D.C. Office Market's Recovery Faltered In Q3 As Delta Variant Slowed Activity

The D.C. office market continues to lose occupancy and hit new vacancy records as the slow recovery from the coronavirus pandemic drags on. 

The market had experienced some positive momentum early in the summer amid the vaccination rollout and the city's reopening, but the resurgence of the pandemic with the delta variant over the past two months slowed that recovery, third-quarter office market data shows.  

Market researchers point to some promising signs for the recovery, including a reduction in the amount of available sublease space and some large new lease deals closing. While new trophy office projects have continued to land tenants, many of them are relocating from older D.C. buildings, and the owners of those second-generation assets face an increasingly difficult market. 

D.C.’s office vacancy rate rose to 18.2% last quarter, surpassing the 18% mark for the first time on record, according to CBRE. The District experienced negative absorption of 321K SF during the quarter, bringing its year-to-date occupancy loss to 1.9M SF.  

Touring activity in the D.C. office market experienced a sharp decline starting in mid-July, according to CBRE, as the delta variant sparked a rise in Covid cases and D.C. reinstated its indoor mask mandate.  

"Things were really looking promising in the second quarter — in April, May and June, we saw such a comeback in touring activity," CBRE Research Director Wei Xie said. "The reaction to the delta surge was immediate. Toward the end of July, overnight there was a drop in tours."

Xie said this pullback in activity was particularly pronounced among smaller firms, which had more flexibility to press pause on their leasing processes.  

"Smaller tenants under 10K SF are just more nimble in nature, so they decided to pause their search because of the delta variant surge," Xie said. "What we're seeing is the midsized and large-sized tenants are taking deliberate steps toward lease execution."

Newmark Associate Director Matt Kruczlnicki said the delta variant caused tenants to push back their returns to the office, which many had planned around Labor Day, and this had an impact on the leasing market. 

"The third quarter was a bit of a recoil following the optimistic forecast that we had in the second quarter with higher vaccination rates and all that," he said. "The spread of delta was a serious concern both nationally and locally."

While Newmark's Q3 report found negative absorption in D.C., the 350K SF of occupancy lost made it the least severe quarter of contraction since the onset of the pandemic.

"I think that suggests we’re seeing less givebacks, less tenants letting leases expire, less sublease vacancy that’s beginning to hit the market, which is good," Kruczlnicki said.

Xie also sees positive signs in the sublease market. Sublease availability decreased in August for the eighth consecutive month, and it is down 17% from its December peak of 3.5M SF, according to CBRE. Xie said this is a result of tenants removing existing sublease offerings from the market and fewer tenants adding new sublease availability to the market. 

"There is a sentiment that tenants put their space up for sublease as an initial reaction because all of their people were working from home, so they might as well test the market and see what happens, but now that more workers are going back to the office, they might decide they need the office space after all," Xie said. 

Another positive sign for the market that Xie highlighted was a string of large leases closing. 

CBRE's report included four federal agency renewals of more than 50K SF, and it identified two new law firm leases. Sterne Kessler leased 71K SF at 1101 K St. NW and Katten leased 55K SF at 1919 Pennsylvania Ave. NW, according to CBRE.

Two more major leases closed over the past week.

The General Services Administration Sept. 30 signed a 1.2M SF deal for the Securities and Exchange Commission to relocate its headquarters to a new Douglas Development project at 60 New York Ave. NW. Monday, Skanska announced it signed law firm Gibson Dunn to a 164K SF pre-lease, taking roughly half of the space in a new building that could break ground this quarter.

While these new leases provide transaction activity for the market, they don't help bring down the city's vacancy rate. Sterne Kessler and Katten are contracting from their prior D.C. office footprints, and with the SEC and Gibson Dunn deals, the tenants will spur new office construction while leaving behind vacancy in existing buildings. 

The buildings being left behind by law firm and government agency relocations include many Class-B buildings that have a hard time drawing tenants in today's market. While Class-B buildings once represented a value play for price-conscious tenants, the record-high concessions in the Class-A segment give those tenants the ability to upgrade to higher-quality space. 

"We're seeing face rents, especially in commodity Class-A, begin to decrease, and that’s compressing the difference between Class-A and Class-B rents that much closer, and it’s really coming at the competitive disadvantage of Class-B space," Kruczlnicki said. 

Over the past 12 months, the Class-A segment in D.C. experienced negative absorption of 460K SF, while the Class-B segment experienced 1.5M SF of negative absorption, according to Newmark. Class-B vacancy now represents more than one-third of the District's total vacant space, according to Newmark, compared to less than a quarter of the city's vacancy in 2016. 

In addition to being less of a value play, Class-B buildings have also become less appealing during the pandemic as tenants have begun to care more about features like high-quality air filtration systems and outdoor terraces that are more common in newer buildings. 

Cresa principal Lucia Hedke, a tenant representative, said last week at Bisnow's D.C. State of the Market event that she doesn't want to show clients Class-B and Class-C buildings because they aren't up to their standards of quality. 

"I don’t know how C buildings are surviving, and B is kind of pushing it," Hedke said. "Tenants are willing to pay for a great quality, safe environment. The reality is they don’t need as much space, so their annual costs are going to maintain, but they’re getting much higher quality. For B and C, it’s almost insulting that the product is there, and that someone is pushing it on someone like me, because I feel obligated to steer my clients away from a product that is not of a certain quality."

Many owners of older office buildings have invested in repositioning projects to bring them up to Class-A and trophy quality, and those efforts have proven successful in some instances.

The Meridian Group in June signed two leases totaling over 180K SF at its renovated 1333 New Hampshire Ave. NW building, and that same month it signed a 97K SF lease at its renovated 1400 L St. NW building. 

"There are deals to be had, so there are winners and losers right now," Meridian Group Senior Vice President Katie Yanushonis said at the State of the Market event. "The winners are the buildings that are highly amenitized, have health top of mind, have a great location, and we’ve been very successful for that reason."

But not all buildings have the ability to be renovated up to a Class-A standard, Kruczlnicki said. He said buildings on the corner of a block have much greater flexibility for upgrades than those in the middle of the block. 

"Part of the problem is you've got these well-positioned, corner-block Class-B buildings that have gotten elevated to Class-A," Kruczlnicki said. "That’s one of the issues that's leading to more challenging Class-B fundamentals is that you're just losing inventory due to renovations and upgrades in those buildings, which leaves you with a larger pot of Class-B buildings that are those mid-block, underperforming assets that are harder to lease."

Economic development officials and developers have eyed these older Class-B buildings as targets for conversions to residential, a strategy that could remove office vacancy while adding much-needed supply to the city's housing stock.

This strategy has proven difficult in the Central Business District, as downtown office buildings are typically more valuable than apartments, but Kruczlnicki said buildings with long-term vacancies have declining property values and could create opportunities for conversions. And he said Newmark has seen more developers looking at those opportunities this year. 

"We’ve heard of more converters in the market looking at assets to purchase in D.C.," he said. "Our capital markets team noted a couple projects that probably would not have been considered for conversion that are getting some interest from converters for sale ... The pricing is starting to potentially fall in the range where conversions could be a little more financially tenable."