Office Giants Call For D.C. Government To Take Risk Of Distress More Seriously

D.C.’s most prominent office owners say the city isn’t properly accounting for plummeting property values in the office market and could face major budget issues if it doesn’t take action.

Those property owners — including the heads of JBG Smith, Carr Properties, Akridge, Hoffman & Associates and more — signed a letter to D.C.’s top officials raising concerns over the "very troubling" state of the city’s office market and the risks it could pose to its fiscal health. 

Property owners that spoke with Bisnow said D.C. is operating without a plan to account for tens of millions of dollars in lost future revenue and isn't properly evaluating the market's conditions. They are urging officials to meet with them to understand the shortfall and develop a way to address the impending budget gap.

“They need to wake the hell up and do things differently, because the way they’re doing things now, it could lead to economic disaster, frankly,” said Paul Dougherty, principal of developer PRP and one of the signatories of the letter.

The letter was sent by the Federal City Council and was also signed by local executives from Hines, Boston Properties, Brookfield and Trammell Crow, as well as former Mayor Anthony Williams, the president and CEO of the Federal City Council. It falls short of criticizing District officials, but it does highlight the property owners' desire for D.C. leaders to "fully comprehend" how distressed the office market is.

“This is the PG, G version of this letter," Dougherty said.

D.C.’s chief financial officer projected that commercial property tax revenues would increase for fiscal 2023, even as office owners say values are falling fast. The budget includes an assumption that owners say is a major inaccuracy in today’s troubled market: that the District’s older Class-B and C office buildings will see cap rates tighten from this year to next, a trend that typically happens in a competitive market. 

More than 10% of the District’s revenue comes from taxes on commercial office properties. But capital markets have been brought to a near-standstill by rising interest rates, with few office deals happening over the third quarter and little improvement in the fourth quarter.

Meanwhile, the federal government, D.C.’s largest tenant and a countercyclical force for the last two economic downturns, shows no sign of halting or reversing its years-long trend of reducing its office footprint.

That leaves property owners with few options for relief. Earlier this year, national property owner Hines reportedly began talks to hand back a downtown office property to lender Allianz, and Dougherty believes many more agreements in which property owners give their lenders the deed rather than risk being foreclosed upon are on the way.

“Those of us who are active in the market think that the majority of buildings in the market are underwater,” Dougherty said. “There’s a 25% vacancy rate just in Class-B in downtown. That number is only going in one direction. It’s going up.”

The letter’s signatories are calling for D.C. Chief Financial Officer Glen Lee to explain how his office determines key variables like cap rates for office buildings and how it takes into account sales of distressed properties. 

"Our interest in this matter is not about being overtaxed. We are primarily concerned about the future fiscal health of the city," the letter reads. "It is vitally important for city officials to fully comprehend the difficult environment commercial office buildings are operating under and the risks to the future tax revenue."

Dougherty said officials need to find long-term solutions to remake the D.C. economy, including through an independent economic development arm that will attract new businesses and workers to D.C.

“We’re generally concerned about what’s going to happen to downtown D.C. and what’s going to happen to the District’s coffers,” Dougherty said. “We’re doing this to say hey, you’ve got a problem, and if you don’t get a hold of this in 2022 … the city could face being taken over by the Oversight Board.”

'Very High Stakes'

Not everyone thinks that nightmare scenario of the 1990s — when the federal government took control of the D.C. budget — is coming. Yesim Sayin, executive director of the D.C. Policy Center, worked under the District’s chief financial officer in the months leading up to and after the Great Recession. At the time, she said, the financial outlook for the District was changing so fast that the council met roughly half a dozen times to revise the budget as revenues sharply declined.

“During that time, there was a lot of uncertainty as well, and we just didn't know what would happen to the District's real property,” Sayin said. “It’s a very high stakes thing.”

In that crisis, the CFO estimated revenues from real property down by nearly $1B over four quarters, taking into account sales of distressed assets as they became public. Sayin said the role of the CFO worked as intended then, averting a broken budget and the need for federal intervention by extension. But that wasn’t without pain — the cuts represented about one-sixth of the District’s total budget.

The concerns raised in Monday’s letter also start with tax revenue estimates from commercial properties. Those estimates are based on assessments, which are determined in part by a building’s cap rate.

The CFO estimates cap rates in part by looking at overall market conditions, and in times of economic uncertainty, cap rates go up, which drives down assessments and revenues as a result.

But when the CFO’s office released projected cap rates for the 2023 tax year in March, it lowered the cap rate for Class-B offices by 0.2 percentage points and Class-C offices by 0.5 percentage points. That has left property owners who expect the difficult economic environment to further depress property values scratching their heads.

“If those cap rates would have increased [for the next fiscal year], which I think they should have, the property values would have gone down,” Sayin said. “Rather, in downtown D.C., property values went up by like a billion dollars. And some of it is like The Wharf, you know, new delivery, but that's not enough to explain all of it.”

