For D.C.'s Older Office Buildings, 'A Day Of Reckoning' Approaches

The owners of hundreds of aging office buildings in the nation's capital are stuck between a rock and a hard place. 

Demand for their product has evaporated, with tenants fleeing for newer trophy-class buildings and leaving millions of square feet of office space vacant. Rising interest rates have all but frozen the debt market for office, experts say, leaving many struggling owners unable to obtain financing to reinvest in their portfolios. 

Signs of distress have begun to appear in the market, with Hines last month agreeing to hand back the keys to a downtown office building after losing its anchor tenant. Market leaders say that is only the beginning.

"I feel like we've hit a tipping point," Tishman Speyer Managing Director Dan Dooley said. "You can keep pushing and pushing, but I think you'll start to see buildings go back to lenders."

Dooley, who leads regional leasing and asset strategy for the firm that owns more than a dozen D.C.-area office buildings, was one of several executives at Bisnow's Washington D.C. Office Market event — held Sept. 29 at the Westin DC City Center hotel — who shared an unusually grim outlook for an industry that typically leans toward optimism. 

The optimistic scenario for the D.C. office market, which some panelists did share, is that many of the city's older office buildings will be converted to residential. That strategy has become increasingly prevalent, with several conversion projects moving forward in the last two years.

“What you’re seeing is a lot of older urban core product that could become multifamily, so it could be a silver lining," said Katie Yanushonis, a senior vice president at developer TMG, formerly The Meridian Group. "At the end of the day, I think it’s a positive thing that some are being taken out of production and being put to a higher and better use that will help the fabric of city.”

But the properties where conversions make sense represent a small share of the overall market. 

The District has more than 300 Class-B and Class-C office buildings totaling more than 35M SF, according to CBRE. Many of these buildings sit in the middle of a block with insufficient lighting and floor plates for a residential conversion, Dooley said. 

"I keep hearing that they're going to get converted to residential, but every single building somebody says that about will not get converted," Dooley said. "There are places where it's going to work and places where it won't."

For the places where conversions won't work, landlords face an uphill battle in trying to lease old buildings to new tenants. The city's office vacancy rate crossed 20% for the first time ever in the third quarter, according to CBRE's new market report.

The soft market has given tenants more power than ever, with CBRE reporting that concession packages have risen to a new high this year of $283 per SF. That is up from $252 per SF last year, $213 per SF in 2020 and $187 per SF in 2019. 

"Nobody underwrote $300 in concessions when they underwrote these buildings, and frankly a lot of people aren’t well-capitalized enough to give those concession packages and get their building to 90% [leased]," Dooley said. "There will be a day of reckoning, and I think that will tighten the market."

Republic Properties CEO Steven Grigg, whose firm also owns more than a dozen office buildings in the region, said D.C. has some older office assets that can be saved, such as properties with smaller floor plates or those located on the corner of a block. 

But he said the city has many buildings without those attributes, especially downtown assets that were once leased by the federal government but have lost those tenants as agencies have spread across the region. Grigg said he expects to see more owners hand the keys back to lenders in the coming years. 

"If you have a huge government office building with a floor that’s 150 feet deep in one direction and 250 feet long, you’re going to have a harder time making that work in today’s market. It's not impossible, but it becomes more difficult," Grigg said. "It may not work out for everybody. As Darwin said: not everyone is guaranteed survival."

"You want to look at how you can survive, and how you can make things work," Grigg added. "Understand that sometimes success is surviving and getting through a difficult period in this environment."

The mindset of office owners is similar to what Mark Sullivan said he heard when he entered the industry in the early 1990s, as the savings and loan crisis created severe distress in the office market. 

"I've got this memory of what it was back then, the saying was 'Stay alive until '95,'" Sullivan said. "Now people are reviving that for 2025."

Sullivan, an executive vice president at Colliers who represents landlords in leasing their buildings, said he thinks the D.C. market will continue to see more buildings going back to lenders. 

"I get calls from owners all the time talking to them about their assets," Sullivan said. "The frequency of calls from special servicers and banks who have loans maturing or large vacancy coming in has increased significantly."

For leasing broker Evan Behr, an executive vice president at JLL, the D.C. office market is a story of winners and losers. The winners are the trophy buildings in destination-level developments like The Wharf, which landed Williams & Connolly to anchor its second phase. 

The losers are the older buildings downtown that are losing the tenants to those destinations. This is the case with 700 11th St. NW, the building above the Metro Center station that Williams & Connolly vacated. Hines, which owned that building for over a quarter century, reportedly signed a deed-in-lieu-of-foreclosure agreement last month to give control of the property to lender Allianz. The lender is now marketing the property as a potential residential conversion. 

"It pains me, but that will likely be converted to residential," Behr said of the 11th Street building. "It's an unbelievably awesome office site, but the economics don’t support it today."

Behr said there is an increasing awareness in the market that some older buildings have become obsolete. In some cases, he said owners are able to make the right kind of renovations and find tenants, but he said those strategies don't work for every asset — and could lead to deeper pain if the risk doesn't pan out.

"As it relates to the obsolescence and the buildings that are dying, I think we all see it," Behr said. "There’s a ton of amenitization going on, and I think you’ve got to be creative and the ones that are the most creative are the ones that are winning. The death trap is the copycat syndrome. There’s some of that going on. If a building is not meant to have a conferencing facility, then don’t force the issue."

Despite new office projects having emerged as the winners of the leasing market, today's capital markets environment have made it increasingly difficult to finance any new construction. The uncertainty of future office demand has made lenders more skittish, developers said, and the Federal Reserve's continued interest rate hikes have made it even harder to underwrite deals. 

"Rising interest rates and inflation creates a more challenging environment in an already challenging environment," said Jake Stroman, executive vice president and co-head of the D.C. region for BXP. "We’re developers and long-term owners of real estate. When the spread between development yields and interest rates tightens, it makes it a much more challenging environment for us to execute on the business that we’re really good at."

Boston Properties, the country's largest publicly traded REIT that focuses on office, has pivoted away from its bread-and-butter property type for some projects. For a development site in D.C.'s Mount Vernon Triangle neighborhood, BXP and its partner switched plans last month from 525K SF of office to instead build residential with a possible hotel use. 

Stroman said the team made the switch because of how difficult it would have been to finance an office project on the site, even if it were to land a substantial pre-lease. 

"If a tenant came to us today and said we want to lease 300K SF of space to you and we want to anchor that building and move forward with that development, I’m not sure we could do that given the environment," Stroman said. "The fact that there would be another couple hundred thousand square feet of speculative leasing risk, I’m not sure we have faith and confidence that space would move very quickly in today’s market."

Carr Properties Chief Financial Officer Eric Tracy, whose firm developed the Midtown Center project in 2018 and delivered office projects in Bethesda and Union Market over the last two years, said rising interest rates have also made it harder for developers to sell their projects after completion. 

"Without a functioning debt market, that makes it challenging to sell assets, to monetize, to recycle capital," Tracy said. "Inflation and rising interest rates are filtering through, and it's going to take some time to sort out."