Spike in Vacancy Due to Deliveries
During the third quarter of 2017, the recovery in the Northern Virginia Office market slowed as new demand for space flattened. After registering four quarters of solid growth, net absorption turned slightly negative as federal consolidations and the remaining effects of BRAC impacted the market. While these hold-overs from last cycle played out, the private sector and federal intelligence agencies continued to occupy and lease additional space in the market, pointing to a continuation of the recovery started in 2016.
The market recovery commenced with the end of Sequestration and the resumption of increased federal spending. However, after a significant increase in fiscal year 2016, government spending by federal agencies in Northern Virginia shrank in 2017. Since the beginning of October 2016, $384.7 billion in contracts were awarded to companies in Northern Virginia. This is significantly down from fiscal year 2016, when $460.4 billion was awarded. This decrease in spending has slowed the employment growth in the office using sectors of the economy. So far in 2017, about 3,860 new jobs were created. This compares to 9,600 office-using jobs created during the first three quarters of 2016.
Demand for office space in Northern Virginia was largely flat, with just 65,991 square feet of space returned during the third quarter of 2017. This breaks the four-quarter trend of positive absorption. While absorption overall was flat, demand for Class A and Class C product increased across the Northern Virginia market. Class A space accounted for 159,001 square feet of positive net absorption for the quarter. This compares to 430,423 square feet absorbed last quarter, and brings the 2017 year-to-date total to 1.77 million square feet. Demand was the greatest for Class C product, with 177,573 square feet taken off the market. This is the fourth straight quarter of positive demand for Class C product, bringing the year-to-date total up to 235,980 square feet.
In contrast, demand for Class B space fell this quarter with tenants giving back 402,565 square feet to the market. The return of this space brought the Class B year-to-date total down to negative 556,932 square feet of absorption.
With new supply outpacing new demand, the overall vacancy rate increased 62 basis points to end the quarter at 18.0 percent. The direct vacancy jumped considerably from 16.2 percent to 17.2 percent during the quarter.
Vacancy rose in both Class A and B space, while it dropped in Class C product. Vacancy in the Class A market increased from 17.1 percent to 18.4 percent during the quarter, primarily due to the delivery of new office product. The Class B vacancy increased slightly from 19.7 to 20.0 percent because of falling demand. It fell in Class C product, decreasing from 12.1 percent to 11.5 percent.
During the quarter, the direct average asking rate fell from $32.21 to $31.98 per square foot. While down from last quarter, asking rates are still $0.61 higher than compaired to the same time last year when the rate was $31.37 per square foot. Class A product was the only sector where the rental rate fell, dropping from $36.75 to $36.25 per square foot during the quarter. This compares to the same time last year when it stood at $34.83 per square foot. Both the Class B and C direct asking rates remained relatively flat, rising slightly from $29.59 to $29.60 and from $26.49 to $26.52 per square foot, respectively. While flat for the quarter, the rates for both sectors decreased from a year ago when they stood at $29.68 and $26.70 per square foot.
While slower job growth has resulted in flat demand for office space during the third quarter, many non-government related organizations are bringing new jobs to the region. As a result, the Northern Virginia economy is expected to add about 26,000 new office-using jobs over the next six quarters. Assuming these projections are not reduced as a result of slower Federal spending, these jobs should produce more han three million square feet of new demand for office space. Over the same six quarters, all the 3.73 million square feet currently under construction should deliver. As a result, vacancy rates should rise, as new supply continues to outpace demand. The Class A and B markets will continue to see the bulk of the increase; Class A because of the new supply and Class B because of falling demand. A number of additional projects are expected to break ground, but little purely speculative development is anticipated.