Tenant-Favorable Conditions Persist in Slow-Going Office Market

The metropolitan area has recovered its pre-recession employment levels; however, with the federal government being the region’s major economic driver, there has been considerable impact on the office market from BRAC (Base Realignment and Closure), sequestration, the recent government shutdown and the failure of Congress and the President to permanently resolve budget and debt-ceiling issues. And while sequestration technically took effect in 2013, many major tenants, in anticipation of cutbacks, began right-sizing their occupancy well in advance. Obviously any tenant whose revenues depend on government contracts led the charge in this proactive right-sizing movement.

At the same time, federal tenants face a mandated reduction in their utilization rate, and private-sector tenants are looking for more densely packed, open-workspace floor plans as demonstrated by tenants leasing less space as they relocate. Notwithstanding the apparent economic headwinds, it is a remarkable time for confident tenants to lock in favorable terms. Concession packages, which comprise improvement allowances and rent abatement periods, are at all-time market highs, and landlords have demonstrated a willingness to restructure leases considerably in advance of expirations.

Nevertheless, the private sector has added nearly 50,000 jobs for the 12 months ending in July, which is a positive offset to the federal slowdown and, perhaps, points to a greater diversification of the regional employment base. Leisure and hospitality, education/health services and financial activities posted the strongest gains and far outpaced the U.S. rate of growth for those sectors.

Fundamentals

As of third-quarter 2013, the Washington region’s office market comprised 369.6 million square feet in Washington, D.C. (131.2 million square feet), northern Virginia (163.5 million square feet) and suburban Maryland (75 million square feet). Overall vacancy was virtually unchanged from year-end 2012 and ended the quarter at 13.7 percent. As in 2012, transaction volume remains below average with an abundance of short-term new deals and renewals — though brokers report that tenant tours ticked upward in the spring and have remained robust through the fall. Still, the timeline for bringing a deal to completion has lengthened.

In Washington, D.C., overall vacancy is 9.3 percent and absorption has reached 424,000 square feet year-to-date. Law firms remain an active player downtown and are supporting several major new construction projects. Arnold & Porter has preleased 80 percent of the new building that Boston Properties is developing on the site of National Public Radio’s former headquarters. More recently, Miller & Chevalier agreed to anchor 900 16th Street N.W., a new 120,000-square-foot building two blocks from the White House. The JBG Cos. and ICG Properties are developing the project for delivery in 2015. Both law firms are slated to occupy less space in their new locations. Altogether, 1.7 million square feet is expected to reach completion in 2013, and another 1 million square feet is slated for delivery next year. Projects under construction boast a 60 percent prelease rate. Similar to vacancy, rental rates moved little in 2013, and the overall average asking rent was $50.71 per square foot as of Oct. 1.

Suburbs

Washington’s suburbs, northern Virginia and suburban Maryland, recorded a combined 16.1 percent vacancy rate in the third quarter, and absorption totals 1.6 million square feet year-to-date. Historically, the top-performing suburban markets have been those close-in, due to their concentration of federal tenants and access to Washington, D.C., the Capital and the Pentagon. In contrast, many of those same markets continue to lose occupancy and are a drag on the region’s performance this year. This trend is evidenced by net absorption in outside-the-Beltway submarkets in Virginia (Tysons Corner and the Dulles Corridor) and Maryland (the I-270 Corridor) leading the region’s growth with tenants such as Amazon, DynCorp, National Cancer Institute and Choice Hotels. In Tysons Corner, tenant activity is markedly higher, and positive take-up has kept this submarket’s vacancy lower than the market average.

Well-located construction has successfully attracted tenants at the expense of older properties, some of which will be adapted for uses other than office, demolished or substantially upgraded for re-tenanting. This year, 3.6 million square feet is expected to be delivered in Washington’s suburbs, and another 2.3 million square feet is slated for completion in 2014. Projects under construction are preleased at a rate similar to D.C. (59 percent), some at record rent levels. One of the largest deals year-to-date is the long-anticipated resolution of the National Science Foundation’s (NSF) expiring lease in Arlington, Va. NSF announced that it will relocate in 2017 to a new 661,000-square-foot development in Alexandria. Also of note is Macerich’s mixed-use Tysons Tower, which includes 525,000 square feet of office space that is more than 50 percent preleased to Intelsat and Deloitte. Intelsat will relocate its headquarters from Washington, D.C., to Tysons Tower when the building is completed in mid-2014.

Look for the tenant-favorable conditions to be sustained into 2014 as vacancy rates remain elevated relative to this market’s historical performance.

— Margaret Donkerbrook, vice president of U.S. Research with Avison Young