Rentable Building Area/Inventory

• Market: 501,678,570 SF
• 4 & 5 Star: 249,960,981 SF
• 3 Star: 190,133,632 SF
• 1 & 2 Star: 61,583,957 SF

Everyone knows that Washington, DC is home to the federal government. Of the 501,678,570 SF of office space in the metro area, the federal government occupies more than 100,000,000 SF (20%), and of the 157,863,785 SF in the District the federal government occupies approximately 55,000,000 SF (35%). This has made the DMV one of, if not the, most stable albeit slow growing markets in the country. Something less well known is that the DC metro area is, and has always been, a technology hub. AOL was started in Northern Virginia and the area has one the largest concentrations of software engineers in the nation, but while the west coast are innovators the east coast are integrators. Historically, the area’s IT industry was driven by the needs of the federal government and the resulting “unsexy” products and solutions were focused on interoperability, enterprise architecture, etc. rather than the apps that occupy the home screen on our smart phones. Federal dollars will still fuel a large part of the local economy, but Amazon’s decision to locate its HQ2 in Crystal City (National Landing) provided the spark that will fundamentally change the makeup of the entire region.

With regards to the DC metro area office market, there are several overarching themes, influenced by a number of factors; including but not limited to, a booming economy and increased government spending, changing demographics and preferences, rising construction and labor costs, and emerging submarkets. In a few words, the state of the DC metro office market can be characterized by a flight to (relatively) less expensive, quality space in metro-accessible, mixed-use/work-live-play environments. Increased funding for the Department of Defense and the resulting billions in federal contracts will benefit the area’s traditionally large tenants such as Northrop Grumman, General Dynamics, Booz Allen Hamilton, Leidos, and Accenture, which notably reduced their footprints from 2008-2016 due to sequestration. A large part of federal dollars are being allocated to cyber security and cloud computing. Federal contractors will need to compete with tech companies such as Amazon, Amazon Web Services, Google, and Microsoft for top talent. This will result in higher wages, an influx of new workers to the area, and companies leasing quality space to attract employees. With regards to demographics, more and more baby boomers are retiring every day and millennials are comprising a greater and greater share of the labor force. Companies and landlords are responding by locating in and creating work-live-play environments with access to public transportation (metro). Due to rising construction and labor costs, developers are forced/choosing to build in submarkets with rents high enough to offset their costs, which are invariably metro-accessible. Finally, emerging submarkets in Northern Virginia and DC are challenging the metro area’s (formerly) premier office markets. New construction and lower rents in submarkets like NoMA, Southwest (the Wharf), and Capitol Riverfront (Navy Yard) and Tysons Corner and Reston have caused a shift in demand away from areas like the downtown DC and the Rosslyn-Ballston corridor respectively. These “new” submarkets offer newer product and provide the same access to the region via metro.

Vacancy Rate

• Market: 14.1%
• 4 & 5 Star: 15.2%
• 3 Star: 12.6%
• 1 & 2 Star: 6.2%
• Market Net Absorption Past 12 Months: 1,300,000 SF
• Market Vacancy Change Past 12 Months: 0.2%

The GSA announced a 2020 initiative to reduce the federal government’s footprint nationwide by leasing less space but in nicer buildings. This will most negatively impact the District as other traditional, large tenants, notably law firms, are following suit; maintaining or lowering costs by leasing smaller spaces in more expensive buildings. New types of tenants are emerging to fill large blocks of space, particularly co-working companies like WeWork, Industrious, etc. but their long-term viability is still in question. Venture capital and job growth, specifically in the life sciences (bio-tech) industry, are driving demand in Maryland along the I-270 corridor, but the king of the DMV is (and has always been) Northern Virginia. Amazon has already leased over 500,000 SF in Crystal City with plans to occupy at least 6,000,000 SF by 2024, and while it may have chosen chosen National Landing as the site for its HQ2, but its subsidiary Amazon Web Services has quietly making Herndon its unofficial headquarters in the DC metro; purchasing and leasing over 1,000,000 SF this past year. Microsoft recently purchased over 300 acres in Loudoun County (data center demand has driven the price of land to over $1,000,000/acre). In addition, Microsoft was recently awarded the Department of Defense’s $10 billion, Joint Enterprise Defense Infrastructure (JEDI)contract and is looking for space in NoVA. Finally, Google leased 112,000 SF in Reston at the Wiehle Metro Station.

