DC Metro Can't sustain new speculative office construction

Implications: The DC/Metro market’s growth in the office sector has by and large been fueled by the Federal Government and Defense Contractors. The article suggests that law firms that are in The District Proper will want and need to stay close to their client base and suggests law firms may be the ticket to future office space absorption. During the last couple of years many law firms have already committed to new office, so that demand may not exist to the extent the article suggests.

Analysis:

The fact is this new “speculative” construction is based upon the euphoria of the past couple of years. It is typical developer mentality to want to build when times are good. The problem is the forecasting of future demand based on todays or even yesterday’s market cycle.

The suburban DC/Metro area is at or near full employment. The late Eighties highlighted what happens when you do not take into account the fundamentals of the workforce, meaning the number of bodies available to fill the office space, general business conditions, and the lending climate.

The question has to be asked of these developers...”where are the people coming from?”

If they are coming from other companies or agencies then all that happens is you cannibalize the local labor force pitting one employer against another. To fill the 10 million square feet that was constructed last year that would require between 40,000 and 50,000 people. The next question is what has been the economic driver in the DC/Metro area since 9-11-2001? The driver has been the Federal Government and their defense contractors.

It has already been documented the Federal Contractors especially the Defense oriented companies are already scaling back as is the Federal Government spending overall. It has been reported in several business publications the Feds have several agencies needing to expand from their existing locations or will be scheduled for lease renewals. The part that is overlooked is the GSA has a top limit for the office rents they are willing to pay of approximately $35 psf full gross. The developers coming out of the ground with new construction will not be able to accept that low a rent based upon the increased cost of construction and the cost of the land they have recently paid. The renewals will probably be the best bet for most of the landlords who have the Feds as tenants. If the Feds are in buildings recently purchased by investors during this abnormal cap rate environment, they too will have difficulties getting the rent spikes they envisioned when they purchased.

Lastly, in case no has noticed, the lending climate for commercial real estate has dramatically changed for the worse. Underwriting standards have tightened up considerably even with the CMBS lenders. Therefore to replace construction loans with permanent financing, which every developer wants to do sooner rather than later, they will need a much higher percentage of their newly constructed buildings being pre-leased. If demand is not what has been forecasted those developers will have some major issues.

The article in question noted several times the local commercial real estate market is headed towards a slowdown. Then one would have to believe these speculative projects are being built with the idea of “If you build them they will come”. Eventually perhaps but not in the foreseeable future.

Finally, will the suburban markets where there is speculative construction going be successful that remains to be seen. The fact that most of the employers in DC Proper have a labor force which commutes to The District; one would argue that this would be an advantage to the suburban market. Again the suburban markets are experiencing the same low unemployment and business slow down everyone else is having.

The retail sector has been soft and will get softer the longer the housing slump continues.

There is an old business adage that says...”Bad decisions are often made during good times”. I see these developers being caught looking backwards not forward. I wish them the most success, but unfortunately, hope doesn’t replace good planning.