We are now 6 months into “15 days to slow the spread.” Many small businesses have closed for good and the survivors are either teleworking or downsizing; leaving many to speculate about the future of office space. The economic devastation caused by the lockdowns is clearly reflected in changes to market fundamentals across the board; however, the psychological impact of the virus will have greater, long-term effects. As demand plummets, tenants are constantly asking if this will be reflected in proportionate decreases in rents… “good deals.” As we enter the 4^th quarter of 2020, where are we and what can we expect in the future?

Rentable Building Area

• Market: 507,641,251 SF
• 4 & 5 Star: 257,547,778 SF
• 3 Star: 188,690,068 SF
• 1 & 2 Star: 61,403,405 SF
• Deliveries Past 12 Months: 3,800,000 SF

The Washington DC metro area has traditionally been insulated from economic downturns due to the presence of the federal government and, with West Coast-based companies continuing to expand their footprint, the region has become a major East Coast tech hub as well. The Dulles Technology Corridor has been home to big tech firms for years. With its extensive fiber infrastructure, reasonable energy costs, and tax incentives, Ashburn, VA has evolved into the top data center market in the nation; hosting over 70% of the world’s internet traffic and earning the name: Data Center Alley. Historically, the area’s tech industry has centered around the needs of the federal government with a focus on integration versus innovation; however, with Amazon’s decision to locate its HQ2 in National Landing in 2018, big tech is now driving demand and has accounted for some of the largest leases in the past year.

The DMV has not been immune to the effects of the pandemic and government lockdowns. Approximately 230,000 jobs were lost since March 2020 and, while office users were able to adapt more easily by allowing their employees to work from home, many were still furloughed or laid off. Demand is down across the board, vacancies are up, and rent growth has flatlined. Small businesses are likely to delay leasing decisions at least until after the November election, the result of which could have a major impact on the national and local economy due to potential changes in tax rates and defense spending. Furthermore, Montgomery County, Prince George’s County, and Northern Virginia were slower to reopen than the rest of the country and, while this was in part due to the number of Covid-19 cases, the partisan nature and extent of the lockdowns cannot be ignored.

Vacancy Rate

• Market: 13.8%
• 4 & 5 Star: 15.8%
• 3 Star: 13.4%
• 1 & 2 Star: 6.5%

Availability Rate

• Market: 17.8%
• 4 & 5 Star: 20.8%
• 3 Star: 16.5%
• 1 & 2 Star: 9.3%
• Net Absorption Past 12 Months: (1,400,000 SF)
• Vacancy Change Past 12 Months: 0.7%

At 13.8%, the vacancy rate in the DC metro area is the highest its been in 4 years. Net absorption is at negative 1,400,000 SF over the past 12 months with the District being disproportionately impacted with over 1,000,000 SF being vacated since March. A more telling statistic is the availability rate, which reflects the actual amount of space on the market. At 17.8%, the market availability rate is 4% higher than the vacancy rate. This is the result of over 1,500,000 SF being added to the market since the beginning of the year, an increase of 25%. The gap is further pronounced (5%) in 4 & 5-Star properties with the area’s premier submarkets (East End, CBD, Tysons Corner, and Bethesda/Chevy Chase) accounting for nearly 50% of all available sublease space. As of this date, there is over 8,300,000 SF of sublease space on the market. Whether from struggling businesses seeking to reduce costs or healthy businesses reevaluating their space needs, this presents a troubling outlook for office market fundamentals.

The twin pillars of big tech and the federal government have accounted for some of the largest leases in the past year; however, many of the government-related deals were renewals rather than relocations or expansions. Large West Coast-based firms are driving demand as evidenced by Microsoft’s lease of nearly 400,000 SF at 11955 Freedom Dr in Reston Town Center in May, an expansion of its existing 150,000 SF footprint in the submarket at 12012 Sunset Hills Rd. The company plans to create a new software development hub, adding 1,500 new employees. Reston is also home to fellow tech giant, Google, which leased approximately 165,000 SF within the past year.

These leases reflect a tale of 2 economies. Large, multi-national companies are more easily able to weather the economic turmoil brought about by the pandemic while small businesses struggle to stay afloat. In fact, Google, Microsoft, and Facebook have all announced that employees may work from home indefinitely. Add to that the uncertainty surrounding the November elections and most firms will be delaying leasing decisions for the foreseeable future.