Average Asking Rent

• Market: $37.74/SF
• 4 & 5 Star: $45.02/SF
• 3 Star: $31.49/SF
• 1 & 2 Star: $26.01/SF
• Market Rent Growth Past 12 Months: (0.1%)

Rent growth in the DC metro area has always been slow in relation to other markets in the country. A good year is typically defined by rent growth that keeps pace with inflation. Some analysts attribute this the federal government’s influence and associated market stability; however, I believe there are different factors at play that can better explain the negative 0.1% rent growth this past year. A closer look will reveal a fundamental change in demand and outlook for the future. The DC metro office market is a bifurcated one, with 4 & 5-Star properties on one end and 3-Star and lower properties on the other. In addition, there is a bifurcation between metro-accessible and non-metro-accessible properties. Most rent gains occurred in 4 & 5-Star, metro-accessible properties with those gains being offset by 3-Star, non-metro-accessible properties. When viewed in terms of rent growth, the numbers appear to present a troubling picture; however, the force at work here is competition. Premier submarkets are now having to compete with emerging submarkets which will result in rent losses in some places and gains in others; however, the overall effect will be an increase in 4 & 5-Star rents. Unfortunately, these gains will likely be offset by losses in 3-Star (and lower) properties and in what are currently considered 4 & 5-Star properties in non-metro-accessible submarkets which are increasingly becoming obsolete both from a functional and locational standpoint.

When breaking the DMV down into its parts, we see Maryland particularly hard hit by this flight to quality. Maryland suffers from a lack of quality buildings and, as a result, most submarkets saw rent losses in 2019. Perhaps most disturbing is the fact that its premier office market, Bethesda/Chevy Chase, experienced rent losses across the board, in 3-Star and 4 & 5-Star properties alike. Supply-side pressure in DC is driving down rates in the District. Emerging submarkets like NoMA, Southwest, and Capitol Riverfront are offering newer product at lower rates while simultaneously providing the same metro accessibility and more residential options. While a similar trend is happening in Northern Virginia, it remains the strongest area of the metro area. Average rent growth was 1.2% over the past year but was 3.1% for 4 & 5-Star properties. The Silver Line immediately connected (former) suburban submarkets like Reston and Tysons Corner to the entire region and spurred a flurry of development both office and multi-family. When compared to Northern Virginia’s premier submarkets along the Rosslyn-Ballston corridor, these areas offered newer, nicer product at a lower cost. With the delivery of the 2nd phase of the Silver Line set for the end of the year, NoVA should continue to see strong demand and rent growth along with the emergence of Herndon as a major office submarket.

Under Construction

• Market: 12,657,030
• 4 & 5 Star: 12,424,463 SF
• 3 Star: 232,567 SF
• 1 & 2 Star: 0 SF

In terms of office square footage under construction, the DC metro ranks 2nd nationwide. Approximately 5,000,000 SF delivered last year; bringing quality office space to submarkets that desperately needed it, notably Crystal City and Bethesda. Another 5,000,000 SF is expected to deliver in 2020, but a strong economy should continue to fuel demand and mitigate supply-side pressure. The is particularly true because most, if not all, development is occurring in metro-accessible submarkets with rental rates that can compensate for rising construction and labor costs. Many new projects are mixed-use; providing a combination of office and multi-family in order to cater to the preferences of the growing millennial labor force. In fact, the DC metro area ranks 3rd in multi-family development in the nation. Developers understand that creating work-live-play environments is the recipe for long-term growth and stability.

Sales Past 12 Months

• Sales Volume: $8,400,000,000
• Market Cap Rate: 6.7%

At $8.4 billion in sales in 2019, the DC metro area was behind only New York City in terms of sales volume. While more than $2.7 billion traded in Q3 2019, the largest quarterly sales volume in 3 years, this was in response to the District’s Fiscal Year 2020 Budget Support Act, which increased transfer and recordation fees from 2.9% to 5% starting on October 1, 2019. While the impact on capital investment of this short-sighted and punitive change to the tax law is yet to be seen, it will likely contribute to the overall trend towards and growing preference for Northern Virginia. The Amazon effect on National Landing and surrounding submarkets coupled with the delivery of the 2nd phase of the Silver Line and corresponding increase in metro-accessible submarkets will provide more than enough viable and profitable options for investors.

At an average market cap rate of 6.7% the DC metro area is in the middle of the pack when compared to other markets. This puts it alongside fast-growth markets like Charlotte, Dallas-Fort Worth, and Denver. When considering the risk associated with such markets, the DMV becomes even more attractive from an investment standpoint. Fast growth creates prime conditions for a bubble and, while increased demand and trading drive cap rates down and values up, the last person holding the hot potato will likely get burned. What the Great Recession taught us is that the DC metro area is somewhat recession proof, a byproduct of the sizable segment of the local economy related to the federal government. The stability inherent in this market makes a 6.7% (all cash) return significantly more valuable than comparable yields in riskier markets. Despite speculation of an impending economic slowdown, forecasts are calling for continued vacancy compression in the DC metro area over the next 2 years. This is unsurprising when considering the fact that the private sector now employs more people than the region’s automatic stabilizer, the federal government. The DMV is now in an unprecedented position, in which it will likely continue to enjoy its historical stability due to the federal government while achieving growth and gains associated with riskier markets driven by a booming tech industry.