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Washington DC Metro Area Market Q1 2022

Rentable Building Area
Market: 512,236,442 SF
4 & 5 Star: 267,374,370 SF
3 Star: 183,753,559 SF

1 & 2 Star: 61,108,513 SF

It has been 2 years since I provided a snapshot and forecast of the DC metro area office market, which at the time looked so bright it had to wear shades. The date was January 15, 2020, nearly 2 months to the day before “2 weeks to slow the spread.” At the time, the nation was experiencing the longest period of sustained growth on record and, with no glaring/imminent threats on the horizon, it appeared that vacancies would continue to fall and market rents rise, at least along trendlines. Then a black swan from China fed by a contentious election year and nurtured by power-hungry and authoritarian politicians and bureaucrats fundamentally changed the way we live, work, and play. Teleworking was not a new concept at the time. Many companies allowed employees some measure of flexibility in being able to work from home, but the growing consensus seemed to be that having employees work in the office was a net positive. The practical and psychological impacts of the pandemic changed all that. Demand for office space is on life support, vacancies are at historic highs, and rents are falling. Barring some unforeseen catalyst, a “white swan” if you will, it’s hard to see how the office market recovers.

Even the combined might of the federal government and the area’s many Fortune 500 companies was insufficient to save the DC metro office market from the scourge of Covid-19. At 15.2% the market vacancy rate is the highest in recorded history; however, this belies the truly dire state of office demand. The availability rate is a more accurate representation of the supply of office space competing for tenants and that number is at 18.8%; the result of 7 straight quarters of negative net absorption. It gets worse when considering recent demand trends towards transit-oriented, 4 & 5-Star properties. The vacancy and availability rate for that class of office buildings is at 17.9% and 22.8% respectively.

The federal government has been a major driver and stabilizing force in the DC metro office market and when Amazon announced that it would make National Landing the site of its HQ2 in 2019, the area was poised for the explosive growth associated with big-tech. Unfortunately, these 2 juggernauts are unlikely to aid in the recovery of the market. Policy changes at the General Services Administration, will result in the federal government reducing its footprint with private landlords and federally owned buildings over the coming years. Many of the area’s largest employers are moving into their own headquarters, i.e. Amazon, Capital One, Marriott, which means the impact on absorption will be a net neutral. Both are exploring hybrid schedules and remote work, which will have a larger impact on overall demand than the sum of their parts.

The pandemic saw the greatest transfer of wealth in human history, mainly caused by government policies and lockdowns. Amazon and Google can afford to have their employees work from home indefinitely while continuing to pay for office space. Small to medium-sized businesses, on the other hand, cannot necessarily do the same, as evidenced by the largest inventory of sublet space in history. Amazon will continue to develop the 6 million SF that it must “occupy” in order to take advantage of tax benefits offered by state and local governments, but it is unlikely to take a leading role in getting employees back in the office. By driving other tenants out of the market, the area’s largest companies will only increase their leverage and competitive advantage.

Vacancy Rate/Availability Rate
Market: 15.2%/18.8%
4 & 5 Star: 17.9%/22.8%
3 Star: 14.2%/16.3%

1 & 2 Star: 6.6%/8.0%

Net Absorption Past 12 Months
Market: (1,523,080 SF)
4 & 5 Star: (932,256 SF)
3 Star: (531,519 SF)

1 & 2 Star: (59,305 SF)

Vacancy Change Past 12 Months

Market: 1.5%

Just 2 years ago, the big story in leasing was Amazon’s HQ2 and the potential for explosive growth led by big-tech. The opposite is now true and rather than fueling demand for office space, big-tech is leading the teleworking charge; adjusting their leasing strategies to the new remote-work paradigm and getting richer in the process. Amazon’s remote-work policy is currently in flux and Capital One has pushed back its return-to-office policy (employees will be required to be in the office Tuesday-Thursday in 2022). Small to medium-sized businesses will likely be required to follow suit and adopt similar policies in order to compete for talent; however, as stated earlier, Fortune 500 companies can afford the expense of leasing office space while absorbing any loss in productivity associated with not having their employees physically in the office. In fact, this may be a strategy to monopolize negotiating leverage and talent acquisition.

If you’re looking for the federal government to drive the recovery, think again. Instead, the GSA will further disrupt a return to normalcy. The new commissioner of Public Building Service at the GSA, Nina Albert, plans to reduce the federal government’s leasing footprint with private landlords and move to flexible, remote policies. The impact on the office market could be catastrophic as approximately 60% of federal leases expire in the next 5 years.

Costar lists notable leases as the Securities and Exchange Commission relocating and expanding from 700k to 1.2M SF at 60 New York Ave NE (but not until 2025), the American Banker’s Association relocating from 3-Star space in the CBD to 1333 New Hampshire Ave, , and the National Institute of Health leasing additional space in North Bethesda (2115 E Jefferson St). It’s interesting to note that these and the overwhelming majority of significant leasing activity was from government, government-funded, i.e. Raytheon, and non-profit tenants. The government never runs out of money even if ordinary for-profit businesses do.

