Washington, DC East End Submarket Q1 2019

Overview – Vacancies in the East End ticked above the metro average at the end of last year, and several projects that are anticipated to deliver early this year could cause rates to continue to increase. Demand rebounded last year after tenant downsizings weighed on growth for several years, with net absorption negative in 2015 and negligible from 2016–17. Construction activity is ramping up, regardless, with 1.2 million SF delivered in 2018 and another 1.2 million SF set to deliver in 2019.

D.C. tenants willing to pay higher rents, such as corporate law firms, prefer newer, more efficient space in the East End. Healthy pre-leasing of new deliveries highlights the flight to quality. Of the 11 properties delivered from 2015–18, six are at least 90% occupied and the remaining properties are between at least 50%.

The flight-to quality trend explains why some of East End’s older, 3 Star inventory—which totals 8.5 million SF—is being renovated into 5 Star office space. Although buildings offering the newest, most amenitized space are landing big tenants, recent deals include generous tenant improvement packages and prolonged periods of free rent, suggesting that tenants have meaningful leverage. Sales last year posted the strongest year since 2014 and matched the total volume in 2016 and 2017 combined.

Leasing – As longstanding tenants such as the GSA and corporate law firms downsize and relocate into new, top-quality product, demand growth in Washington’s East End continues to lag. Examples of tenant downsizing include Covington & Burling, which reduced its footprint by 7% (nearly 30,000 SF) when it moved from 1201 Pennsylvania Ave. NW to CityCenter. The National Labor Relations Board also left its home at 1099 14th St. NW for new space in the Capitol Riverfront, shrinking its occupancy by almost 50%.

WMATA recently announced plans to consolidate its office space—spread throughout D.C., Maryland, and Virginia—which will result in the agency vacating the 270,000-SF Jackson Graham building at 600 Fifth St. NW and moving to Southwest D.C. Most recently, Baker Botts announced it has pre-leased 103,300 SF at Meridian Group’s 700 K St. NW, anticipated to deliver in early 2019. The law firm will reduce its footprint by about 27% when it leaves JBG’s Warner Building at 1299 Pennsylvania Ave. NW.

Growing tech companies—promising enterprises that can’t yet afford premium space but nonetheless want prime locations—could pick up the slack for office demand in the East End. Washington, D.C. has the highest level of educational attainment in the country (more than 50% of residents hold a bachelor’s degree or higher), which has resulted in tech employers targeting the metro to tap the talented labor pool. Furthermore, a study by the American Institute for Economic Research recently ranked D.C. as the top destination for recent college graduates among major metro areas. The metro has gained millennials at one of the fastest rates of any metro in the U.S., particularly early in the cycle.

The D.C. government also sees the potential and recently passed legislation that gives capital gains tax breaks to “long-term, quality high-tech companies.” The new legislation aims to encourage the creation, expansion, and retention of District-based technology companies and to incentivize District investors to diversify by placing capital in technology startups. Recognizing the potential demand upside, co-working giant WeWork opened one of its first D.C. locations in Chinatown in 2014, leasing around 21,000 SF of creative office space at 718 Seventh St. NW. The company recently opened its 11th location in the D.C. metro just one block away on 6th Street NW. Spaces, an Amsterdam-based co-working company that has also quickly expanded in the U.S., recently leased roughly 50,000 SF at 1441 L St. NW, a space that was formerly occupied by the Bureau of Economic Analysis.

Rapidly growing tech giant Uber Technologies has demonstrated its interest in proximity to the federal government. The company recently chose Downtown D.C. as the new location for its East Coast operations headquarters, where it occupies roughly 73,000 SF. Other well-known tech companies are making their way to the East End, as well. Yelp moved into 52,000 SF at Terrell Place earlier this year—the same building where Facebook recently leased 75,000 SF, more than doubling its previous footprint. More recently, Apple signed a lease for 29,000 SF of office space at 700 K St. NW. The building is across the street from the Carnegie Library, where the tech giant plans to open a retail store by the end of the year.

Rent – At more than $56/SF, Washington’s East End is the priciest submarket in the D.C. metro, with rents that were roughly $3/SF more than the next nearest submarket at year-end. Other submarkets in the District, such as Capitol Riverfront and NoMa, are emerging as alternatives for tenants in the market for 4 & 5 Star space; this competition from other submarkets may explain why rent growth has become increasingly slow in the East End over the past few years.

Landlords’ willingness to provide ample tenant improvement allowances to large office users is indicative of tenants’ negotiating power. Since 2013, seven major law firms have inked long-term deals to be anchor tenants in newly constructed office buildings (Kirkland & Ellis, LLP; Baker Botts; Simpson Thatcher; Venable; Arnold & Porter; Covington & Burling; and Cleary Gottlieb). The average contract rent for these deals is about $57/SF, but the concession packages show just how much leverage such tenants have. The average lease term is 16 years, but these tenants received an average of 13 months of free rent and a staggering $120/SF in tenant improvement allowances.

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