Washington DC Year End 2013

The McBride Market Report
Washington DC Year End 2013

Growing Pains: New Development + Tepid Demand

The final quarter of 2013 saw growth on multiple levels: inventory, absorption and vacancy. 1.7 Million square feet of office space was added to the Washington, DC Metro Area inventory, which now consists of 10,000 buildings totaling of over 468 Million square feet. (Note: the DC Metro Market is far and away the 2nd largest office market in the USA.) Demand grew as well, but at a much lower rate. Approximately 245,000 square feet of office space was absorbed during the 4th quarter and the overall vacancy rate swelled to 14.1%. Simply put, there’s been a significant disconnect between supply and demand for new office space. Looking at the entire year, 2013 saw a meager 750,000 square feet absorbed, while inventory expanded by close to 4 Million square feet. Growing supply and vacancy have contributed towards lowering asking rents and increasing concessions. With another 5 Million square feet of new office inventory in the pipeline, 2014 portends a continuation of a tenant-centric market.

Significant indicators of ballooning vacancies witnessed last quarter include: 4 new buildings totaling over 1.2 Million square feet delivered entirely vacant and a significant number of large blocks of vacant Class A space. It may not be the 1980’s all over again, but for the first time in recent memory, we witnessed multiple brand-new, see-through buildings deliver vacant. Note that the new vacancies aren’t empty warehouses in off locations or data centers in the shadow of the Blue Ridge Mountains, but trophy quality office buildings in Arlington and in DC’s NOMA submarket. At year-end, over 30 buildings in downtown DC had large blocks (>50,000 square feet) of vacant space available.

Private sector demand for office space has shown signs of health, but government fueled growth stalled due to the sequestration and defense spending cuts. Until the public sector returns to providing some measure of steady growth, the DC market will continue to amble along the high-vacancy highway. We believe that significant government driven absorption is inevitable, but the timing of that demand is uncertain.  Irrespective of the rhetorical battle over the scope and role of government, the fact remains that the true battleground is not whether government will grow or shrink. The only measure being contested is government’s rate of growth. Therefore, a return to driving absorption will occur, the only question is when. Of course given that there’s no end in sight to the high level of discord in Congress, we may have to bear through a few more election cycles before witnessing steady public sector demand again.

Although absorption is weak, transaction activity remains robust. Fortunately the clock keeps ticking and leases expire. Rolling leases in a softening market have also incentivized many tenants to negotiate renewals well in advance of their expiration date.

Investment sales were also affected by governmental dysfunction. Washington, DC dropped from the top of the target list for the world’s institutional investors and some major office buildings were pulled from the market due to uncertainties generated by the government shutdown. Even so, sales volume remained strong and prices were slightly higher than 2012. Year-end 2013 sales figures were not available at the time of publishing, but through the 3rd quarter, average prices rose to $312 per square foot (up 1.25% over 2012) and average cap rates fell 11 basis points to 6.5%. Sales of institutional quality assets continue to command a significant premium. For example, 1200 19th Street, NW, a Class A 334,174 square foot building, sold for almost $886 per square foot ($296 Million), at a 4.4% cap rate.

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.

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But What Does It Mean?

  • The Vacancy Rate inside the Beltway grew to over 10% at the end of the year. Many suburban submarkets will continue to be “soft” (Vacancy Rates > 15%) throughout 2014.
  • 5 million SF of new office supply is still under construction, buffering future absorption.
  • Capitalizing upon “Owner Anxiety” results in great leasing terms.
  • “Aggressive” deals should be available at least through 2015.
  • For the time being, the cost of owning is still lower than renting in many submarkets. This phenomenon will vanish when interest rates and sales prices increase.
  • Average asking rental rates dropped slightly. Generous concessions in the “A” and “B” markets have increased.
  • Construction costs are increasing, but are made up for by larger concession packages.
  • “Turnkey” build outs are becoming more common as landlords look to streamline the leasing process.
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Richard McBride Jr.