New leases give signs of life to struggling DC office market

A slew of new leases signed in December helped DC’s office market end 2021 on a positive note, but its recovery could be complicated by the omicron variant, and experts say it could be at least a year before DC’s record vacancy rate begins to fall.

Bisnow / Jon Banister

The Signal House office building at 1255 Union Street NE, near Union Market.

The district office market recorded a positive net absorption of 93,000 square feet in the last quarter, according to CBRE’s Fourth Quarter Market Report, marking the first quarter of demand growth since the third quarter of 2019. Volume Gross rental in the district totaled 2.3 million square feet in the fourth quarter, largely thanks to the private sector, which, according to CBRE, recorded its highest level of rental since the start of the pandemic.

“The private sector has a strong foundation, especially in downtown DC, where nearly half of all leases signed have resulted in growth,” said Wei Xie, CBRE’s research director. “It was a surprising number of leases that represent net growth because their business is doing well and they expect strong growth in membership. “

Two of those private sector leases were signed at Signal House, the special office project that Carr Properties handed over vacant last year. The developer signed a 50,000 SF lease with TikTok for the social media company’s first DC office, bisnow first reported last month. Carr also signed a 48K SF deal with nonprofit NeighborWorks last month, an unreported deal previously included in CBRE’s report that a spokesperson for Carr confirmed to bisnow.

Two other new deals were signed at the Warner Building, a downtown office building located at 1299 Pennsylvania Ave. NW, owned by CBRE Investment Management and leased by CBRE. According to the CBRE report, the building landed a 54K SF lease with Deloitte and entered into a 55K SF deal with Industrious, a coworking company that often structures its deals in the form of management agreements.

The last quarter also featured a 54K SF deal at Capitol Crossing with Elias Law Group, the new firm opening its first office, and law firm Katten Muchin Rosenman. sign a 55K SF deal to relocate to DC at 1919 Pennsylvania Ave. NW.

This growth in leasing demand has crossed the river to Northern Virginia, where CBRE reported 76,000 square feet of positive net absorption, ending a five-quarter streak of occupancy losses.

New North Virginia leases last quarter included a 185,000 square foot lease to Ballston from a group of nonprofits backed by Charles Koch, a 100,000 square foot lease to Reston Town Center with the computer company Peraton and a 85K SF lease at Reston Station with software company Qualtrics International.

The fourth quarter Savills report found that DC had 3 million square feet of rental business in the last quarter, an increase of 52% from the fourth quarter of 2020. Newmark’s fourth quarter report found that DC had recorded its first quarter of positive occupancy since the second quarter of 2020, with 45,000 square feet of positive net absorption.

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Courtesy of Newmark

A graph from Newmark’s Q4 DC office report showing quarterly net absorption over the past five years.

Newmark found that demand growth for DC was particularly strong in the Class A segment of the market, which recorded a positive net absorption of 242K SF in the fourth quarter.

“In the fourth quarter, we saw a significant number of leases,” said Matt Kruczlnicki, associate director of market research at Newmark. “You could attribute this to pent-up demand, which we have tracked throughout the pandemic as rental activity practically came to a halt at the start of the pandemic. Ultimately, these tenants have to make a decision.”

The district’s demand growth was still outstripped by the amount of new supply available in the market, leading its vacancy rate to hit a new record high of 18.4%, according to the CBRE report. Newmark set the district’s vacancy rate at 17.2 percent, up 170 basis points from a year ago.

The positive rental momentum in the fourth quarter could be slowed by the omicron variant, which has resulted in a record spike in Covid-19 cases in the last few weeks of the year and has led many companies to delay their return to the office.

While Kruczlnicki said many companies with employees working remotely still plan to return this year, and some are touring offices before leases expire, he said the continued resurgence of the pandemic is not helping. market recovery.

“In the last six months since the start of the delta variant, we have seen that the fundamentals of the office market are very closely tied to the re-embarkation and the use and utility of office space, and the Re-embarkation from offices is strongly correlated with current public health conditions and the spread of variants, ”he said.“ As long as variants continue to spread throughout the region, it will be a challenge to see a massive increase of the occupancy rate. “

Xie said that while the variants have had an impact on the market, she doesn’t see a direct correlation between the percentage of people returning to offices and the amount of space rented. And she said the effect of remote working on downsizing companies can be countered by increasing the size of companies as they grow.

