Five Major Takeaways From Q4 In DC's Office Market

While the office leasing and investment sales markets were both sluggish for much of 2016 in DC, momentum has picked up since the election, and signs point to a strong 2017. We dug into the Q4 office market reports and identified some key takeaways from the final three months of office activity. 

Leasing activity picked up post-election

Net absorption in Q4 for the DC Metro area was 821k SF, according to Newmark Grubb Knight Frank's Q4 report, up from 143k SF in Q3. Notable deals included The Wharf landing its first law firm, Fish & Richardson, for 60k SF and Trammell Crow scooping up three government tenants, the FCC, FEC and DC government, at its Sentinel Square development in NoMa. 

NGKF research manager Bethany Schneider, above, attributes the momentum partly to a thaw in activity following the election. But she suspects the surprising results could have further delayed many leasing decisions, meaning the momentum will continue into 2017. 

"As things work themselves out in 2017, those decisions can’t be delayed any further," Schneider said. "So I think we will see leasing activity pick up in 2017." 

The fast pace of deliveries is hurting vacancy

While absorption remained positive in Q4, office vacancy in the District ticked up to 12.6%, according to CBRE's Q4 report, a year-over-year increase of 120 basis points, the largest since 1992. This can largely be attributed to the pace of new construction, with seven office buildings delivering in the District this year adding 750k SF.  

CBRE director of research and analysis Revathi Greenwood, above, said she doesn't see this supply influx as much of a problem because new trophy buildings are still leasing up well.

"Vacancy increasing is due to the supply being polarized," Greenwood said. "The market is quite differentiated between trophy, which is seeing strong demand, while commodity Class-A is seeing increased vacancy." 

Absorption continues to be driven by nontraditional tenants

The continued consolidation of law firms led to 185k SF becoming vacant in DC's core market during Q4, according to JLL's report. Analysts expect this trend to continue, with JLL predicting another 600k SF will be returned to the market by 2024. The same consolidation is occurring with government tenants, and Greenwood sees the potential for another 1.5M to 2M SF of federal government contraction in the next five years.

These contractions among DC's traditional office tenants would be cause for a big net absorption loss, if it weren't for co-working tenants picking up the slack. Co-working accounted for 7.6% of the District's total leasing activity in 2016, up from 2% in 2015. WeWork, which grew rapidly in the District this year, signed a 69k SF lease at 80 M St SE in November, its first location south of the National Mall. 

Fundamentals are strongest in the core Class-B market

In the CBD and East End, the Class-B market gained 134k SF of occupancy during Q4, bringing its vacancy down to 8.5%, its lowest point in eight years, according to JLL's report. This is partly because Class-B supply has been reduced by more than 2M SF in the last two years, with much of it being repositioned.

This has allowed rents to grow at a healthy rate, as the above graph shows, while they have remained largely stagnant in other parts of the market. The potential for another 5.8M SF reduction of Class-B space over the next six years signals this trend will continue.

JLL director of US office research Scott Homa also attributes the success of core Class-B office to the growth of creative tenants, who typically want more affordable space.

"It's seeing activity from the bottom up, rather than top down," Homa said. "DC for years has been a flight-to-quality market ... but that's been upended recently, based on changes in industry drivers where job growth is materializing in the creative sectors, which want short-term leases and value."

Investment sales picked up toward the end of 2016

The first half of the year saw anemic investment sales activity, but that picked up in Q3 and Q4, with a few big deals closing right before the holidays. The year's total sales volume in the District reached nearly $3.5B, while NoVa had $572M and suburban Maryland had $983M in sales.

Tokyo-based Unizo dove head first into the market with five major acquisitions in 2016, making it by far the year's biggest buyer. DC dropped out of the top five in AFIRE's latest ranking of cities for foreign investment, but Homa doesn't put too much stock in that.

"We're still seeing extraordinarily strong demand for core product from foreign buyers," Homa, pictured above at a Bisnow event in 2015, said. "Foreign investors tend to be drawn to core product with long-term leases, and they’ve been very active in recent years when those types of opportunities become available."