research Nathan Edwards said the competition is beginning to put pressure on rents.
"The very best space at the top of the projects has done well and the rent numbers are strong, but for the lower-level space, I think they've come off those rents a little bit," Edwards said. "A lot of them were looking to lease in the low $50s [per square foot] triple-net, and I think most of the deals we're going to see on those lower level floors are going to be in the mid-to-high $40s."
Even if landlords have to bring down rents, Edwards expects the new trophy buildings will fully lease up within three to four years, given the continued flight to quality. But he said the second-generation, commodity Class-A space those tenants vacate will have a hard time leasing back up and could also be forced to lower rents.
"We expect the new space to continue to lease, but the question is for the tenants that migrate, the space they leave behind is where we think a majority of the distress is going to be," Edwards said.
Transwestern principal George Vogelei, who leads a team that specializes in working with landlords to reposition second-generation Class-A space, also sees that as the segment of the office market that will be hardest hit by the growing supply and rising vacancy rates. He has seen a sharp rise in the number of those landlords launching renovations on their buildings. Between 2000 and 2010, an average of three to five renovations took place in the D.C. office market each year, according to Transwestern's research, but over the last three years that has ballooned to 15 to 20 renovations a year.
But not all renovations guarantee leasing success. Vogelei said it is important for landlords to focus on not only building larger amenities, but to think holistically about the way their amenities connect and interact with each other. He also said landlords need to invest more in quality architects and property managers, and partner with them early on to ensure the design and management fits with the vision they have for the project.
"In that commodity A space there are winners and losers," Vogelei said. "Some guys who are not putting out the right product aren't going to lease, but for buildings that are doing successful, smart renovations, they're still getting paid back."
The impact of the supply surge coming onto D.C.'s office market is not expected to slow down anytime soon. Another 2.2M SF of office space, including new construction and substantial renovations, is expected to deliver by the end of 2018, according to Cushman & Wakefield, and 60% of that space remains available.
The D.C. office market has a total of 4M SF under construction, according to Newmark Knight Frank. But that total is down significantly from last year because the recent surge of deliveries has not been matched by an equal amount of new construction starts.
"It seems like the peak of construction has happened," Schneider said. "There is definitely a lot in the pipeline, but it does seem developers are being slightly more cautious with the amount of construction that has delivered recently."
With so much new supply being added, the D.C. office market needs to attract a substantial amount of new growth to keep vacancy rates from rising further. Absorption has been strong so far this year, but it was not enough to keep vacancy from spiking.
Edwards said demand is relatively flat outside of the fast-growing coworking sector, and consolidation from government agencies and law firms continues to reduce occupancy in the market. An additional problem he sees is landlords are reaching further into the future to sign tenants, inking deals for firms that don't plan to move until at least five years from now.
"With a lack of immediate tenants to occupy products, they're continuing to look further into the future to poach future demand," Edwards said. "A lot of these bigger deals are being executed well in advance. That's a testament to how difficult the market is today from a large user perspective."
The market has seen some demand growth from tech companies, both large Silicon Valley firms increasing their D.C. presence and local startups expanding their footprints. Landlords are hoping Amazon picks D.C. for its second headquarters, a win that could transform the city's office market dynamics overnight.
"Everybody is keeping HQ2 in their back pocket," Glass said. "If that were to happen, a whole new host of businesses will follow suit. But right now, I don't know where demand is going to come from to eat up all of this supply."
Even if Amazon doesn't pick D.C, Vogelei said the fact that the region is seen as a front-runner is already helping it attract new office tenants.
"I think all of the reasons people think D.C. is the No. 1 lead contender for Amazon are exactly the reasons we’re going to see headquarters and large firms relocating here," Vogelei said.