D.C. Region Sees More Development as Tenants Seek Efficient, Amenity-Rich Office Space

by John Nelson

On the surface, the Washington, D.C., metropolitan office market has shown little change over the past five years. But dig a little deeper, and some interesting trends emerge.

Metro D.C.’s office market totaled 377 million square feet as of the third quarter of 2017 and recorded a vacancy rate of just under 15 percent — inclusive of sublease space — and cumulative net absorption of 600,000 square feet year-to-date.

The market has demonstrated little change in major market indicators over the last five years. Notably, three of the last five years (2012 to 2016) recorded negative absorption on a regionwide basis — averaging 82,000 square feet annually.

Jessica Mistrik, Avison Young

Jessica Mistrik, Avison Young

Overall vacancy levels have thus far been held in check in part due to vacant buildings being removed from inventory for renovation and retrofitting or for conversion from office to other uses such as schools and residential. Nevertheless, core submarkets and micro-markets are benefitting from occupancy growth and rental rate increases, with tenants demonstrating a decided preference for amenity-rich areas.

Tenant Preferences
Regionally, the office segment is characterized by flight to quality and tenant-leaning leasing conditions. Tenants continue to favor efficient space design. They’re relying more heavily on building amenities such as conference centers, for example, often reducing or eliminating big conference rooms in their spaces.

Preference for transit-oriented locations continues to influence tenants’ decision making as well. This has as much to do with an expanding amenity base, often clustered near Metrorail stations, as it does with employee commuting patterns.

Over the last year, meanwhile, the region experienced further growth in coworking or flex space options. These are not simply flexible suites and terms with shared operational amenities. New operators are taking a hotel approach with features such as coffee bars, game rooms and concierge services.

Landlords have responded by increasing the number of plug-and-play spec suite options — often gaining leasing share in the very competitive sub-10,000-square-feet arena. And because build-outs across the region can cost more than $50 per square foot, pre-built suites can offer shorter-term leases or serve tenants who do not want to navigate the construction process.

Building renovations are common and range from base building and façades to upgrading common areas and energizing lobby spaces. As owners build more tenant conveniences into new properties and retrofit older spaces, Avison Young anticipates that operating expenses could also tick upward.

New Projects Underway
Construction and new product deliveries will play an increasing role in the region’s office health as renovated product delivers to compete with commodity Class A and trophy assets, particularly downtown. Eleven office properties totaling 2.5 million square feet have come on line throughout the metro area year-to-date and were 61 percent preleased as of the third quarter. Another 1.1 million square feet is anticipated to be delivered before year-end.

Looking forward, both the suburban and downtown markets have a considerable pipeline of new construction underway for completion in 2018 and 2019 (10.6 million square feet total), including entire building renovations and ground-up development.

The largest new projects under development are Capital One’s new headquarters (975,000 square feet in Northern Virginia’s Tysons submarket), 1100 15th St. N.W. (869,000 square feet, largely for Fannie Mae, in the CBD) and Alexander Court at 2001 K St. N.W. (814,000 square feet, also in the CBD and preleased to tenants such as Akin Gump Strauss Hauer & Feld LLP and Bates White). While buildings under construction are 67 percent preleased, overall regional vacancy will likely increase slightly during the next 24 months.

Transactional Activity
Not surprisingly, the region’s top lease transactions list for year-to-date 2017 was again dominated by government deals and renewals. Two leases, however, were notable because they represent expansion.

Amazon’s office-using Web Services division took 400,000 square feet in Herndon, Virginia, for a new East Coast corporate campus, which will bring up to 1,500 new jobs. Meanwhile, Nestlé agreed to move its headquarters from Glendale, California, to 206,000 square feet in Rosslyn, Virginia, creating 750 new jobs.

By mid-year 2017, investment sales volume in the region remained virtually unchanged year-over-year at $7.8 billion. There were, however, dramatic fluctuations in dollar volume for the various property types.
Office investment sales accounted for almost 60 percent of the total first-half 2017 volume, posting a 36 percent increase compared with the same period in 2016. Investors are focusing on amenity-rich submarkets with demonstrable rental growth or demand drivers.

Despite the 30-basis point uptick in the average cap rate, buyers’ optimism in the region’s office market remains high. The transaction profile fits mostly core, core-plus and value-add investment strategies. Foreign investors, which continue to show interest in the metro’s core product market, accounted for roughly half of the transactions by total dollar amount.

Tenant right-sizing and building renovations and redevelopment are trends that we expect to continue well into 2018. Watch for vacancy rates to climb in select submarkets, while pricing for sales and leasing is maintained.

— By Jessica Mistrik, Research Manager of Avison Young. This article was originally published in the November 2017 issue of Southeast Real Estate Business.

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