The trajectory of office demand this year remains uncertain due to the pandemic and remote working, but the picture of office supply is much clearer.

As the pandemic nears the two-year mark, many buildings that were already under construction in March 2020 have been delivered, and slowing new innovations after that point is reducing the amount of space that is expected to hit the market in those areas. years to come.

The district’s pipeline of office space under construction at year-end stood at 1.4 million square feet, according to Newmark, the smallest construction pipeline it has measured since 2014. Newmark does not. found two office projects that broke new ground in the district in the past year. , totaling 306,000 square feet, whereas before the onset of the pandemic, annual construction typically exceeded 1 million square feet.

“Throughout Covid, there have been very few speculative departures,” Kruczlnicki said. “Developers are facing the uncertainty of future demand, they are facing current pricing challenges with supply chain constraints and the cost of construction, so many projects will not be innovated in the current environment. unless they have a significant pre-lease, and these pre-leases have been rare over the past 18 months. “

Some buildings that were under construction before the pandemic are still expected to deliver vacant space to the market this year, which could further increase the vacancy rate, Kruczlnicki said. But after 2022, he said the drop in supply should help tighten the market.

“The fact that we are not increasing our delivery pipeline in 2023, 2024 and 2025 bodes well for future increases in vacancies,” he said. “While we face headwinds with increases in job vacancies during 2022 due to expanding inventories, the lack of new innovations in the past 18 months at least will hold back any increases in job vacancies resulting from the expansion of inventories in subsequent years. “

Xie noted that while DC’s office vacancy rate has continued to rise over the past year, the pace of that increase has slowed. She also said that the slowdown in housing starts will help reduce the vacancy rate over time, but that may not happen immediately.

“I’m not going to say the vacancy rate has peaked; I’ve wanted to say it for a few years now, but it continues to rise,” Xie said. “We think the peak of acceleration has passed. We think it’s going to stabilize gradually as it has been throughout 2021. So in 2022 we certainly don’t see the rate of increase that we’ve seen in the last couple of years. “

In addition to the slowdown in the pipeline of new construction starts, the trend of converting older, vacant office buildings to other uses could help reduce the inventory available in the market and lower the rate. vacancy.

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The vacant office building at 1125 15th St. NW.

The DC government is formulate a plan to spur office-to-housing conversions, and at least three of these conversion projects are progressing in downtown DC

Lincoln Property Co. and Cadillac Fairview acquired an office building at 1313 L St. NW in 2020 which they are in the process of converting into apartments, and last week the partnership closed with the acquisition of 1125 15th St. NW, which he is also planning to convert into apartments. Foulger-Pratt acquired the vacant office building at 1425 New York Ave. NW and declared bisnow he plans to convert the 13-storey building into 255 apartments.

While these projects present challenges, such as the larger floor plates of office buildings and the higher rents that offices typically command, Xie said the high vacancy rate for Class B offices – CBRE fixes it. at 23.7% in DC – makes these projects more achievable.

“The Class B product has a lot of vacancies and a lot of this product is in very good locations, so these are projects waiting to be reactivated and re-energized,” Xie said. “Certainly the conversion is not easy and it is not cheap, which is why it has not happened on a large scale… but it seems that there is a lot of talk about it, and a concentration of the public sector, so this could potentially be an excellent solution both for the oversupply of the office market and for our housing needs. “

Another type of conversion project, desktop to lab, could help improve the office market in suburban Maryland, which has seen strong growth in the life sciences industry. Maryland’s suburban office market has a 17% vacancy rate, down 10 basis points from the previous quarter, CBRE reported.

CBRE announced Monday that it has negotiated the $ 45 million sale of three flexible office properties on West Guide Drive in Rockville to Thor Equities, which CBRE says is considering converting them into space for the life sciences.

“Suburban Maryland’s vacancy rate actually declined slightly this quarter, in part due to the removal of vacant buildings from office inventory due to life science conversions,” Xie said.

Jose C. Birney