In 2012, the Washington commercial real estate market became more competitive for investors. Our region faced the threat of sequestration — automatic federal budget cuts — only to see a decision on those cuts deferred until March. Uncertainty led to stasis: executives across the region paused their hiring and investment, waiting for the government to act. This led to the first year of negative net absorption — more space being vacated than leased — on record for the Washington area office market. At the same time, developers began building so many new apartments that supply now exceeds demand.
What will 2013 bring? We have identified six major trends influencing the local economy and commercial markets. These trends are creating both challenges and opportunities for Washington investors.
1Washington realized its vulnerability in 2012. Thanks to the presence of the federal government, the Washington area economy has proven to be more resilient than the nation’s during downturns. The area has consistently enjoyed lower unemployment rates and higher job growth rates than the nation as a whole. During the past 20 years, the Washington area grew new payroll jobs at an annual average rate of 1.6 percent, compared to the national rate of 1 percent. The local unemployment rate during the past 20 years averaged 4 percent, below the national average of 6 percent.
However, with the federal government now in austerity mode, our recession-resistant nature has been compromised. Nowhere is that more evident than in local procurement spending. In 1980, when records were first kept, procurement spending was $4.2 billion. It grew every subsequent year to $82.5 billion in 2010. It declined for the first time in history to $80 billion in 2011, and then to $75.6 billion in 2012. This two-year decline alone accounts for the loss of nearly 50,000 jobs in the private sector. In addition, over the past 12 months, the federal government shed 4,200 payroll jobs.
2Despite vulnerability, the private sector continued to create jobs in the Washington area during 2012. During the 12 months ending November 2012, the local private sector added 27,600 jobs, with the education, health and professional services sectors leading the way. This growth is above the 10-year annual average of 17,000 new private sector jobs. Public sector job growth decelerated during the 12 months ending in November, with just 6,700 new jobs created.
Private sector growth should continue as the federal government recedes. It is supported by one of the most educated workforces in the nation, one that helps attract headquarters facilities from other parts of the country. According to the Greater Washington Board of Trade, the region has recently captured a third of all major corporate headquarters relocations in the United States.
Demand for commercial real estate should remain at reduced levels in 2013, as economic uncertainty continues. However, demographic shifts and the rise in technology offer some long-term opportunities.
Office market: Tenants are leasing less space per worker at the same time the General Services Administration is pulling back on leasing.
Multifamily market: Leverage in rent negotiations is likely to shift from owner to renter because of demographic changes.
Retail market: Structural shifts (such as the rise of e-commerce) are likely to benefit some store formats over others.
Industrial market: Advancements in technology should fuel demand, such as the need for warehouse space to host data centers.
4A more development-friendly environment has emerged, adding to competition.
Combined with reduced demand for space, local competition among economic development authorities has been heating up. As they reduce red tape and streamline permitting, more new development is occurring.
Public officials know that they must broaden their tax bases in order to continue providing the level of service that residents demand. This means making their jurisdictions more appealing to companies that are creating jobs. They are attempting to strike a balance between protecting the residential character of communities and inviting new development that will bring jobs, tax revenue and amenities. These efforts have contributed to a temporary oversupply of office and apartment product.
5These trends portend a foreseeable future that is more competitive and features higher vacancy rates, lower rent growth rates and a continuing flight to quality.
We expect office rents to decline approximately 1 percent in 2013 before gaining traction and rising 1-2 percent in 2014. By 2015, we expect the office market to favor landlords and experience rent growth of 3-4 percent. However, we do not foresee office rent spikes in this cycle.
In 2013, rents on high-end apartments are likely to drop 2 percent as vacancy rises. In 2014 we expect rents to edge up, with growth of positive 0.25 percent. By 2015, the higher-end (Class A) apartment market is likely to experience 1-2 percent rent growth. We expect to wait until 2016 before the market returns to rent growth of 4-5 percent, which is in line with the long-term average, but still less than the robust growth of 7.8 percent in 2010 that encouraged so much new supply.
The best way to distinguish a project in the near term will be by connecting design to the needs of the targeted user; this principle applies to all building types, but especially to office and apartment projects, where competition is likely to be fierce.
For office development, that means keeping in mind the changing needs of tenants. Tenants are increasingly asking for fewer private offices, a more efficient floor plan, flexible design, accommodations for technology, more space for collaboration, and other design elements that allow for fitting more people into less space than before. Some also want higher levels of finishes to appeal to staff.
For apartment development, that means smaller units appealing to the young renters of the future, but also amenities that they can share with their friends, including common areas and outdoor living spaces. However, developers should not lose sight of the empty-nesters (age 55+) who will be renting in great numbers in the decade ahead. Their needs are quite different from those of the age 25-34 cohort.
Sandy Paul is senior vice president and national research director at Delta Associates. Staff at Delta Associates contributed to this article.