Sayin said some nuances in the budgeting process may mitigate the impact, but she believes the CFO is being far too generous given the current economic environment. 

"They cannot keep saying, 'Oh, we're not going to change the cap rates because nothing else is happening,'" Sayin said. "Clearly, it's far riskier right now."

The true impact to the budget is dependent on just how bad the distress in the office market becomes. Sayin predicts the market could lose $6B in value, which would mean the District loses over $100M in revenue, but she said some project the impact to be even greater.

If revenues fall far enough that they risk breaking the budget, the mayor must work with the council to pass a supplementary budget, which happened during the financial crisis.

Sayin believes the District’s true budget cliff is about two years away, as tax assessment appeals for older office buildings work their way through the courts and transactions — which the CFO uses to help set cap rates — begin to appear. 

There are 733 large office buildings in the office-heavy parts of the District today, of which 228 are more than 25% vacant or are likely to become vacant in the next two years as tenants leave with no one to replace them, according to a data analysis by the D.C. Policy Center. Those buildings, in turn, could trade for bargain prices and potentially depress the values of similar properties.

In addition to the rising vacancy, the rapid pace of interest rate hikes this year is bringing down the values of office buildings, Carr Properties CEO Oliver Carr said. 

“That has a pretty big negative impact on values,” Carr said. “I think on the whole, market values are probably going to reset down 20%-plus just based on the increase in interest rates.”

Another major fiscal pinch is approaching. D.C. was awarded federal recovery funds first by the CARES Act and then by the American Rescue Plan, the latter of which provided the District with funding that treated D.C. like a state.

But most of that funding is set to expire by the end of fiscal year 2024, just as the wave of negative office valuations is expected to crest. Without coming up with an alternative funding source, the District is likely to face some difficult budget cuts.

“I wouldn’t go as far to say as the Control Board is going to come back. That’s not my concern at all,” Sayin said. “My concern is that we will lose city services."

'A Real Math Problem'

In recent months, D.C. officials have been eager to discuss a particular real estate solution that they say will spur the revitalization of downtown — office-to-residential conversions. But property owners who spoke with Bisnow argue that the District can’t bet on widespread conversions downtown without betting on a level of destruction in the value of office buildings not seen in years.

In order for conversions to pencil, owners say, the value of older office buildings will likely need to hit $150 per SF. That’s a steep discount in areas like the East End, where land values alone once exceeded $300 per SF, PRP’s Dougherty said. Residential properties are also taxed at a lower rate than commercial property, further compounding the revenue losses, he said.

“When you start replacing stock from commercial office to resi, you’re gonna start losing tax revenue,” Dougherty said. “It’s a huge loss.”

Doug Firstenberg, principal of Stonebridge, said he expects a “tsunami” of negative factors, including rising interest rates and a shrinking pool of capital willing to invest in older D.C. offices, will wipe away much of the remaining value in Class-B and Class-C properties.

“If you look out two, three, four years … if a building isn’t competitive and can’t get leased, its value is going to go down by half or two-thirds,” Firstenberg said. “There’s a real math problem for a lot of the older buildings.”

Since the pandemic began, buildings constructed or substantially renovated before 2015 lost roughly 6M SF of occupancy, with additional downsizing on the way. But conversions that have been announced to date account for less than half of that new vacancy, according to data provided by JLL.

Firstenberg and others are skeptical that conversions can fully address the growing tide of emptying office buildings, despite D.C. being one of the top markets for such development plays.

“Those conversion projects, they are not easy. They are not cheap projects,” Wei Xie, a senior research director at JLL, told Bisnow.

Experts agree that D.C. needs to see more foot traffic downtown, and soon, in order to stave off a negative spiral of stubbornly high vacancies and falling demand. But so far they’ve yet to come to a consensus on what can restore that foot traffic.

“What makes a downtown successful is that vibrancy, that bustle, that sense of people bouncing against each other,” said Kevin Clinton, chief program officer of Federal City Council. “If fewer people are going to be in offices, we need to find other ways to get people downtown.”

Dougherty is pushing for an independent economic development agency similar to one set up by Austin, Texas, in the 2000s that could attract industries that require in-person work, like health sciences and biotechnology. Clinton also said the District could place a renewed emphasis on public spaces and tourism, an idea that has been echoed by the business improvement districts in D.C.’s downtown core this year.

For Firstenberg, the issue is central to the identity of D.C. as a place that funds robust, growing social programs. He said he wants the District to find ways to attract new jobs that can bring new residents to D.C., filling apartments and offices as they settle in.

He’d like officials to start working on that now, before the fiscal crunch truly hits. 

“It’s actually my expectation that people are going to understand what’s coming at us, and get different plans to put in place, so things will be redeveloped, things will be changing, and so I think the District could be really dynamic in two or three years,” Firstenberg said. “But I think it’s going to take work and focus to make that a reality.”