The office market in metropolitan Washington, D.C., is currently differentiated between a vigorous investment sales market and anemic leasing fundamentals. According to data from CoStar Group and Cushman & Wakefield, office investment sales have averaged $8.4 billion annually from 2014 to 2018 versus $5.5 billion annually from 2008 to 2013. Investment sales in the District have been dominated by Class A and trophy assets with little leasing risk, while demand is buoyed by foreign capital sources.
In Northern Virginia, sales have trended toward core-plus and value-add investments led by domestic buyers seeking additional yield. Investors are more comfortable with leasing risk in Northern Virginia due to its robust job growth, a trend likely to continue given the jurisdiction’s comparative advantages in cloud computing, cybersecurity and internet infrastructure. Amazon’s selection of Crystal City for HQ2 and Amazon Web Services’ large block leasing in the Dulles Toll Road corridor are emblematic of these larger regional trends.
However, there are signs that investment demand may have peaked for the current cycle. This year’s sales volume is the weakest in several years despite an influx of closings in September to beat Washington, D.C.’s increase to the transfer and recordation taxes from 2.9 percent to 5 percent.
Michael Wagoner
Assistant Vice President,
Quadrangle Development Corp.
An additional factor is pullback by foreign capital. An example of this trend is the Japanese investor Unizo Holding Co., which acquired a $1.4 billion District office portfolio in 2016 and 2017. CBRE is now marketing this portfolio for sale despite a similar investment profile to its recent acquisition. Despite a gradually cooling market, Class A and trophy assets with the appropriate physical characteristics, close proximity to amenities and transit and without near-term leasing risk will typically fetch over $1,000 per square foot in the District.
Increased efficiency and the changing nature of space utilization by office tenants, as well as continued new supply and repositioning of existing office buildings, has produced an excess supply of older Class A re-let office space that is likely to last several years. Many of these buildings have physical impediments such as tight column spacing or comparatively low slab-to-slab heights that will make it difficult for them to compete with newer product, even with the addition of modern office amenities. These factors have produced lower net absorption, elevated vacancy and declining effective rents as a result of higher tenant improvement allowances and longer rent-free periods.
In certain well-located and transit-rich submarkets in the District, Class B office space has been outperforming the market given continued demand at rent levels in the range of $50 per square foot and in the face of diminished supply. Since a large number of Class B properties have been demolished for new construction or upgraded to Class A quality over the past few years, there is a growing shortage of Class B product, resulting in lower vacancy rates and increasing net effective rents, a trend that should continue.
As evidence of the growth of coworking, as well as an indicator of the nature of changing office use, WeWork is now the largest private office tenant in downtown Washington, D.C., and has continued expanding in suburban submarkets as well, with recent expansions in Bethesda and Tysons.
Overall, coworking currently represents a relatively small fraction of the overall office market — most estimates place the level at around 3 percent — but a disproportionate share of recent absorption as existing competitors expand, new firms enter the market, and large landlords start their own coworking platforms. However, growth in this category has been at a slower rate in recent quarters even before the issues plaguing WeWork led to its $8 billion rescue via SoftBank.
Northern Virginia submarkets along Metrorail’s Silver Line, in particular Tysons, Reston and Herndon, continue to be a relative bright spot. According to research from JLL, there are few blocks available for large tenants wanting to be along the Metro: three options in Tysons, three in Reston and five in the Rosslyn-Ballston Corridor.
These submarkets have seen a steady increase in net new job creation and resulting office space net absorption. From 2010 to 2014, the Tysons and Toll Road submarkets accounted for just over half of all leases larger than 100,000 square feet.
Since 2015, these submarkets have captured over 67 percent of these large leases. This relative scarcity has led tenants with large space needs to shop across submarkets and eventually spur new development.
However, due to rising construction costs, a new project requires a significant premium to existing Class A rents in order to be economically viable. Further, debt markets generally require a prelease anchor tenant to secure financing, which has limited speculative development in recent years.
— By Michael Wagoner, Assistant Vice President at Quadrangle Development Corp. This article originally appeared in the November 2019 issue of Southeast Real Estate Business.