Average Asking Rent

• Market: $38.47/SF
• 4 & 5 Star: $45.68/SF
• 3 Star: $32.14/SF
• 1 & 2 Star: $26.67/SF
• Rent Growth Past 12 Months: 0.2%

High vacancy rates have been the main impediment to significant rent growth in the DC metro area in recent years, a trend that will be further exacerbated by the reduction in demand for office space and increased availability of sublease space as a result of the pandemic. Wholesale discounts are not widespread yet at least in the form of lower asking rents; however, large concession packages especially in high vacancy submarkets are revelatory of the true state of the market. One example is Dweck Properties’ lease of 12,162 SF at 1050 17^th St NW in DC’s Central Business District submarket. The lease rate of $52.00/NNN reflected a 9% discount from the $57.00/NNN asking rate. When combined with the $135/SF tenant improvement allowance and 12 months free (assuming a 132-month term and 3% annual escalations) the resulting average effective rent over the entire lease term is only $43.55/SF/yr. Landlords will also have to compete with a glut of sublease space on the market which is, on average, about 13% lower than direct market rents.

Unfortunately, the pain has only just begun with forecasts predicting a 4.5% decrease in rents by mid-2021; however, rent growth and/or losses will likely vary by submarkets. National Landing is positioned for strong rent growth as home to Amazon’s HQ2 and due to its proximity to the Pentagon. The Dulles Technology Corridor should also perform well as big tech firms continue to expand in Reston and Herndon. The expansion of the Silver Line has leveled the playing field for these suburban submarkets which offer new, 4 & 5-Star product at a discount compared to closer-in urban submarkets. Reston and Herndon are also able to offer an often overlooked but economically poignant amenity: ample free parking. This may signal an emerging trend in office demand towards more affordable, suburban submarkets in general. With the increase in teleworking, companies may abandon or decrease their presence in urban areas and move to a “hub-and-spoke” model with multiple, smaller satellite offices in closer proximity to their employees’ homes.

Under Construction

• Market: 9,057,194 SF
• 4 & 5 Star: 8,972,317 SF
• 3 Star: 84,877 SF
• 1 & 2 Star: 0 SF
• Percent of Inventory: 1.8%
• Preleased: 74.4%

There is nearly 9.1M SF currently in the pipeline and while this may seem like a significant amount of space it is actually the lowest total since 2016 and represents only 1.8% of the existing market inventory. Due to strong pre-leasing this new supply will not be overly detrimental to the overall market vacancy rate but upon closer inspection a growing trend and demand shift away from the District is becoming evident. Despite accounting for over 1/3 of the new product under construction, the Reston and Chevy Chase/Bethesda submarkets are 80% preleased. This includes the 785,000 SF build-to-suit new Marriot headquarters at 7750 Wisconsin Ave, 7272 Wisconsin Ave (362,643 SF) which is 67.7% preleased to a diverse group of tenants, and the Reston Gateway Twin Buildings where Fannie Mae preleased 1,200,000 of the 1,400,000 SF. Government agencies contributed to strong preleasing activity further bolstering suburban submarket performance. The Transportation Security Administration recently moved into its new 623,000 SF headquarters at 6595 Springfield Center Dr in Springfield, VA, the Department of Homeland Security will relocate its headquarters to Camp Springs, MD where it will occupy 575,000 SF, and the Institute for Defense Analyses will lease 370,000 SF at 730 E Glebe Rd in Potomac Yard one block down from the future Virginia Tech Innovation Campus. Conversely, the District’s upcoming projects have an availability rate of 45% with the entire 226,000 SF at 1255 Union St NE in the Capitol Hill submarket and 165,000 SF at 699 14^th St NW in the East End still available.

Sales Past 12 Months

• Sales Volume: $8,400,000,000
• Market Cap Rate: 7.2%
• Average Vacancy at Sale: 18.2%

The effects of the pandemic on the commercial real estate market can most easily be seen in its impact on investment sales. The $600,000,000 in sales in the 2^nd quarter of 2020 marked a 75% decrease from Q1 (70% of the quarterly average for the past 2 years). Office prices have been decreasing since 2015 and, with the exception of some premier properties which can trade at over $1,000/SF, many deals involve repositioning strategies such as Dallas-based private equity firm Velocis’ purchase of 1530 Wilson Blvd or long-term bets like JBG’s investment in Crystal City (in retrospect). Perhaps the greatest and most startling example of the pandemic’s destructive impact was the sale of 8283 Greensboro Dr in Tysons Corner. Originally under contract for $63,400,000 in February, the property sold for over $6,000,000 less ($57,000,000). This was a particularly good deal for the Meridian Group, which purchased the building in addition to 2 others in the overarching Boro Project, and a bad one for Washington Real Estate Investment Trust which purchased the property in 2011 for $73,500,000. With the future of office demand in question, prices are likely to continue to fall as investors require a higher return/cap rate to justify their increased risk. Add to that the fact that many older office properties will require large capital investments to attract tenants in a competitive, high vacancy environment and office sales are likely to decline in overall volume in addition to price per square foot.