Q&A on the State of the DC Market

Devon Munos, the Savills DC research manager, is charged with understanding the complexities of the DC real estate market and how evolving market dynamics impact the tenants we represent. Below, she discusses the history of the DC market during past periods of economic disruption and what we might expect in the future.

How has DC’s office market reacted to past economic downturns?

DC is viewed as a resilient market due its core tenant base of government, legal and related sectors, which have provided a safeguard during past recessions relative to other metropolitan regions. However, the cushion provided by this tenant base does not leave the market impervious to economic volatility.

To understand the health of an office market, many real estate firms analyze the change in asking rents as an indication of strengthening or weakening. Comparing asking rents to the S&P 500 Index, which often serves as a proxy for the health of the economy, shows a coincidence and likely correlation between previous economic downturns and a decline in rents in some markets, but not in DC.

During the financial crisis in 2008 and 2009:

• S&P 500 Index fell as much as 40%
• New York rents dropped 38%, nearly a 1 to 1 correlation
• San Francisco rents dropped 25%
• But DC rents only fell 2.5%

Using that same metric, how has DC fared since the financial crisis?

Since that time, since 2010:

• S&P 500 Index gained 175%
• New York rents increased 94%
• San Francisco rents increased 121%
• DC rents only increased 13%

So while DC asking rents remained insulated from the downturn, the asking rents didn’t really benefit from the bull market run over the last 10 or so years.

What metrics does the Savills research team utilize to determine the health of the market from a tenant perspective? 

At Savills, we track two additional metrics:

1. Landlord-provided Concessions (meaning free rent and tenant improvement allowance)
2. Tenant Effective Rent, which takes into account these concessions.

In DC, a market that has been tenant-favorable for more than a decade, studying landlord-provided concessions and tenant effective rents is more revealing than asking rents.

When the S&P plunged during the financial crisis, the total value of concessions increased 28% and tenant effective rents dropped 6% during that same period.

In the 12 years since 2008, concessions have more than doubled (115%) and are actually the highest of any major market in the US. As a result, tenant effective rents have decreased 13% — meaning effective rents are actually lower now than they were over 10 years ago — despite the increase in asking rents.

Using these metrics demonstrates that DC’s office market never really recovered from the Great Financial Crisis and didn’t benefit from the long period of economic growth of the past decade.

What else contributed to the lack of recovery in the DC office market?

DC’s office intensive tenant base took the opportunity to become more efficient, taking less office space per employee, and new construction activity continued at a rapid pace, fueling a flight to quality among tenants. This supply-demand imbalance increased the availability of space without any rapidly expanding industries to fill the void.

Q2 2020 will be the first full quarter of data since the stay-at-home orders across the region. Have you noticed any indications of how COVID-19 has impacted the market?

DC has upheld its reputation to be resilient during periods of recession with sustained leasing activity in Q2 – largely due to the government sector.

Q2 leasing is set to close just below the five-year leasing average, and ahead of Q1 activity. Half of the transactions completed during Q2 have been long-term renewals and a good portion have signed short-term extensions – likely postponing real estate decisions until more clarity is revealed about what to expect in the near to mid-term.

As expected, there has been minimal change in asking rents over the quarter, but we are already seeing an increase in concessions. Tenants willing to sign leases during these uncertain times are receiving favorable terms and opportunities in many forms.

Availability in Q2 is reaching the highest rate in a decade – the highest availability seen since the last recession – which will continue to weaken the market.

Overall demand remains tepid, and the crisis could cause conditions to worsen in the months ahead before the market begins to make a recovery.

So what’s the takeaway for the DC market?

Prior to COVID-19, we predicted that DC would remain a tenant favorable market for the foreseeable future. DC lacks a tenant base poised for explosive growth and tenants continue to use real estate more and more efficiently.

After COVID-19, we would expect these trends to continue and even accelerate. We don’t know the net impact on the amount of office space per employee, but many tenants will likely be hyper-focused on the bottom line – similar to a decade ago – and thus their real estate budget.