Falling D.C. Office Valuations Making Teardowns More Feasible

While several office-to-residential conversions are moving forward in D.C., experts say only a small fraction of the region's hundreds of old office buildings have layouts that make it possible to transform the existing structure.

But if office valuations keep falling the way they have been, that may not matter. 

"We’re in a situation now where spot values for some of this office are so low that it’s just a teardown and start over," TMG partner Gary Block said Tuesday at Bisnow's D.C., Maryland and Virginia Economic Forecast event, held at the Ronald Reagan Building and International Trade Center.

"The land value for residential is higher," Block added.

In the past, the steeper rents that urban office can command meant that those properties held higher values than apartment buildings. But with the pandemic-era disruption to the office market and the sharp rise in interest rates over the last six months, office values are dropping dramatically.

Block, in an interview with Bisnow Thursday morning, said he is seeing properties where values today are 50% below what the owner had projected they could sell for before the pandemic began. In these cases, he said the value of land that is entitled for residential development is higher than the existing office property. 

"There can be situations where it's so attractive from a residential perspective that the value of tearing down a building and building back up can still work, for either the existing owner or a new owner," Block said. 

He said his firm is looking at some acquisition opportunities where this is the case, but he declined to share further details. TMG, formerly known as The Meridian Group, owns a large portfolio of office and mixed-use assets across D.C., Maryland and Virginia. 

Block said he is seeing this valuation dynamic most in Northern Virginia submarkets like Arlington and Tysons, where office properties haven't historically been as expensive as in Downtown D.C., but he thinks the phenomenon could begin to happen more in the central business district as values keep falling.

Deal volume has been slow as many owners are holding onto assets rather than sell at sharp discounts, making it hard to pinpoint where values are today, but two recent examples shed light on the pain office assets face.

A 10-year-old Arlington office building that has LEED Platinum certification and is 82% leased sold in October for $59.5M, about 34% less than its 2014 sale price. Also in October, a Downtown D.C. office building sold for $16M, a 29% drop from its 2008 sale price, and the new owner is planning a residential conversion. 

As the Federal Reserve has continued rapidly hiking interest rates, property values have kept dropping. 

"That sledgehammer has just destroyed asset values," Block said at the event. 

While painful for existing owners, the drop in office values is creating more impetus for repurposing sites from office to residential, whether that's via adaptive reuse or redevelopment. The opportunities for the former are slim.

The District has 130M SF of total office inventory with a vacancy rate of 18.5%, according to Newmark's fourth-quarter report. The Class-B segment — older properties that are more likely to be redeveloped — has 43M SF of inventory with a 23% vacancy rate. Northern Virginia has another 44M SF of Class-B inventory with a similarly high vacancy rate. 

Most of those buildings won't work for conversions, experts said. 

"What we’ve seen is in some of the markets we’ve taken a look at, a very small percentage of buildings actually have the proper floor plate for conversions," CBRE Senior Director of Capital Markets Research Darin Mellot said at Tuesday's event.

"I'd say one out of 10 or 20 actually work," MRP Realty Managing Principal Bob Murphy said in response. 

"Maybe even less," Mellot added.

The examples of conversion projects planned or underway in D.C. may not be indicative of an oncoming wave, but they could help accelerate the phenomenon of downtown residential becoming more valuable than office. 

"The more successful the conversions are, the less the conversation is about whether the floor plates are right or wrong, because if the value is in residential, then you may as well just tear down and rebuild," DC Policy Center Executive Director Yesim Sayin said.

These teardown projects may occur in distressed situations where the owner defaults on a loan and a new investor can come in at a lower cost basis. One downtown office owner lost control of a building last year, with Hines giving back the keys to 700 11th St. NW to its lender, and experts have said they expect to see more buildings go back to lenders. 

"There’s a lot of devastation out there in the office market right now, in the District worse than Northern Virginia and Maryland," Murphy said. "And whenever there’s devastation, there’s eventually opportunity, so that’s what I’m thinking about."

D.C.'s office market is facing more pain than many cities because of its dependence on the federal government, which has continued to allow employees to work from home.

Despite repeated calls from local officials and some Congress members for the federal government to bring its people back, office owners say they aren't seeing it happen.

"Of the major cities in the U.S., D.C. is the exception," Murphy said. "I was in New York yesterday with a client and friend who has a lot of office in New York, he was telling me they are 75% back in the office. That could just be his portfolio, but regardless we are not. And it’s impacted the city big time."

The slow federal return to the office has made D.C. more vulnerable than it has been in past recessions, Sayin said. 

"The federal government has generally been been countercyclical, when there’s a recession they hire more and they expand more, but we’re not seeing the impacts of this economic activity, especially in D.C., because folks are not showing up," she said. 

D.C. has also suffered from people leaving the city over the last two years, a trend that leaders say is hurting its economic prospects. 

Between April 2020 and July 2022, D.C. experienced a net loss of 17,743 people, a 2.6% drop, according to the Census Bureau's American Community Survey. This put D.C. in a tie with New York for the highest percentage population loss of any state or territory. 

"The outmigration of our skilled workforce, which we used to pride ourselves in, is becoming a real problem," said Bob Buchanan, founding principal of Buchanan Partners and president of the 2030 Group. 

Ultimately, Murphy said he thinks the D.C. region's economy will recover, but how long it takes is uncertain. 

"We will work our way through it," Murphy said. "It’s still the capital of the most powerful country in the world. It has so many things to offer."

"I tend to be more bullish long-term," he added. "But we need to get to the long term."

CORRECTION, JAN. 27, 9:45 A.M. ET: A previous version of this story misstated the last name of DC Policy Center Executive Director Yesim Sayin.