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It’s no secret that the office market around the nation is troubled, and that’s certainly the case in the D.C. and Baltimore markets, where landlords are having a tough time filling space.
In some cases, landlords may never be able to fill their office space as in the past. That’s led to speculation about the fate of that vacant space. Residential conversion is the most talked-about option, and there’s been a great deal of that within the D.C. and Baltimore regions. Some 14 office buildings in D.C. alone are slated for multifamily conversion. If all go through, it would remove 2.8 million square feet of space from the office inventory, reducing overall vacancy to a still-high 16.7 percent.
Owen Rouse, senior vice president of Lutherville, Md.-based brokerage MacKenzie Commercial Real Estate Services, spoke with Commercial Observer this month about what he’s seeing and how the office market might shake out this year.
This interview has been edited for length and clarity.
Commercial Observer: Now that we’re in April, how would you characterize the state of the office market in Maryland and D.C.?
Owen Rouse: Activity among end users searching for commercial office space currently falls into three camps: downsizing to quality, in which companies are slightly shrinking their office footprint but doing so in a high-quality building; downsizing in the existing footprint, where groups are giving up unnecessary space but remaining in a highly desirable address; and departing altogether from the market, as a result of a corporate merger, companywide shrinkage of office footprint or the closing of an unprofitable location.
What are the factors most impacting the sector right now?
The return-to-office vs. work-from-home saga is starting to have clarity, with an increasing number of companies demanding a physical presence in the office, which removes uncertainty from the decision-making process. Suburban-based office product, particularly highly amenitized ones, are having greater access in attracting and retaining tenants. The Baltimore-Washington, D.C., area remains among the most recession-proof sections of the country, so we expect less economic pain and uncertainty for the balance of 2023.
How much of an impact has remote working had on the sector?
Although varying industry by industry and company by company, the impact of remote work has been significant, with nearly every organization maintaining heads-down work functions that do not require a daily presence in the traditional office. In many instances, remote work becomes isolating and difficult, with employees hurt by less contact with mentors and peers and engendering proximity bias. More and more employees are choosing to work at home less often to overcome some of these challenges and perceived slights. The line between can work remotely vs. should work remotely is clear. It is believed that some elements of the workforce will remain remote with only occasional visits to the main office or satellite location.
The return-to-the-office movement currently underway will pick up momentum as employers highlight the value of in-person collaboration and as workers understand that if you are not seen regularly, you may miss out on plum assignments and might not get promoted.
What should owners of office properties be doing now?
First and foremost, identify threats to occupancy and formulate a strategy for the balance of the year. This begins by speaking directly with each tenant to fully understand their short-term and long-term plans, and formulate how the landlord can offer solutions. Next, create a scenario plan for the potential loss in income, which involves lender discussions and placing operational costs under a microscope. Finally, examine feasible ways to amenitize your properties, including tenant-centric floors, unique design elements, placemaking in the public elements of a building, and carving out retail spaces to contribute to the overall tenant experience.
What are the best ways to fill empty space?
In markets experiencing a drop in demand, rent reduction tactics may not be the answer, because there might not exist takers at any price. Landlords need to be in a position to make the deal that is in front of them, so they need to make sure they see every existing deal. Their building needs to be a place where tenants have a need to go, including proximity to government offices or larger occupiers, access to a RAD network or representing a significant upgrade in quality from a previous space. Across the marketplace, we are seeing longer periods of free rent to entice tenants and help them survive through potential months of economic uncertainty.
Are there any particular areas that are strong in the D.C. and Baltimore regions?
Defense and health care remain the brighter parts of the office economy. Defense contractors, including cyber-related activities, require secure workspaces to conduct sensitive assignments in proper office environments. The health care sector takes on many forms of occupancy and crosses geographies, workforce populations and asset sizes.
The growth in the bio sector is also front and center with activity. Large, well-leased facilities are trading, and new construction is filling pipelines in key markets, including Washington, D.C. Strong markets are often the result of the presence of underlying research universities or government departments.
What does a savvy marketing and leasing strategy look like today?
A savvy marketer is aware of the need to manage their brand buoyancy through a combination of electronic marketing — which creates and sustains awareness — combined with an amenity narrative that resonates with potential tenants. Clean, safe and well-managed buildings are attractive to cognitive tenants coached by equally cognitive real estate brokers.
How would you project the rest of 2023 and 2024? Will the office market continue down this path?
In the coming months, landlords will need to manage new dynamics that directly affect value. This includes an increase in operating costs across the board, a decrease in income due to higher vacancies and potentially a drop in rental rates, significant tenant improvement costs required to install a tenant, and increased interest rates and constricted lending terms in the event of the need to refinance.
In some cases, owners who have held properties for an extended period of time should be contemplating a sale at a market-driven price (i.e. higher capitalization rate) as opposed to becoming the frequent check writer for a needy, aging-in-place asset. A sale to the next investor, who believes they can make things work better, or for a teardown, particularly in an older, land-constrained market, may also be a smart play.
Keith Loria can be reached at Kloria@commercialobserver.com.
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