Slow Growth Settles In – A New Normal in Downtown D.C.

Savills Studley Insights
March 11, 2014
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Rightsizing of Core Tenants Likely to Continue

Between the mid-1990s and 2011, during times of prosperity and even in the aftermath of two recessions, Washington, D.C.’s economy and office market established a reputation as essentially recession-proof. This period of nearly uninterrupted growth resulted from the federal government’s largesse as well as a development renaissance in Downtown D.C. that was given further impetus by renewed confidence in the District of Columbia Government’s fiscal health and stability. Over the last two years, with the private sector still recovering from the Great Recession and the federal government curbing spending, Downtown D.C.’s office market appears to be at risk of losing its relative immunity to national economic cycles. Since 2012, office using employment in the D.C. region has been growing at a fraction of the longer-term historical average. As the market sustains its third year of low office-using employment growth, lackluster tenant demand, and declining rents, some market observers are anticipating a rebound by 2015 or 2016. Studley is not among them.

We see little prospect of widespread rental rate growth in Downtown D.C. over the next two to three years. Faced with cost pressures, reduced revenue streams and more recently, the impact of sequestration, D.C.’s public and private sectors have been aggressively implementing concrete measures to do more with less. These have included freezing or cutting payroll, merging operations with competing firms or related agencies in the public sector, and reducing the amount of office space allocated per person. Even if the economy grows at a faster rate and moves beyond its current post recession doldrums, tenants are unlikely to shed the new space efficiency standards that have become a permanent part of operating principles and space-use decisions.

(Click or tap images to enlarge)

Downtown D.C. Tenant Base by Major Industry

Law firms and federal agencies together account for over 40% of Downtown’s tenant base and have traditionally served as two of the most important drivers of office space demand (Figure 1). A rebound with enough strength to trigger extensive rental rate growth would require one or more significant changes to demand drivers—which Studley sees little likelihood of occurring anytime soon:

  • The private sector, particularly law firms, as well as federal agencies, would have to abandon current space efficiency campaigns and revert to a more aggressive leasing velocity last seen in 2005–2007
  • New expansion in an industry sector such as technology, education, or medical would need to be large enough to fill the gap in demand for downtown office space
  • Long-term Federal budget, debt limit, and appropriations clarity would need to return and Federal spending would need to resume a substantial upward march

Law Firm Leases Over 50,000 SF before and after 2008 recession

Tenants Are Doing More with Less

Virtually every private sector tenant, including law firms, as well as government contractors and professional and business services companies, has rightsized at lease expiration and the trend continues to accelerate. Faced with revenue pressures and tight operating margins, firms and government agencies have identified office occupancy costs as a significant way to reduce expenses. A Studley analysis (Figures 2 & 3) of the largest law firm leases over 50,000 square feet signed before and after the recession (2005–2007 and 2010–2013 respectively) indicates a clear shift toward reduction in law firms’ appetite for office space.

This rightsizing has gained traction since 2010 as law firms continue to adopt space-design strategies incorporating multipurpose spaces, and in some cases, the implementation of smaller and more uniform office sizes for partners and associates. Additionally, many law firms have relocated a portion of their administrative operations outside of downtown. Some forecasts that are calling for growth in 2015 hinge on the large volume of lease rollovers in the next few years. However, expiring leases offer tenants the opportunity to examine their space needs and associated costs. As tenant rightsizing continues to work its way through the marketplace, companies are likely to pursue workplace strategies that cut costs and more efficiently utilize office space. Absent a dramatic shift to more aggressive expansionary leasing by tenants, the large volume of lease expirations should accelerate a reduction in the total net space occupied by those tenants.