What little leasing activity there was followed the existing trend of flight-to-quality and consolidation into premier and emerging submarkets. The East End, Reston, DC’s Central Business District (CBD), NoMa, and Tysons Corner were the top 5 submarkets in terms of overall leasing activity in 2021 with Crystal City, Capital Riverfront, and Bethesda reporting notable but more deal-specific wins. These trends are likely to continue as rising construction costs make renovations and/or redevelopments in secondary and tertiary (suburban) submarkets cost prohibitive. Despite 4 & 5-Star properties absorbing nearly all demand, they have almost 61M SF available for lease across the metro area.

Average Asking Rent
Market: $38.79/SF
4 & 5 Star: $45.78/SF
3 Star: $32.00/SF

1 & 2 Star: $27.40/SF

Rent Growth Past 12 Months: (0.7%)

Existing, long-term leases have buffered against the devastation caused by the pandemic; however, market rents have not been immune to the law of supply and demand. Landlords may still be collecting rents for already leased space but, as evidenced by the 9.9M SF of sublet space on the market, tenants are looking to offload space rather than lease it; creating additional competition for struggling landlords. As a result, rents are falling and landlords are making other significant concessions, i.e. free rent, tenant improvement allowances, etc. to lease up properties. A real life example can be seen at 1875 Pennsylvania Ave, which after losing its anchor tenant (WilmerHale), was marketing space around $29.00/SF, triple net compared to the CBD/submarket average of $65/SF, full-service. The fact that this is for a 15-year lease with free rent and tenant improvement allowance included reveals a shocking and frightening insight into landlords’ perception of the future of office demand.

Northern Virginia, once the leader in rent growth for the DC metro, saw rents decline more than the market average due to large tenant relocations to build-to-suit headquarters, and Southern Maryland, previously 3rd in terms of leasing activity and rent growth, saw the most absorption over the past 12-months, which unsurprisingly was Covid-19 related and due to its reputation as a bio-tech hub. Despite this, rents still fell in Montgomery County with a notable exception being a large lease signed by TCR2 Therapeutics, which received significant funding from federal, state, and local governments.

Under Construction
Properties: 44
Market: 10,482,678 SF
4 & 5 Star: 10,438,678 SF
3 Star: 44,000 SF

1 & 2 Star: 0 SF

Percent of Inventory: 2.0%

Preleased: 68.5%

Delivered Past 12 Months: 2,100,000 SF

The construction pipeline for the DC metro office market is one of the largest in the country but, luckily, the amount currently under construction is small in comparison, equating to only about 2% of the existing inventory. A significant portion of the projects underway are build-to-suit, corporate headquarters, i.e. Amazon, Capital One, and Marriott, and while this mitigates supply-side increases in the vacancy and availability rates, it removes some of the market’s largest tenants, further reducing demand and exacerbating the vacancy epidemic. Pre-pandemic demand and development trends continue to be transit-oriented/metro-accessible and typified by leasing less space in nicer buildings (flight-to-quality); accelerating the functional obsolescence of many of the metro’s submarkets and buildings (3-Star and below). It is yet to be seen how the pandemic will impact the use of public transit and preferred housing density, but many employees that have the ability to work from home are relocating to more affordable areas, even out-of-state. In normal times, this might have been a boon to suburban submarket; however, due to increased construction costs (both labor and materials), it will be some time before renovations and/or multi-tenanting floors/buildings) become economically viable.

Sales Past 12 Months
Properties: 910
Average Cap Rate: 7.0%
Average Price/SF: $302/SF

Average Vacancy at Sale: 16.7%

Sales Volume: $5,900,000

Costar claims that investor confidence is rising as evidenced by sales activity in the 3rd quarter of 2021, which topped $2.5B and was the highest quarterly total since the pandemic. The DC metro office market is apparently one of the most liquid in the nation due to its stable tenant base, notably the federal government. Indeed, the common factor in the majority of the major transactions was federal, state, and/or local government tenants. This is a sound strategy, at least in the short term. The government never runs out of money, making it the best/most reliable tenant in uncertain times; however, if the GSA follows through with its plan to reduce the amount of space it leases from private landlords, what we’re likely seeing is a game of hot potato where the final investor holding the property gets burned. Indeed, some owners like Washington Real Estate Trust are jumping ship entirely. The company sold a dozen office buildings in key submarkets (Ballston, CBD, Old Town Alexandria, Rosslyn, and Tysons Corner) for $766M to free up capital for its transition into multi-family investment.

Two interesting sales were of distressed properties. The largest was the purchase of 1350 I St NW by an affiliate of MetLife. The 400k SF, 4-Star office building in the CBD last traded in November 2010 for $517.84/SF. The recent sale of $120.5M equates to a mere $301.25/SF and represents a 42% reduction in value. The 2nd largest foreclosure sale was of 1500 Wilson Blvd. The 261k SF, 4-Star office building located in Rosslyn last sold for $351.31/SF in July of 2015; however, because this was part of a portfolio sale the per square foot market value of the property on an individual basis was likely higher at the time. An affiliate of the Meridian Group purchasing the building for $58.3M or $223.06/SF, a reduction in value of over 36%. Even market sales like Hines Global Trust’s purchase of 1015 Half St SE in the Capitol Riverfront submarket for $215M ($508/SF) are indicative of falling values. The common theme in all of these sales is the discount to replacement for each property, which means that one could not build the property for the purchase price.

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