How Bad Is the Office Market? Just Look at What D.C. Landlords Are Giving Away

There’s a lot of empty office space to fill in Washington D.C. — and landlords are paying up to lure tenants.

Building owners in the nation’s capital are facing record vacancies as the employers weigh how much office space, if any, is necessary for the post-pandemic workforce. So landlords are sweetening their lease terms, offering nearly two years of free rent on the city’s most prime office properties, and upping how much they spend to help tenants build out their space.

The D.C. market offers a snapshot of how much further commercial real estate needs to go to be fully recovered from Covid 19’s devastating hit.

Those extra, out-of-pocket outlays in D.C. mean certain owners won’t realize income on their leased space for several years. It’s a trade-off that’s helped fuel some high-profile loan defaults by office investors in other major cities.

“There’s some landlords out there doing any kind of deal they can do, just to get tenants in the building," said Matthew Levin, executive vice president at Transwestern who advises law firms, non-profits and NGOs on their office needs in D.C.

Washington lags the national average in the share of workers who’ve returned to their office since the start of the pandemic. About 46% percent of the city’s  pre-Covid workforce is swiping key cards into work, compared with about 49% of a 10-city national average in the first quarter, said Amy Bowser, executive vice president at brokerage CBRE, citing data from Kastle Systems. While law firms have encouraged more in-person attendance, government and non-profit employees — a staple of the capital’s office market — have remained largely remote, Levin said.

The city’s office vacancy rate was 20.3 % in the first quarter, according to CBRE. It was closer to 21% last year. The national average was 17.8 % in the first quarter. Overall, more office space in Washington is being vacated than occupied, with 1.2 million square feet emptied of tenants in 2022, and an additional 190,000 square feet of “negative absorption” in the first three months of this year.

The composition of Washington’s workforce may be unique, but the question that property investors, lenders and tenants are struggling with is universal in the hybrid work era: How much office space do you need for a workforce that comes in only some of the time?

The answer is being hashed out in today’s lease negotiations, and the volume of concessions that  landlords are making to tenants who themselves aren’t sure.

“The biggest word, or theme, is ‘flexibility’," said Jonathan Danziger, a principal at commercial brokerage Avison Young, who manages a D.C. tenant advisory practice.

Office clients considering a new lease are largely seeking to downsize, taking fewer square feet, and demanding the option to shrink their footprint even further during the term of the contract, said Danziger and Sam Werner, another principal at Avison Young.

“Now, what we do upfront is identify a piece of space that we can give back to the landlord in the third or fifth year," Danziger said. “We identify a space where we can throw up a wall."

These days, D.C. landlords are willing to fund at greater costs their tenants’ ongoing deliberations on how to configure their space, as they tinker with adding conference rooms, more communal gathering spots and smaller private offices. They’re not only offering more money upfront to  customize the office before a tenant moves in, but some have agreed to bankroll draw-down accounts that the tenant can tap for renovations over as long as five years, Werner said.

Transwestern's Levin shares a case study of two leases he negotiated for tenants in the same Washington D.C. office building — one in March 2020, before the pandemic lockdowns, and the other one, this year.  The 2020 tenant, a tech company, was offered a 30,000 square foot space with an 11.5 year lease, and landlord-paid improvements worth $120 per square foot. (The tenant ultimately didn't sign).

The building has, in the interim, undergone renovations to its lobby and common spaces, as a way to make it more appealing to would-be tenants.  Still, in a 36,000-square foot lease deal this year with a law firm, the landlord agreed to pay for improvements worth $150 per square foot, Levin said.  In addition, the term of that lease is just shy of 16 years. 

“For groups that have some certainty around what their office space is going to look like and would like to transact, they can lock in aggressive and really unprecedented deals,’’ said Avison Young's Werner.

For Washington’s Class A properties — newer, in prime locations and with amenities like fitness centers and outdoor terraces — landlords offered an average of 20.3 months of free rent in deals signed in the first quarter, according to Transwestern data. That’s compared with the 19.9 free months they offered the same time last year.

Owners are funding office improvements at an average of $135 per square foot, compared with the $130 per foot they offered a year ago, the highest on record.

For Class B buildings — smaller, with no amenities, which are getting increasingly harder to rent as tenants have choices — owners upped their outlays for improvements by 15% since last year, spending an average of $115 per square foot, Transwestern said.

That means landlords who lease out office space today may not see any income from the deal for as much as six years, Transwestern’s Levin said.  Even that math may not work for every building—particularly ones with significant vacancies and facing the maturity of a loan that would be impossible to refinance given today’s higher interest rates and the lower valuation of the property from when it was first acquired.

“Some landlords have to do an analysis of where they are: If our loan is coming up in two years, we’re never going to stabilize this building, so let’s just shut it down," Levin said. "We’re not going to do any deals so let’s try to work it out with the bank. And if we’re giving the keys back, why put more money in?”

In February, landlord Columbia Property Trust made that call, when it defaulted on $1.7 billion in loans tied to seven office buildings, some in New York City and San Francisco. The same month, commercial real estate giant Brookfield defaulted on loans for office towers in downtown Los Angeles.

In Washington, tenant advisors considering a sweetheart lease deal for their clients, now increasingly check the financial durability of the owner that is offering it. 

“It used to be that the landlord wanted to make sure the tenant was healthy to pay the rent,” said Danziger, of Avison Young. “Now we want to ensure the landlord is healthy.”

There’s hope right now that the period of office retrenchment could be ephemeral, as employers taking flexible leases realize they’ve shrunk too much, said CBRE’s Bowser. Clients seeking to save money and still move to higher class buildings have been whittling their lease space by as much as 30%, she said.

“We anticipate there may be some companies that have overcorrected," Bowser said.

Another silver lining: an Office of Management and Budget memo that went out last month directed government agencies to assess how they may "increase meaningful in-person work.’’

“That’s something that investors are encouraged by,’’ Bowser said.