Federal Agencies Continue Transition to More Efficient Space

Federal agencies have just begun what is likely to be a multiyear process of intense space densification that exceeds the scale seen in the private sector. A five percent reduction in space occupied by federal agencies would add more than 500,000 square feet of available space downtown. In March of 2013, the Office of Management & Budget (OMB) issued a ‘Freeze the Footprint’ guide directing Federal agencies to reduce the size and cost of their real estate requirements. A Studley analysis of a sample of authorized GSA prospectus level requirements over 50,000 square feet which resulted in leases signed before (2005–2007) and after (2010–2013) the recession found that the average utilization rate (square feet per person) decreased by 8% from 190 square feet per person to 175 square feet. Additionally, more rigorous oversight is protracting the Federal leasing process and delaying transitions to smaller footprints. This is serving to artificially support the market and current space occupancy levels of many agencies. The recently approved Department of Justice prospectus provides an example of what is on the horizon. The DOJ occupies over 1 million square feet downtown in four buildings and is being directed to reduce its space utilization rate from 184 square feet to 130 square feet per person—a nearly 30% reduction in the amount of space allocated per employee. Moreover, the eventual move of agencies such as the FBI and Homeland Security to more isolated campus/enclaves located outside of Downtown D.C. will likely add more vacancy and opportunity for tenants.

Net Change in Space Leased by Law Firms - Leases Over 50,000 SF

Who Will Fill the Gap in Demand?

Contraction by law firms and federal agencies has the region seeking alternative sectors—such as technology, education and medical—that can fill the gap in employment and office space demand. Tech companies, as well as schools, universities and the medical industry, have boosted leasing activity in the wider region, but their impact on Downtown D.C. office space has been limited. In the near to mid term, demand from these sectors is unlikely to reach levels that will offset the pullback by the city’s traditional tenants.Tech and creative sector companies often prefer more affordable and unique space in redeveloping neighborhoods. Ideaspace, for example, leased space in an historic former Navy Yard industrial building located in the Capitol Riverfront Submarket, and creative incubator WeWork signed a lease in a former Wonder Bread factory in D.C.’s Shaw neighborhood. Similarly, medical sector companies are more likely to choose locations in suburban Maryland locations that offer proximity to NIH.

Continued Uncertainty

Barring a major change in the economy or a larger global disruption, federal spending levels are likely to remain flat , or possibly decline, in real dollars over the next several years. While the recent bipartisan budget agreement provides a blueprint for spending over the next two years, there was no grand bargain. At best the recent budget plan is an agreement to avoid short-term disruptions and suspend the brinkmanship and crisis of this past October. With continued uncertainty regarding longer term Federal spending, weakened office space demand is likely to persist due to many tenants’ inability to make long term commitments.

Despite widespread focus on cost control, some companies and organizations have been willing to pay a premium for space in newly constructed buildings due to a building’s greater efficiency, technological enhancements, and more open“collaborative” layouts. More importantly, new buildings have highly efficient layouts, enabling tenants to reduce the size of their leases and provide for existing operations while often also providing the capacity to accommodate some degree of growth. Demand for space in newly-constructed or renovated buildings will likely support some rental rate growth in the highest-caliber properties in premier locations. However, this will only accelerate the bifurcation of the market into a set of elite properties and a group of older buildings that will be forced to aggressively compete to retain their tenant rosters. Aging buildings in all classes will continue to face downward pressure on effective rental rates.

Newer buildings are already outperforming their predecessors (Figure 4). A Studley analysis indicates that prior to the recession, available space among Class A buildings in Downtown D.C. was consistent and proportionate among different building age groups. However, following the disruption and volatility initiated at the onset of the recession, available space in Class A buildings constructed since 2000 and older buildings have generally trended indifferent directions with newer buildings currently having less available space than their older counterparts.

Net Absorption and Change in Available Space (Downtown DC Class A Buildings) Since 2010

Early in 2014, Downtown D.C.’s Class A availability rates its at approximately 14.2%, nearly 100 basis points above the long-term average. Availability is likely to remain at this elevated level as new construction activity continues and demand remains muted. Availability will rise when some larger blocks not currently accounted for in many analyses—such as Arnold & Porter’s 400,000+ square feet at 555 12th Street, NW to be vacated in 2015—join the statistics.

Moving forward, the demonstrated preference for efficient and often new or renovated space, coupled with restrained spending and space-use demand from core tenants, will heighten challenges for Downtown D.C. landlords of all but the most well located and efficiently configured buildings. A return to consistent and market-wide periods of rental rate growth—taken for granted over the last 15 years—appears unlikely over the next two or three years in Downtown D.C.