Evaporating Pipeline May Improve D.C. Office Market After 'Dismal' Quarter

The D.C. office market experienced unusually slow leasing activity last quarter, but new market reports indicate a declining pipeline and lease expirations may spur activity in the near future.

D.C.'s office market surpassed 20% vacancy for the first time ever in the third quarter, rising 40 basis points from the previous quarter, according to CBRE's quarterly market report.

The "dismal" quarter, as the brokerage described it in the report, was punctuated by 351K SF of negative net absorption with few large private sector leases.

Total leasing activity in the quarter was 1.2M SF, down 59% from pre-pandemic quarterly averages, according to CBRE. According to a Colliers report, zero leases of more than 100K SF were signed last quarter, and only two 50K SF-plus leases closed. 

The tenants that did sign leases gravitated toward Class-A space, driving up Class-B office vacancy to 25.1%.

CBRE Vice Chairman Randy Harrell, a top leasing broker who represents landlords and tenants, said he is seeing increased competition for new trophy office space. 

"We’re already seeing some recognition of trophy scarcity by key tenants and key occupiers in the market," he said. "I think there’s going to be even more disparity in the next two to three years."

The market's office pipeline shows how stark that scarcity could soon become. Three trophy-class office buildings are scheduled to come online this year, but only one — 1401 Massachussetts Ave. NW in the central business district — has availability. Just two additional office properties are scheduled to come online by the end of 2024: 20 Massachusetts Ave. NW in 2023 and 1700 M St. NW in 2024.

What's more, construction financing has become much more difficult in the current economic climate, several D.C. office developers said at a Bisnow event last week. By the time 1700 M St. NW — a 334K SF Skanska-built office building in the central business district — comes online, there will be fewer opportunities for tenants on the move to find brand-new, trophy-level office space.

"The delivery pipeline of new trophy in the core has come to a screeching halt," Harrell said. "Even if you put a shovel in the ground, if you try to get started today, and that’s very difficult to do in these bumpy financial markets, you’re probably 2026 or 2027 before there’s any net new trophy inventory other than what is already underway."

There are some signs that tenants are growing more comfortable with long-term decisions. The most prominent public sector lease of the quarter was the Financial Industry Regulatory Authority signing a new downtown lease for 68K SF at 1700 K St. NW, though that deal represented a contraction.

CBRE reports it is tracking about 400K SF of additional leases in the final stages, meaning tenants have signed a letter of intent. Harrell also said contrary to trends during the delta and omicron Covid variant spikes, building tours continued over the summer even as cases rose.

Meanwhile, tenants may be getting more comfortable with long-term decision-making. JLL's third-quarter report found the average lease length reached 83 months last quarter, while the average in Q3 of 2019 was 79 months.

There may be other bright spots for the D.C. office market in the months ahead. Residential conversions are still on the rise, a trend that would take older, unattractive office stock offline and push down vacancies.

Office occupancy also surpassed 44% in September, and despite a slight slide of 0.4% percentage points over the past three weeks appears to be holding at that slightly elevated rate, according to Kastle Systems.

And despite seeing a similar number of lease contractions, New York's office market saw relatively strong leasing activity this quarter, spurred in part by tenants finally making decisions after years of uncertainty about the space they'd need.

Harrell said the D.C. office market could see a similar boost at some point soon. He noted that the D.C. Class-A office market alone constitutes nearly 100M SF in inventory, and with average lease terms about seven years, an estimated 10M to 15M SF of leases should be ending each year. 

"Just reversion to the mean, the leasing activity is going to go up," Harrell said. "This quarter, and maybe the balance of the year, might be a blip on the screen, but the other leases have to be dealt with."