D.C. Leading The Nation In Foreign Investment And 5 Other CRE Trends To Watch

Despite the challenges facing the commercial real estate industry, from office vacancy to housing affordability to retail closures, the D.C. market has been the beneficiary of a massive influx of capital. 

The District leads the nation in foreign investment per capita, according to Sage Policy Group CEO Anirban Basu, who raised the prospect that this could be leading properties to become overvalued. This was one of six key trends highlighted in a wide-ranging presentation Thursday evening at Transwestern's 23rd annual TrendLines event.

1. Strong Influx Of Capital, Especially From Overseas

The D.C. market has long been among the top U.S. targets for foreign investors. In recent quarters, D.C. has experienced some slowing in overseas capital flows, but it remains at the top of investors' lists. In 2018, the District led the nation in foreign investment in commercial real estate per capita, Basu said. It received $83.6M in foreign investment per 100,000 residents, followed by New York with $81.7M.  

"There has been a lot of capital flowing into commercial real estate, including commercial real estate in this region," Basu said. 

Foreign investment creates benefits for a market, but it can also present some challenges, Basu said. Aggressive investors looking for a place to put money could bid up assets to the point where valuations rise higher than the underlying real estate fundamentals warrant. This could create a disconnect between the investment sales and leasing markets, especially as D.C.'s office vacancy rates have risen to record highs. 

"Generally, as a macroeconomist, I ask the question, ‘Is it too much capital?’" Basu said. "Is it resulting in artificially elevated valuations and setting the stage for something worse to come? We’ve seen this before." 

2. A Diversifying Regional Economy

Amazon selecting Northern Virginia for its second headquarters represented a significant win for the region, but Basu cautioned business leaders against thinking that Amazon alone will diversify the region's economy.  

"Amazon itself cannot be a diversification engine," Basu said, noting that the 25,000 jobs it plans to bring over more than a decade pale in comparison to the 50,000-plus jobs the region adds annually. "It’s a drop in [the] bucket." 

To achieve more economic diversification, a goal Basu said the region should strive for, he said it needs to focus on cybersecurity and other sectors of the economy. 

3. Buildings Becoming Obsolete Faster

The District's office market has been one of the weak points in the region's commercial real estate industry, with vacancy rising above 14%. One of the hardest-hit segments of the office market has been second-generation Class-A space.

Transwestern Managing Research Director Elizabeth Norton said office buildings are becoming obsolete faster than they did in the past because the competitive labor market leads tenants to want the newest and flashiest amenities in their buildings to attract talent. This incentivizes developers to break ground on new trophy office projects despite the market's poor fundamentals, and that new supply increases the vacancy rate.  

"The construction pipeline has put millions of new square feet on [the] market that offer high quality of design and amenities," Norton said. "This has shifted our perception of what’s possible and has caused office buildings to become outdated at a higher rate."

Tenants have historically relocated out of buildings that have an average age of 46 years, Norton said, but that number has been declining and now averages around 38 years. Some buildings lose their anchor tenants after only 10 years, she said. 

"Although pre-lease deliveries have boosted absorption, our vacancy rate remains elevated," Norton said. "Demand has not been robust enough to backfill all of the second generation space. It’s a trend that we expect to continue."

4. Tightening Industrial Market Could Make Construction More Feasible

The industrial real estate market has benefited from rising demand from e-commerce and other delivery-focused retailers, but this has not been met with a surge of new supply. 

The vacancy rate in the D.C.-area industrial market has reached a record low of 5.4%, Norton said. She expects the market to tighten even further, with 4.6M SF of obsolete industrial properties slated for demolition as developers continue to use the sites to build multifamily projects. 

Because of this dynamic, Norton projected rent increases in the industrial market of at least 5% annually. She said more tenants are willing to pay higher rents for well-located industrial properties because of the need to be close to consumers. 

New industrial buildings are able to move product faster, and Norton said tenants are often willing to pay a 40% premium for new projects in infill urban areas. If this trend continues, Norton said it could reach a point where rents are high enough that new industrial construction becomes more feasible. 

"Given this robust rent growth, infill development could become less challenging from a cost perspective," Norton said. 

5. Opportunity Zone Development Increasing

Some of the initial buzz around the opportunity zone program has quieted down, but growing fundraising totals and development statistics show positive signs for the program. 

A January report from Novogradac & Co. found the 502 qualified opportunity funds it tracks had raised over $6.7B, up more than 50% from the start of December. 

"We expect opportunity zone development to be increasing in the coming years now that the rules and regulations have been finalized," Delta Associates President Will Rich said, after citing the Novogradac data. 

Opportunity zone funds in the D.C. area have helped leverage $900M in total investment across at least seven projects totaling 2,100 apartments, Rich said.

Much of this investment thus far has been concentrated in areas already experiencing development, such as Buzzard Point and Hill East, Rich said. The neighborhoods east of the Anacostia River, where more than half of the District's opportunity zones are located, have not yet experienced a development boom, with fewer than 500 units in the pipeline, Rich said. 

"In most cases, these areas were already experiencing a lot of development activity prior to the opportunity zone program," Rich said. 

6. Development Clustering Around New Transit Lines

The final D.C.-area trend the researchers identified was the explosion of development around transit hubs on the region's two under-construction rail projects: the Silver Line Phase 2 and the Purple Line. 

More than 2,600 units have been built over the last year near Silver Line Phase 2 stations, with another 10,300 units planned, Rich said. These projects are largely concentrated around the Reston Town Center and Innovation Center stations.  

More than 3,500 units have recently been built near Purple Line stations, including 2,600 in Montgomery County and 900 in Prince George's County, Rich said. The stations with the most development are in Bethesda, Silver Spring, College Park and New Carrollton. 

An additional 7,800 units are planned around the Montgomery County Purple Line stations, Rich said, and Prince George's County's stations have another 2,100 units in the pipeline. 

"Major transit infrastructure projects are underway in the Washington suburbs that have the potential to reshape entire communities," Rich said.