Small Expansions Fuel Demand
During the fourth quarter of 2017, overall demand fundamentals strengthened significantly for the first time in six quarters. Tenants, who previous consolidated over the last few years, have grown, resulting in new space requirements. This, coupled with the growth in smaller firms in the District, has caused new demand for blocks of space less than 20,000 square feet to grow. During the fourth quarter, the incremental demand from these smaller leases was more than enough to offset the continued shrinking of the Federal Government’s real estate footprint and the impact of larger tenants consolidating as they implement space-saving workplace strategies. As a result, overall net absorption measured 295,678 squares for the quarter. Some of the more notable tenants that took these smaller blocks of space included Amazon, Food and Water Watch, Bill and Melinda Gates Foundation, and Weiner Brodsky Sidman Kider PC. While it is unclear if continued expansion from smaller tenants will replace the expected demand loss by some of Washington’s larger tenants in 2018, it is encouraging that the District’s economy is creating growth in at least a portion of the commercial real estate market.
During the fourth quarter of 2017, the District of Columbia’s economy remained repressed, growing the least of the three jurisdictions that make up the Greater Washington, DC Metropolitan Area. During the quarter, the economy increased by a projected annualized rate of 0.77 percent. While the growth rate was up marginally from 0.72 percent last quarter, it was well off the 1.94 percent growth that occurred in 2016. Despite lower output, employment continued to expand in the District. During the quarter, 3,370 jobs were created; 3,060 occurred in office-using industries. As a result, this new spate of employment offset the losses that happened in the first three quarters of 2017, resulting in 980 new office-using jobs created throughout the year. This upswing in employment was largely attributed to the tax reform initiative on Capitol Hill.
Both lobbying and legislative activity continued to be major demand drivers for the office market. While lobbyists were in the midst of reporting their fourth quarter activity, lobbying activity in the first three quarters of 2017 was well ahead of 2016 levels. Additionally, the pace of laws being passed increased steadily in 2017. During the fourth quarter, 33 new laws were passed, this compares to 21 in the third, 24 in the second and 19 in the first. However, the number of bills introduced fell off sharply, totaling 8,330 bills introduced in 2017. In comparison, 12,063 bills were introduced in 2016 and 10,637 in 2015. Additionally, new bills introduced slowed dramatically in the last half of 2017; only 31.1 percent of the 8,330 pieces of legislation created occurred in the last half of year.
DemandDespite new demand of 295,678 square feet in the fourth quarter, it was not enough to compensate for the contractions over the previous two quarters when net demand fell 907,550 square feet. As a result, 2017 was the second year in a row and third in the last four when the demand for office space decreased. During the quarter, there was considerable downsizing among larger tenants, most notably the Federal Government. An uptick in smaller expansions from the private sector offset t he impact of these big blocks of space returned to the market. This was the first sign that tenants are starting to outgrow the space they leased over the last seven years. In the years following the 2008 recession, tenants have primarily shrunk their footprints. Recent leases, however, have shown small but numerous expansions. Class A absorption continued to attract the most demand, with seven of the last ten quarters registering positive absorption for high-end space. Class B, on the contrary, has only been positive in three of the previous ten quarters and Class C space only once.
Just over 550,000 square feet of space deliveried during the fourth quarter. The two most significant deliveries came in emerging markets. Phase I of the Wharf located at 800 Maine Avenue, SW delivered 241,450 square feet with 70.8 percent committed. Notable tenants include the American Psychiatric Association (63,017 square feet), MakeOffices (44,693 square feet), and Van Scoyoc Associates (21,227 square feet). Also, 700 Pennsylvania Avenue, SE delivered 234,920 square feet 30.2 percent committed in the Capitol Hill submarket.
Even with the delivery of over 550,000 square feet to the market, the total square footage under construction increased by 230,000 square feet to end 2017 with 7.0 million square feet being built. This was the highest amount since the end of 2004 when 7.6 million square feet was being constructed. Several buildings are expected to deliver during the first quarter of 2018. The first and most significant project delivering is Fannie Mae’s headquarters at 1100 15th Street, NW. Fannie Mae will take 589,000 square feet in the massive 868,721-square-foot building located in the heart of downtown, moving in shortly after delivery. Alexander Court at 2001 K Street, NW is the other large development slated for completion next quarter.
It is a redevelopment of 2000 L Street, NW and 2001 K Street, NW, which will combine to form a 764,417-square-foot office building. Ownership has had several large leases in the building including Akin Gump, Bates & White and Cornerstone Research. Combined, these tenants will take over 300,000 square feet in the building.
The vacancy rate remained at the highest level since the end of 1995, when it peaked at 11.9 percent. Class A vacancy remained the highest of all classes almost entirely due to the new product that delivered over the last few years. Class B vacancy continued to rise as tenants left lower quality, older product for new space. The Class B vacancy would be much higher if not for all the demolitions that have occurred to make way for trophy construction. These trends are expected to continue as a tremendous amount of space is set to deliver over the next few years. Rental Rates Overall, rents increased by nearly a dollar to end the year at the new high watermark of $55.87 per square foot. In fact, rent expectations increased across all classes of space. The most pronounced occurred in Class C product, which ended the quarter averaging $39.07 per square foot. Class B rental rates rose to end the quarter at $47.36 per square foot, also setting a new record. While prices continued to rise, it is still a tenants’ market and concession packages remained very aggressive.
The compounding of several smaller expansions led to positive absorption in the fourth quarter. In 2018, it is expected that private sector tenants will continue to marginally expand their footprints. This, however, will not likely offset the decreases that will come from the Federal Government. Vacancy will continue to rise as 3.2 million square feet, just over 50 percent preleased, is expected to deliver in 2018. Most tenants relocating to these new developments will be vacating more space than they occupy in 2018, which will further push vacancy upwards. Recently, the tenants that have added the most net new demand to the market have been shared office providers such as WeWork, Spaces and MakeOffices. Unfortunately, since these companies release their space to coworking tenants, they will cannibalize some of the demand that otherwise would find its way into the larger office market.
A positive impact of the large-scale construction happening in the District is that the quality of the product continues to improve. In some larger, more sprawling cities, their downtown areas are being underutilized, which can affect the overall look and competitiveness of the city.