Sequestration and other factors dampening market enthusiasm

April 7, 2013

The first quarter ended with sequestration in progress. The ultimate impact of the government’s automatic budget cuts is unknown for two reasons:

Will it be modified by Congress?

How will cuts play out in this region?

The first is unknowable.

The second is intriguing. Consider this: We know that cuts will not be pro rata in Washington. In fact, there is evidence that when an industry shrinks, such as the oil industry in the 1980s, the home base of Houston actually expanded at the expense of satellite locations such as Dallas, Denver and New Orleans. Could that happen here?

Government contractors affected by this reduction should be able to weather this storm as they have had ample time to prepare and reposition. The more immediate impact will likely be felt by federal employees who are forced to take furlough days. Growth in the metropolitan area is likely to remain sluggish during 2013, and only begin to pick up if and when a compromise on federal budget policy is achieved.

For now, the market for office space appears to be soft in the region. The amount of occupied space declined in the quarter and the overall vacancy rate increased from a year earlier.

The arrival of sequestration dampened market enthusiasm and moves prompted by the Pentagon’s base relocation and closure process hampered growth. Those forces coincided with a trend towards “densification,” in which tenants consolidate operations into less space.

Given these conditions, concession packages remain elevated as property owners compete for the limited pool of tenants in the market. This, coupled with shorter lease terms, has put downward pressure on effective rents, declining another 0.6 percent during the past three months. However, better buildings in stronger submarkets are outperforming this metro-wide trend.

Leasing activity from the General Services Administration is likely to be muted during 2013, as proposed federal leases are under increased scrutiny by Congress. GSA recently issued 16 lease prospectuses to Congress for approval. This activity could boost demand in the Washington area. However, Congress continues to push agencies to lease less space per employee, which reduces the amount of total space an agency can lease.

Even if an amendment to sequestration is agreed upon by Congress and the president, the bulk of the jobs added to the economy during this period will likely be from the private sector, as the federal government will remain under budget pressure to shed jobs. Still, we expect leasing activity from the private sector to be restrained compared to past recovery cycles, as companies sitting on unused “shadow” space utilize the additional room before inking new deals. In addition, tenants are increasingly leasing less space per employee due to the rising implementation of hoteling and teleworking programs and “rightsizing” office space because of staff reduction during the downturn.

Ultimately, growth in the private sector over the next several years should overcome densification trends and we look for notable market momentum and improvement by 2015.

Elizabeth Norton is senior vice president and Mid-Atlantic research director at Delta Associates. Staff at Delta Associates contributed to this article.

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