10 Years Later: Construction Hot but Market Dynamics Different
In virtually every submarket in the District, cranes are busy constructing office buildings, multifamily dwellings, retail and mixed-use projects at an incredible pace. Office product alone has more than 6.5 million square feet under development. The market had a similar look ten years ago when 6.0 million square feet of office product being constructed. There is, however, a big difference between where the market dynamics are now versus then. In the third quarter of 2007, the vacancy rate was 8.1 percent versus 11.8 percent at the end of third quarter of 2017. By the third quarter of 2009, much of the space under construction was completed, and vacancy rates spiked to 11.9 percent as all the space was added to the market. Fast forward to 2017, the low watermark is 11.8 percent, and demand has been and is expected to fall. This combination is anticipated to generate another rise in vacancy. While many of these buildings currently under construction are well pre-leased, it is not new or expanding tenants to the market that are leasing in these buildings, but instead, tenants poached from existing, aging Class A and B product.
During the third quarter of 2017, economic output in the District of Columbia declined, marking the third quarter of contraction. During the quarter, the projected gross regional product for the District fell by 0.24 percent for an annualized rate of negative 0.36 percent for the year. As a result, there was very little employment growth from office-using industries of the District of Columbia economy in 2017. Significant decreases in employment occurred in both the financial and government sectors. Since the beginning of the year, the federal government lost approximately 1,500 jobs, while media and telecom related groups shed almost 250. These losses were offset by employment gains in other sectors of the economy. Since the beginning of the year, the professional and business services added about 1,560 jobs, while advocacy groups and financial institutions added about 790 and 70 jobs, respectively.
For the fifth quarter in a row, demand for office space in the District has fallen with net absorption measuring negative 443,618 square feet. Of this drop, negative 563,848 square feet occurred in Class B product. Net absorption in the third quarter was the lowest of the past four quarters. Continued downsizing from Federal tenants over the last few years contributed to falling demand in the market. Started as a response to austerity measures implemented in 2013, Federal downsizing has been one of the most impactful and most sustained trends contributing to falling demand in the District. Almost as significant, tenants continue to move from aging product to newer Class A space. Demand for Class A space has been positive in three of the last five quarters, with 603,537 square feet absorbed. However, this new demand failed to offset the vast amount of Class B and C space given back to the market, as 2.4 million square feet of lower quality space was returned to the market.
During the third quarter, only the 222,721-square-foot building at 2000 K Street, NW delivered. The construction of 2000 K Street included the demolition of a 153,212-square-foot Class A building and densification of the site. Despite the delivery, the amount of product under construction rose by roughly 50,000 square feet to 6.6 million square feet as the redevelopment of the old Techworld buildings commenced. In the fourth quarter of 2017, nearly 2.3 million square feet is expected to deliver including the first new office building to deliver in the Wharf at 800 Maine Avenue, SW. At just over 70 percent leased, it marks a resounding success by developer PN Hoffman. The second and higher quality of the two new Wharf office buildings, 1000 Maine, is expected to deliver in the first half of 2018. It has also been highly successful in securing preleases. Another notable delivery will be the new Fannie Mae headquarters located at 1100 15th Street, NW. It will be the fifth largest privately owned building in the District. With nearly 6.6 million square feet of space under construction, the District has the highest level of space being developed since the third quarter of 2008, when just under 7.2 million square feet was being built. Developers have not shied away from going forward with speculative projects in attempts to lure tenants from aging commodity A product. Both of the Wharf’s two office buildings and Capitol Crossing (200 and 250 Massachusetts Avenue, NW) were started on a completely speculative basis. At the end of the quarter, Capitol Crossing remained without any leases in place.
Vacancy rates in the third quarter continued to rise and set a new cyclical high of 11.8 percent. In the third quarter of 2009, the vacancy rate was 11.9 percent after several quarters of deliveries. Due to the amount of space under construction, a similar bump is expected to occur in the next 18 months. Owners of lower quality buildings will be most affected as tenants in the market have tended to prefer Class A space often at the expense of B and C product. Over the next several quarters, expect the overall vacancy rate to increase several hundred basis points.
While vacancy continued to rise in the third quarter, overall rental rates stayed virtually the same. A slight increase in Class A rents was offset by decreases in Class B and C rents. Class A rents increased from $59.69 to $60.16 per square foot, while the combined Class B and C rents decreased from $45.51 to $45.49 per square foot. To attract a dwindling supply of large, good credit tenants in the District, owners have continued to offer aggressive concession packages. Build-out construction costs, most notably labor, has made it difficult for tenants to fully construct their space for anywhere near $100 per square foot. Owners on ten-year deals are typically offering well above that on new spaces and giving ten to fifteen months of free rent.
With the high level of space under construction and several other projects slated to break ground, the vacancy levels for the District are on the brink of exploding. In a market where most consider 10 to 11 percent vacancy healthy, increases into the mid-teens are likely in the near future. This, however, will not likely keep developers from going forward with speculative developments because the majority of tenants in the market demand new Class A product. Change is dependent on tenants being more impacted occupancy costs associated with high quality space. Up until now, tenants have been able to keep costs down by shedding inefficient space and downsizing their footprint in new product, even at higher rents per square foot. As tenants organically grow and need more space in higher rent buildings, the allure of cost savings in second or third generation space may be able to pull some groups back to older buildings. However, the office-using employment sectors of the economy are expected lose jobs until late in 2018. As result, demand for office space is expected to contract over the next 18 months, propping up the cycle of tenants leaving older space and shrinking their footprint into new space. This will further prompt developers to break on new development.