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Q3 2016 | Washington, DC | Office Market Report

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Market conditions are definitely feeling softer in the District these days. Overall, demand for office space is down and vacancy rates are up, but there is still momentum in the marketplace. Demand for Class A space, though not as robust as it has been, continues to grow while demand for Class B and C space continues to shrink. Landlords are very aware of this trend and continue to either demolish Class B and C product to make way for new Class A, renovate older product to make it competitive in the marketplace, or convert their properties to other uses. This has been an ongoing trend for some time. The question everyone is asking…who will be left with an empty Trophy building? 

ECONOMIC

Economic activity in the District of Columbia has been generating new jobs, and at a faster rate than what occurred in 2015. So far this year, total non-farm employment has grown at an annualized rate of 2.04 percent, adding an estimated 11,700 new jobs. This compares to 7,370 jobs created in 2015. Of the jobs created so far in 2016, 6,430 of them were in office-using sectors of the economy. The government sector has seen the greatest increase so far in 2016, adding an estimated 5,270 new jobs. While significant, the office market is not currently receiving new demand from these jobs as the General Services Administration is still trying to shrink the Federal Government’s leasing footprint. In fact, it is expected that, as Federal leases roll, their space requirements could decrease by as much as 15 percent. The Federal Government will reduce its square-foot-per-employee allocation and continues to promote teleworking and hoteling. 

When the government sector of the economy is factored out, the remaining office-using sectors have created an estimated 1,150 new jobs. The professional and business services sectors contributed the most to this increase, growing by 1,790 new jobs. This growth was offset by job losses in the other office-using sectors of the economy. The largest offset continued to be generated by financial services firms. So far during the year, 300 jobs have been eliminated. The media, information and telecommunications industries eliminated 90 jobs and other service industries eliminated another 1,210 jobs. While considered part of the other services sector of the economy, advocacy firms have started hiring again. So far in 2016, these firms have created an estimated 430 new jobs. This compares to 2015 when 400 jobs were eliminated. 

DEMAND

Net absorption for the quarter was 264,788 square feet, the highest since the third quarter of 2015. On the heels of the first quarter’s negative absorption, the significant growth posted this quarter pushed year-to-date numbers to 223,111 square feet. The positive absorption was focused exclusively in Class A product where it rotated 586,773 square feet. Significant negative absorption came from both Class B and Class C spaces, registering negative 301,006 and a negative 20,979 square feet respectively. Demand in Class A product continues to outperform lower quality space as tenants move into blocks left by the multiple, large tenants which have opted for new build-to-suit spaces.

With all this office-using job growth, nearly 150,000 square feet of space was expected to be absorbed so far in 2016. However, with continued consolidation from firms becoming more efficient with their space, demand for office product has actually fallen with 726,293 square feet of space returned to the market. As has been seen since 2008, demand for Class B and C space continue continued to fall. This quarter alone, 810,965 square feet was returned, mainly as the US Coast Guard vacated the 609,265-square-foot Transpoint building located at 2100 2nd Street, SW and moved into federally-owned space. While positive for the year, even demand for Class A space has been lackluster. The only quarter in 2016 where net absorption was positive occurred during the second quarter when it totaled 586,773 square feet. Bookending the second quarter were two periods of falling demand in Class A space. During the first and third quarter, 79,236 and 89,497 square feet of space were returned, respectively. 

SUPPLY

While demand for Class A space has started showing some increased inconsistency, new demand for Class A space continues to grow and remains strong. Coupled with falling demand for Class B and C space and the limited developable land and height restrictions, this has prompted developers to continue demolishing or renovating old product to make way for more competitive properties. During the third quarter, the 153,212-square-foot office building at 2000 K Street, NW was demolished to make way for a new 222,119-square-foot office building, which is expected to break ground during the fourth quarter of 2016. Additionally, the Fortis Companies commenced the conversion of the 27,871-square-foot office building at 1624- 1632 11th Street, NW to a 33-unit multifamily apartment building. This brings the total demolition, renovation and conversion number to 1.3 million square feet so far in 2016. With no deliveries during the second quarter and only 1.1 million square feet of new product brought online during the first half of the year, the overall office inventory has shrunk by 198,502 square feet in 2016. 

Construction activity remains high in the District of Columbia. At the end of the third quarter of 2016, 15 buildings were either under development or renovation. When delivered, these projects will add a net 4.0 million square feet to the market. These projects, however, are significantly more committed than the ones under construction at the beginning of the year. At the end of the third quarter, 61.4 percent of the space under construction or renovation was already committed. At the beginning of the year, 16 buildings totaling 2.7 million square feet were under development. Of this space, only 34.8 percent was leased. Even as the amount of leasing in the product under development has increased, tenants will largely be relocating from other office buildings. Oftentimes, the relocating tenants will leave behind more space than they will occupy in the buildings currently under construction. 

VACANCY RATES

The demolition and conversion of so much office space has done little to offset falling demand’s impact on the overall vacancy rate in the District of Columbia. During the quarter, it rose from 10.8 to 11.3 percent. This brings the rate within 50 basis points of the historical high of 11.8 percent recorded by Colliers in 2009. The bulk of the increase occurred in Class B space, where the overall vacancy rate rose from 10.0 to 11.6 percent. The vacancy rate also increased in Class C space, rising from 3.7 to 4.1 percent. The Class C vacancy rate remains low because Class C product is often targeted for redevelopment or conversion. As a result, as Class C buildings are vacated, they often are demolished or converted to another use. The Class A vacancy rate remained unchanged at 11.7 percent. 

Vacancy rates are up for the year across all classes of space. New deliveries in 2016 have outpaced demand for Class A space. This has resulted in a marginal increase in the Class A vacancy rate, which rose from 11.5 to 11.7 percent. The combined Class B and C vacancy rate has increased during the year as well, rising from 9.9 to 10.6 percent, as falling demand pushed it up. 

RENTAL RATES

The direct average asking rate across all classes of space increased from $52.24 to $52.35 per square foot during the third quarter of 2016. Optimistic landlord expectations for Class A space prompted this growth as the Class A asking rate increased from $57.55 to $57.67 per square foot. These rent gains were offset by falling expectations for Class B and C product. During the quarter, the combined Class B and C rate fell from $43.75 to $43.63 per square foot. 

OUTLOOK

Currently, there is 4.0 million square feet of space under construction, and at the end of the third quarter 61.4 percent of the space was committed. This leasing activity, in most cases, is not new demand but rather relocations from other product in the market. As a result, large blocks of space will be left behind as tenants relocate into their new offices. Additionally, most of the law firms have recently signed new long-term leases and unless they need to expand, they won’t be engaging the market for the better part of the next decade. Traditionally, this sector of the tenant base has been able to pay a premium for new development, and they have anchored much of the new Trophy space. Their absence in the market could leave developers without tenants willing to pay the high price associated with Trophy space. 

Additionally, with redevelopments, demolitions and renovations being so prevalent, vacancy has been pushed to the future. Given all the leading indicators, demand for office space is expected to grow, but at a slower rate than new supply is being brought to the market. As a result, the overall vacancy rate is expected to rise, and if redevelopment activity stops as the demand for high-end space softens, they could rise to over 15 percent during the next three years. 



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