School Conversion Highlights Start to 2018

One of the most significant blocks of space has come off the market with the lease and planned conversion of 4000 Connecticut Avenue, NW into an international private school. It marks a growing trend in the District as developers continue to redevelop and repurpose aging office buildings. It will not wholly counter the impact on vacancy from the massive amount of space under construction. However, it will lessen its impact. Other than this significant, albeit non-office lease, activity was relatively slow. Two other notable transactions came from the media, a typically underperforming sector. NBC News signed a 72,000-square-foot lease at 400-444 N. Capitol Street, NW, and  the National Association of Broadcasters signed a short-term lease for 59,166 square feet at 1771 N Street, NW. Hogan Lovells LLP expanded at Columbia Square, 555 13th Street, NW, bringing some optimism on the demand side as yet another law firm that previously downsized increased their footprint by over 50,000 square feet. 

Economy

During the first quarter of 2018, the District of Columbia’s economy grew by 0.67 percent, an annualized rate of 2.72 percent. While it was the most growth in a single quarter since 2010, it was lower than both Northern Virginia and Suburban Maryland, contributing only 23.5 percent to the Greater Washington, DC office market’s quarterly economic growth. Although the total workforce grew by 4,010 participants, the Metro area’s unemployment rate fell seven basis points to 3.56 percent. At full employment, strong for talent remained competitive, making office space and the associated amenities both within and surrounding buildings a potential differentiator in attracting and retaining employees.

The office-using sectors of the economy created 2,770 new jobs during the first quarter, well above the pace set in 2017. All but one area of the office-using economy contributed to this increase with the most substantial job growth occurring in the professional and business services industries, which added 820 new positions. 

Also of note, advocacy groups added a considerable number of new jobs. The non-profits and other advocacy institutions added approximately 410 new positions, the most new jobs created in this sector since the end of 2016. The one glaring outlier in employment growth continued to be the Federal Government. Since the Trump administration took office in 2017, Federal employment in the District of Columbia decreased every quarter. During the first quarter of 2018, 220 Federal jobs were lost.  

Demand

After strong demand growth in the fourth quarter of 2017, first quarter’s net absorption returned to negative territory as 87,745 square feet was returned to the market. This marked the third quarter of the last four, and seventh of the last ten where demand fell. Absorption has averaged negative 102,000 square feet per quarter during the previous three years.   
The vast amount of net negative absorption occurred in the CBD due to several significant tenants moving out and substantial sublet space coming to the market. Uptown, also, contributed to the decrease in demand with Fannie Mae moving out of a considerable amount of space and relocating into half of their new headquarters space at Midtown Center. Conversely, net absorption was positive for the East End with DC Bar, Fiscal Note, and Yelp! as chief contributors. 

Class A space continued to drastically outperform lower quality space in the first quarter, registering just under 340,000 square feet of demand versus negative 427,513 square feet in the combined Class B and C space.

Supply 

The completion of 414,271 square feet, half of the Fannie Mae headquarters at 1100 15th Street, NW, accounted for the vast majority of space delivered in the first quarter of 2018. This trophy office building began construction in the second quarter of 2016, and when the sister building delivers next quarter, it will account for over 850,000 square feet of new space added to the market. The build-to-suit project has several bridges connecting the two towers. The other notable delivery in the first quarter came from the new home of the DC Bar at Mount Vernon Place, 901 4th Street, NW. DC Bar took 65,000 square feet from the second to the sixth floor in the 105,000-square-foot Class A office building.  

With no significant groundbreakings and more than 530,000 square feet delivered in the first quarter, the amount of space under construction decreased for the first time in nine quarters. It is likely last quarter was the peak of construction activity for this cycle. With several massive developments expected to deliver in the next six months and only a few anticipated groundbreakings, the  construction numbers should dip below five million square feet by the end of the year. 

Vacancy 

Negative absorption and more than 530,000 square feet delivering in the first quarter pushed vacancy above 12.0 percent for the first time in more than a decade. Vacancy rose by 32 basis points to end the first quarter of 2018 at 12.1 percent. Vacancy rose in both Class A and B space, but for very different reasons. The Class A vacancy increased due to the considerable amount of new space that came to the market. Class B vacancy increased as tenants continued to vacate lower quality space to move into higher-end product. Class C space was the only asset class where vacancy decreased this quarter, falling from 4.7 to 4.0 percent. This was largely due to the demolition of aging and underperforming properties to make way for additional trophy construction.

Rental Rates

Despite the lack of demand in the first quarter of 2018, rental rates rose across the board. The most pronounced increase came in Class C space with a 50 cent bump from $39.07 to $39.57. Both Class A and B rates also increased by four cents and 11 cents, respectively. As previously stated, there will be a significant amount of space delivering in 2018 resulting in upward pressure on Class A asking rents. Net effective rents have stayed relatively static. Increases in concession packages have followed suit and have risen alongside asking rents. It is now common to see tenant improvement allowances over $140 per square foot and 12 to 15 months of free rent on a ten-year deal in trophy buildings.

Outlook 

While office-using job growth is expected to continue throughout 2018 at roughly the same rate as it has for the last several quarters, it will not be enough to overcome tenants downsizing into more efficient floor plans. As a result, demand for office space will remain below what would be anticipated given the number of new jobs created.  With repressed demand, coupled with the exorbitant amount of new product to deliver, the overall vacancy rate will increase over the next 18 months. Despite this upcoming vacancy in the market, it has not discouraged foreign money looking to invest in the District. Investors with long-term hold strategies are expected to be drawn to the new high-end product that delivers with significant occupancy and long-term cash flow. Investors looking for shorter-term holds may find it more difficult to reconcile the District’s low cap rate environment.

Renovations will continue to occur in aging office product in an attempt to reposition these assets to meet current tenant expectations. The demand for higher-end space continues to grow and will place many owners of lower quality product at an extreme disadvantage in attracting tenants. Owners of these types of buildings will either renovate the site or convert their assets to different uses.