Midyear 2013 Market Report
When you paddle out to surf where the waves are breaking, just staying in position to catch a wave can be a lot of work. Frequently large waves are also accompanied by strong current. On these days the sublime sensation of catching and riding a wave is paid for by a long, hard paddle back out through the break and against the current. The first half of 2013 has been a lot like surfing with a strong current. With over one million quare feet of negative absorption in the first quarter, we had to paddle hard in the second quarter just to get back into the same position as of year-end 2012. At mid-year, the overall vacancy rate worked its way back to 13.9%.
Conditions in the real estate market have been challenging, but fortunately there have been a few good waves to ride in the DC area. The good news is that in spite of the “Great Uncertainty” (Government’s inability to agree upon a budget), the local and national economies have made slow, steady progress. Employment is slowly growing and financial markets seem to have fundamental health. (As an aside, we find it ironic that signs of the US economy gaining enough strength for the Federal Reserve to end its bond buyback program generated waves of losses in US and other stock markets.)
One factor tempering demand for office space has been the drive for employers in all sectors to do more with less. The recovery from our “Great Recession” has been driven by new efficiencies. According to the Wall Street Journal, American auto manufacturers will almost match all time production levels set in 2007, but with 100,000 fewer workers (approx. 20% smaller work force). But then again, the drive for efficiency has been a constant since the beginning of commerce. Fortunately for manufacturers, the Luddite*1 movement has run out of steam. In the world of commercial real estate, the quest efficiency has driven office space use towards open, collaborative areas that support work flow and require fewer square feet per employee. Although these waves of efficiency initially result fewer square feet leased (or fewer employees hired to produce the same quantity of goods) the reality is that increased efficiency typically results in higher net consumption. That is, when we create more efficient processes, the end result is greater consumption. Examples of this counter-intuitive effect fall in line with the “Jevons Paradox”*2. However, rather than being applied towards the relationship between the cost of energy production and overall consumption, our expanded view includes, greater efficiencies in the production of any goods or service (including employment) allowing for a lower cost of production, decreased price. Assuming some elasticity of demand, the ultimate result is greater consumption of that good or service. For example, new efficiencies in manufacturing have helped to revive and grow the manufacturing base in the US and resulted in an overall increase in the number of manufacturing jobs. Efficiencies in the office space have helped employers afford to grow. Efficiencies may initially reduce individual consumption of office space (as well as other goods and services/employees), but the resulting lower cost in combination with economic expansion inevitably results in higher consumption.
Economic theories aside, what do these trends mean for the commercial real estate market? Probably not a lot in the near term. The “Rebound Effect” *3 of lower cost resulting in higher consumption of office space is a relatively slow process. However, the fundamental trinity for real estate, “Location, Location, Location”, remains unchanged. In spite of fairly wide spreads in price, demand has clearly been highest in the centrally located submarkets downtown and inside the Beltway. While overall vacancy rates have held steady, the underlying current clearly shows a shift towards submarkets located in and around downtown DC. To wit, the vacancy rate in Downtown DC dropped to 10%, while the vacancy rate in our suburban markets increased to 15.7%.
As tenant representatives, we view the continued tenant friendly attitude of landlords as a welcome longterm phenomenon. Transaction activity remains robust, as many tenants have opted to take advantage of the market to negotiate new leases well in advance of their term expiration. Assuming continued strength in the local economy and slow steady growth of the national economy, we foresee slightly declining vacancy rates over the next 12 months.
Landlord anxiety continues generate the tidal shift of tenants throughout the region. With over 450 Million square feet of office space under lease, approx. 67 Million square feet (15%) is renewed or relocates in any given year. This transaction volume does not add to the absorption of vacant space. In periods of slow growth, landlords compete for this finite pool of tenants, essentially reshuffling them throughout the market. One spinoff of this competition is an increased willingness of landlords to engage in negotiations far in advance of a commencement date. Negotiating leases 18 months in ahead of the expiration date has become more common. Some mid-size (50-60,000 SF) tenants are currently negotiating leases 2 years ahead of their expiration. This phenomenon is interesting on two levels: it indicates that many landlords expect flat demand for the next 18-24 months and secondly, it takes advantage of the reluctance of institutional owners with leases in place to recast leases significantly before their expiration.
The early negotiation trend represents a new strategic advantage for tenants. In years past, early forays by tenants in the market were typically broker driven ploys in an attempt to create some leverage with existing landlords. Today this has become a viable strategy due to landlord willingness to engage. The result is that tenants’ optimal window for negotiation has widened considerably.
Another still-open window of opportunity is the upside-down cost of owning vs. leasing. Traditionally, leasing has been the least expensive method of occupying office space. With the cost of borrowing hovering at historically low levels and sales prices remain flat, the cost of owning is frequently less expensive than leasing office space. Owning isn’t the right decision for every organization. However, if your organization is relatively stable in size and is able to pull together the equity required for a purchase, you may want to include purchase opportunities in your mix of options.
In sum, we expect to see a slow and steady strengthening of the DC office market (especially inside the Beltway). Continuing market trends include:
- City-focused demand. DC recorded 498,000 SF of positive absorption over the last 12 months, while the suburban markets had negative 608,000 SF of absorption during the same period.
- Long lead time opportunities to negotiate or renew leases 18-24 months prior to expiration.
- Limited new supply: only 1.1 Million SF of new space was delivered to the market in the first half of 2013 approx. 80% of that new space was pre-leased. Most of the 6.7 Million SF of space currently under construction is also pre-leased.
- The cost of owning is still lower than renting in many submarkets. This phenomenon will vanish when interest rates and sales prices increase.
- Construction costs are increasing, but Landlord concessions typically cover build out costs for 10 year leases.
- “Turnkey” build outs have become more common.