D.C. Office Market Posts Strong Q1 As Coworking Demand Counteracts Law Firm Consolidation

The continued expansion of coworking companies drove strong absorption in D.C.'s office market in the first quarter, counteracting negative forces such as consolidation of law firm footprints and a slowdown in federal government leasing. 

But even with strong demand, the ongoing surge of new construction is expected to keep vacancy elevated across the District. Emerging submarkets along D.C.'s waterfront have begun to experience tightening conditions as new developments draw large tenants away from the downtown core. 

New Q1 market statistics from CBRE, Newmark Knight Frank, Cushman & Wakefield and Savills, while each calculated using different methods, all show signs of growing demand in D.C.'s office market so far this year. 

Savills, which reports total leasing activity including renewals, found 2.2M SF of leases signed in the first three months of 2019. That is down from the prior quarter but on par with the first quarter of 2018, as Savills Research Director Sarah Dreyer said the beginning of the year tends to be slower than the end. 

"It's one of the stronger years in the last five years as far as Q1 demand," Dreyer said. "It's still healthy and robust. Coming off a strong 2018, that momentum seems to be carrying into 2019." 

The market's leasing momentum has been driven by private sector growth, especially in the rapidly expanding coworking sector, Dreyer said. Savills found 28% of Q1 leasing activity came from coworking tenants. Coworking leader WeWork this week announced its second lease of over 100K SF so far this year in D.C., after signing several deals in the final months of 2018. 

"D.C. continues to shift away from being a government-centric town," Dreyer said. "It's increasingly becoming a coworking town." 

Newmark Knight Frank Research Director Bethany Schneider, whose report found 540K SF of positive net absorption in the District last quarter, also said coworking demand has been the primary driver in the market. 

"When a coworking tenant takes space, they're not moving from a different space, in most cases it tends to be net growth, so that's really been a driver in D.C.," Schneider said.

That type of net growth has been difficult to come by in the D.C. market in recent years as the District's largest tenants, government agencies and law firms, have continued to reduce their footprints. 

"The growth of coworking demand is outpacing the loss of occupancy and negative net absorption from law firms," Schneider said. "That's another positive and encouraging sign for owners."

CBRE Research Manager Wei Xie, whose report found 436K SF of positive Q1 net absorption in D.C., said it was a slow quarter for public sector leasing. This could have been caused in part by the government shutdown affecting General Services Administration operations, she said, but the government also tends to close more deals toward the end of the year.

"We should see a ramp up through the rest of the year [in GSA leasing]," Xie said. "Private sector leasing has been very strong."   

Unfortunately for office landlords, strong private sector demand has been matched by the continued surge in new office construction, keeping vacancy high and maintaining a tenant-favored market. 

Cushman & Wakefield's report found Q1 net absorption of 480K SF in the District, a year-over-year increase, but it also recorded rising vacancy. D.C. office vacancy as of Q1 was 13.3%, the firm found, up from 12.4% in Q1 2018. Cushman & Wakefield Senior Director of Research Nathan Edwards said he expects vacancy to increase throughout the year as 4M SF of new office space delivers with 1.4M SF of current vacancy. 

"It was a good quarter of activity with a decent amount of overall net absorption — about half a year's worth in one quarter," Edwards said. "But when we're looking at the overall market, this is just kind of a blip, and we expect conditions to soften as more new construction comes online." 

Savills includes buildings within 12 months of delivery in its vacancy statistics and found 15.8% vacancy in Q1, well above the long-term average. With 13 office buildings delivering this year, Dreyer said she expects vacancy to remain elevated until construction slows down. But she thinks that could begin to happen soon. 

"I think it's going to gradually taper off from 2020 to 2025," Dreyer said. "There are certainly some large projects in that time frame, but year by year, it will gradually taper a bit." 

Edwards also expects to see a slowdown in construction that could begin to improve market conditions for landlords. 

"When we look at the pipeline moving forward, we've seen a couple developers who could have started construction pull back a little bit," Edwards said. "They don't want to deliver in the 2019-2022 time frame when the last remnants of this big development cycle are going to come on, so they opted to wait until the 2023-2024 time frame." 

New office construction in waterfront developments such as The Yards and The Wharf has leased up well, drawing demand from the Central Business District and creating tighter market conditions in the emerging submarkets.

The largest D.C. lease of the first quarter was Chemonics' 290K SF deal to anchor the next phase of The Yards, Brookfield's megaproject in Capitol Riverfront. That comes after The Wharf, the Southwest Waterfront megaproject, landed Q4's biggest office lease for its second phase, a 300K SF deal with law firm Williams & Connolly.

"Those are the two biggest private sector leases ever in a D.C. emerging market," Xie said. "If you asked somebody even two to three years ago, they would say that an Am Law 200 law firm would never move out of the core market to a waterfront market. Now it's happening."

Dreyer said the high concessions landlords are offering tenants to move to new developments are luring companies out of their old office buildings. Savills found 62% of leases last quarter were relocations or new entrants to the market, far outpacing the number of lease renewals.

The benefits of new buildings, combined with the amenities and views along the riverfront, are leading the emerging submarkets to outperform the CBD. The three D.C. submarkets with the lowest vacancy rates, according to Savills, were NoMa, Southwest and Capitol Riverfront, each under 11%. But the CBD, East End and West End were among the highest, each with vacancy rates over 15%. 

"If there's any small tightening to be seen, it's in those non-core submarkets," Dreyer said. "While options remain abundant in the CBD and East End, new product in the non-core markets is being eaten up very quickly." 

The tightening in emerging markets has come at the expense of the existing office stock in the CBD. New projects in the waterfront areas tend to command lower rents than new CBD developments, Edwards said, leading tenants that would otherwise occupy Class-B space downtown into new trophy projects in areas like the Capitol Riverfront at similar rates. 

"Not only at the high end of the market are we seeing new supply lead to increasing vacancy," Edwards said. "But we're seeing tenants move out from the CBD Class-B space, which has been relatively tight, and they're finding new construction opportunities outside the core market. That will lead to increasing vacancy by year-end."