Washington, DC FY 2020 budget: Impacts on Commercial Real Estate
The recent passage of legislation by the District to raise property taxes on commercial office properties in FY 2020 by 2.2% from $1.85 per $100 to $1.89 per $100 will cause rent paid by office tenants to jump further, at a time when the market’s supply-demand paradigm strongly favors tenants and should present opportunities for cost savings, not increases, to stimulate demand to fill-up excess vacancy.
Office rents in Washington, DC have increased by 21% since 2009 despite tenant-favorable market conditions driven by both excess supply due to a robust speculative development pipeline, and limited tenant growth as the federal government, law firms and nonprofits all have focused on rightsizing their real estate footprints.
Another contributing factor to increased rents has been an increase in property taxes, which owners pass through to tenants each year. The District’s tax assessment methodology is based on the market value of each building, and as investor interest in commercial office properties here has been robust this cycle, the value, and thus the property tax, has increased. In 2009, the average value (based on average sale price p.s.f.) of a Washington, DC office building was $402 p.s.f. (property tax = $402 * $1.85 / $100 = $7.44 p.s.f.) compared to the 2018 value of $584 p.s.f. (property tax = $584 * $1.85 / $100 = $10.80 p.s.f.). The increase in property taxes from $7.44 p.s.f. to $10.80 p.s.f. represents a 45% increase paid by each tenant since 2009.
How will the tax increase impact tenants within each market segment?
As Trophy building valuations and sales have pushed prices above $1,200 p.s.f., the 2.2% property tax passed through to tenants will result in a $0.50 p.s.f. rent increase. This increase will put upward pressure on today’s asking rents, but will not drastically shift preferences for tenants actively in the market for Trophy-quality space as asking rents have recently dipped. Over the past 18 months, Trophy asking rents declined 2.4% due to an elevated supply of new deliveries and limited near-term large-block demand. However, tenants that signed leases at the beginning of this cycle are likely already paying above-market rent, and the rent increase due to the tax change will push rents even further above market. Tenants currently paying above-market rates will have a window of opportunity over the next 24 months as options remain plentiful. However, as the development pipeline begins to slow, these options will become limited and rent growth will begin to materialize as limited new product delivers between 2023 and 2025.
Class A (non-Trophy)
For most of the current cycle, the Class A (non-Trophy) market has been impacted by excess supply, as many 1990s buildings formerly occupied by law firms have become vacant and newly reskinned product has delivered. As supply has outpaced demand, asking rents have remained flat since 2015 while tenant concession packages have increased 30%. Given this muted rent growth and considerable concession increase, the 2.2% increase in property taxes will not significantly impact decisions among tenants looking for Class A (non-Trophy) space as leverage remains strongly in tenants’ favor. However, with recently limited growth in rents, many tenants that signed leases at the beginning of this cycle are currently paying above-market rates. The tax increase that will drive a $0.30 p.s.f. to $0.35 p.s.f. increase in rents will push tenants well into their lease further above market. Opportunity for tenants paying above-market rents will be plentiful over the next 36 months as Class A (non-Trophy) vacancy in the core is approaching 17% and competition will continue to increase as >5.0 million s.f. of new Trophy and Class A (non-Trophy) supply delivers through 2021.
The 2.2% increase on property taxes will most significantly impact tenants occupying Class B buildings. Rent growth within the core Class B market has outpaced all other segments growing by 4.4% since 2016 as supply levels have declined by 2.0 million s.f. due to the repositioned of product to Trophy and Class A+. As rents have increased, Class B tenants have increasingly looked to lower cost alternatives. Over the past 48 months, >1.0 million s.f. of private sector tenants have relocated from the core to lower cost non-core markets. The tax increase will translate into a $0.25 p.s.f. increase in rent and put additional pressure on typically cost-conscious Class B tenants such as nonprofits, associations, education and growing technology companies that are already facing rising market rents at the buildings they occupy, as well as limited lower cost relocations options in the core. The tax increase will further exacerbate the flight from the core to the non-core DC markets and neighboring Virginia and Maryland markets.