16C — February 28 - March 13, 2014 — Commercial Office Spotlight — Mid Atlantic Real Estate Journal
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A continuing trend of a “bifurcated” market Washington DC Metro Area year end 2013 office report
altimore — This past year saw a con- tinuing trend of a “bi- furcated” market with widely varying pricing depending on product type, quality, and location. Capitalization rates for product that is attractive to institutional investors have dropped to record lows. Owners of those sought-after institutional quality buildings should conduct a careful hold- sell analysis and take a hard look at redeploying capital into more opportunistic in- vestments. One such opportu- nity lies in the suburban office market. Suburban office leasing fun- damentals remain soft though there is some strength among the best-of-class office build- ings in the region’s premier parks. This is owing to a “flight to quality” as tenants take advantage of attractive deals to be made in those buildings. Most investors remain more pessimistic. Many -- and per- haps a majority -- of suburban “outside the Beltway” office sales that are transacting to- day have some element of dis- tress associated with them. As these distressed buildings transact to entrepreneurial investors at record low prices, those new entrepreneurial owners will put downward pressure on rental rates, or at the very least keep rates near historic lows. These in- vestors can afford to undercut the market because they own those building at a basis that is much lower than any of their competitors. This will delay the inevitable recovery of the suburban office leasing market for some time. Right now investors that can afford to do so should take a long view and consider investments in distressed suburban office buildings. We believe this market is “oversold” and a cyclical re- covery, while a few years off, is inevitable. With some sub- urban office buildings trading at historic lows and dramatic discounts to replacement cost available, investors should consider these contrarian buys particularly in submarkets that have seen rent growth over the long term. Interest rates remain near historical lows and as such it continues to be a good time for users of office and warehouse space to consider purchases. User-buyers should think furcated” arket with idely varying pricing depending on product type, quality, and location. Capitalization rates for product that is attractive to institutional investors have ners of those so g t-after institutional quality b il i s sel analysis and ta e r lo k at redeployi g c it l nity lies in the s b r offic da entals re ain soft t o there is so e strength a o ings in the region’s pre ier parks. This is o ing to a “flig t to quality” as tenants take advantage of attractive deals to be made in those buildings. ost investors re ain ore haps a majority -- of suburban “outside the Beltway” office As these distressed buildings transact to entrepreneurial investors at record low prices, B This
C LASS A N ET A B SORPTION & V ACANCY R ATES
Vacancy Rate %
Net Absorption (SF)
18%
600,000
16%
400,000
14%
200,000
12%
0
10%
8%
(200,000)
6%
(400,000)
4%
(600,000)
2%
0%
(800,000)
like investors and focus on opportunities where existing buildings can be purchased at a discount to replacement cost. This may make for some additional transactional chal- lenges, e.g. dealing with a short sale situation, a building with deferred maintenance, etc. but the opportunities can be great. Northern Virgin- ia & Washington DC — The Northern Virginia & Washington DC office market continued to be very sluggish throughout 2013. Uncertainty with Federal Budget and Debt Ceiling Negotiations led to the partial Government Shutdown in October 2013. Combine that with the lingering effects of Sequestration and the roll out of theAffordable CareAct, and you have a recipe for contin- ued uncertainty in the busi- ness community; negatively impacting demand for office space throughout the region. Especially hard hit has been the Defense Industry and its related Government Contractors, a major demand drive in the region, especially Northern
Virginia. Most Defense Con- tractors have simply delayed their long term real estate and hiring decisions until our Fed- eral Government moves away from “Crisis” politics, and into an environment which pro- vides more clarity from a real estate and company growth perspective. Government Con- tractors are not the only in- dustry feeling the effects of a sluggish economy: Law Firms, Tech firms and Associations / Non-Profits have all been continuing the growing trend of consolidating into not only less square footage, but into more open collaborative space plans, a trend embraced by the younger workforce. By doing this, businesses are able to be more efficient while providing flexibility and decreasing their rent impact to the bottom line. The head count to s/f ratio of 250-300 s/f per person is now being pushed to as little as 150 s/f per person. There is also a growing trend of “hoteling” where workstations or offices are set up for employees to come into the office only 2-3 times per week, while work- ing a few days a week at
home. These forces have all converged increasing vacancy rates across the region to 17% with less than 10,000 s/f of combined net absorption for class A & B product across the major Northern Virginia submarkets. While still slug- gish, DC has faired better than its suburban neighbors with a class A & B year end vacancy rate of 10.4 % and over 1.3 Mil- lion s/f of net absorption. Therefore, due to weak de- mand for new space, there remains a lot of competition between landlords when a new tenant comes to market. Even in this competitive envi- ronment, most landlords are looking to stay at, or very close to their asking rental rate. To accomplish this, we are seeing generous concession packages in the form of Tenant Improve- ment (“TI”) Allowances and rental abatement. In short, the credit worthy tenant still enjoys the upper hand in the market. In addition, early lease renewals, or the concept of “blend & extend” remains a very popular strategy for both tenants and Landlords alike. Tenants are looking for
reduced leasing costs in the short term, in exchange for an extended lease term. On the flip side, landlords find this attractive because they simply do not want to be faced with a large tenant vacating the building, and incur the “down- time” and associated costs of releasing the space. Depending on the size of the Tenant, Blend & Extend leases are being completed up to 2-3 years in advance of the tenant’s current lease expiration date. While 2013 had its setbacks, there are signs of optimism as we move into 2014. The short term Budget deal has relieved a portion of the Sequestration freeing up previously frozen funds for the Defense Depart- ment. We should therefore see an increase in awards of nu- merous backlogged contracts providing a catalyst to the stagnant Government Con- tractor industry. This coupled with improving economic con- ditions, continued low inter- est rates and the expanding private sector employment numbers should help bring velocity back to our regions office markets. n
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