Volume 12, Number 1 – January 2015

The Future Commercial Office Market

1812 North Moore Street is an impressive building.  Located in Arlington, VA, it is the tallest building in the Washington DC metro area and has achieved the prestigious LEED platinum rating for green buildings.  It is also completely empty and has been so since it formally opened in 2013.

The problems facing this building and the overall high vacancy rates in Northern Virginia are creating major challenges for economic developers and real estate professionals.   Why is the local commercial office market so challenged?    Some of the causes are unique to the DC area—namely the impact of federal budget cuts and, in the Arlington’s case, the lingering effects of defense base closure decisions from a decade ago.   However, larger forces also appear to be at work and a major change in the commercial office market—with big implications for local economic development–may be underway.  (NOTE:  According to a recent report from Deloitte, the national 2015 prospects for commercial real estate are pretty solid. However, the report does note that “new (office) development activity is likely to remain low.”)

In an effort to better understand these trends, Arlington officials created a Future Office Market  Study Task Force to examine these issues.  I was fortunate to participate in this task force and we have spent the past year immersing ourselves in the brave new world (for me, at least) of commercial real estate  We also had the opportunity to visit some very cool work spaces in and around the DC metro area.  Our Task Force has completed our preliminary work—that’s the focus for this issue of EntreWorks Insights.

The Current Office Market in Arlington

Our task force was created to address a new and pressing challenge for Arlington County.  Located across the Potomac River from DC, Arlington has traditionally been among the US’s best performing county economies—in good times and bad.    Even at the height of the Great Recession, unemployment rates never exceeded 4.5 percent.  Much of this economic strength was built on a strong commercial office market which benefited from proximity to DC and to the local presence of the Pentagon and other government agencies.

Today, that once robust commercial office market is reeling.   Countywide office vacancy rates are at 21.4% and are even higher in certain submarkets. (National vacancy rates were roughly 14.5% in late 2014).   In the view of county leaders, a government spending downturn was only part of the story. Something bigger was underway and our task force sought to figure it out.

The Changing Demand for Office Space

As we began our work, the task force quickly recognized that the market demand for commercial office space was changing.  New kinds of companies—technology and high growth entrepreneur-driven ventures—are seeking to locate in denser urban and suburban markets.  Similarly, traditional anchor tenants, like law firms or government agencies, are downsizing.  Meanwhile, new ways of working, such as telecommuting and hoteling, are affecting all kinds of companies.   The bottom line is that potential tenants want less space and they want new kinds of workspace.   

The impact of these new preferences is quite pronounced.  In 2000, the average office in the DC Metro area provided nearly 200 square feet (sf) per employee.   Today, that average is about 185 sf per worker.  Certain tenants, like law firms and many government agencies, are cutting even further, reducing their space needs by nearly fifty percent.  A recent study of New York City commercial real estate identified similar trends.  To put it clearly:  commercial demand for office space per worker is expected to drop by anywhere from 1/3 to 1/2 in coming years.

Companies want less space; they also want different space.   Flexibility is their most pressing demand—they abhor long term leases that lock them into large spaces.   They want shorter leases, more flexible work space, and the ability to expand or reduce space demands as needed.   The anchor tenants who sign a long term lease for large swaths of space are becoming rarer and much more desirable.   They are being replaced by more and smaller clients that want it all—flexible leases, cool spaces, lots of amenities, and the like.  But, they may not be able to pay a lot for it—at least for a long and extended period of time.

Implications of Changing Demand

All of these trends are getting a lot of public attention in stories about the growing use of open offices, the end of cubicles, and the growing demand for cool and hip co-working spaces.   They are also spurring something of a backlash and a cottage industry of articles on topics like how open offices ruin the workplace or “The Open Office Trap.”  

Even with some griping, these new office structures look like they’re here to stay.  They save energy, they reduce costs, and a good share of employees, especially millennials, like them.  So, a period of adjustment is upon us.   First up is the commercial real estate sector that is scrambling to adjust to the new realities.    As the Deloitte analysis predicts, 2015 and beyond will be focused on redevelopment, where key players allocate “resources to newer formats and design for redeveloping existing properties” in response to lower levels of tenant demand.

Economic developers will also need to adjust.  Adjustment number one focuses on the broader question of tax revenues.  Jurisdictions that rely heavily on property taxes to finance local government must pay close attention.   Nationwide, property taxes account for 35% of state and local government revenue.  This represents the largest source of local revenue so large scale declines will be felt.

Second, economic developers and real estate professionals will need to help support a new “product mix” when it comes to commercial office space.  Aligning available space to various business life cycles may make sense.    Traditional anchor tenants may still seek out prestigious class A space, but new and growing ventures may need access to more flexible class B and C space.   This shifting market demand may open up new opportunities.  For example, in New York City, boroughs outside of Manhattan, such as Brooklyn and Queens, may enjoy opportunities to develop stronger local office markets. In San Francisco, new office markets have emerged in new neighborhoods like the Mission and SoMa.

Finally, big anchor tenants will likely find themselves in prime negotiating positions, able to demand incentives or other kinds of sweeteners as they consider new or expanded leases.  The competition for these kinds of deals may get even more intense than it is today. 

Principles for Moving Forward

While our Task Force generated lots of insights, we recognized that our future crystal ball remains cloudy.  Instead of making hard (and perhaps misguided) predictions on the nature of the future office market, we opted to develop some basic principles that are likely to guide the evolution of our office market.   Some of the principles are unique to the DC Metro area (e.g. “Reframe the Federal Presence”), but a number of them have relevance for all communities.  A few highlights worth considering:

• A New Paradigm:  As tenants begin to prefer mixed use over traditional single-use office settings, economic developers must actively assess previously set aside space for office development and consider other uses or mixed uses (e.g. entertainment, live-work space) as well.
• Grow the Pie:  Office space initiatives should be linked to entrepreneurial development efforts.  Develop “step out space” for firms that have the potential for growth.
• Activity Attracts Investment:  A nice building is no longer sufficient.  Firms and workers want amenity rich urban environments, so effective place making goes hand-in-hand with successful commercial office development. 
• Mixed Use Inside and Out:  Mixed use needs to occur in neighborhoods and inside buildings themselves.  Desirable office spaces combine workspace with play space and even living space.  Expect to see more live-work spaces in the future.
• Connect Everything: Successful markets will have interconnections across all forms of infrastructure, with special focus on multi-modal transportation options and world class broadband connections.

This shifting office market is not just about real estate—it’s part of a wider transformation of work now underway and part of a larger constellation of forces that also includes the rise of the 1099 or freelance economy and the emergence of new on-demand ventures like Uber and AirBnB.   How we work, where we work, and what companies look like are now in flux.  This will create many challenges, but also more opportunities for communities, firms, and individuals that effectively handle the transition.

What’s New at EntreWorks Consulting?

2015 is starting off as a busy year—no complaints here.  We are kicking off new projects in Northeast Wisconsin and for the Pentagon’s Office of Economic Adjustment, and heading out to numerous conferences and workshops.   Erik Pages of EntreWorks continues to hit the road and is set to do a number of presentations this Spring.  He’s slated to be a keynote speaker at Washington’s Rural Pathways to Prosperity conference in April.  During April, he’ll also be teaching IEDC’s Entrepreneurship and Small Business Development course in Atlanta and presenting on manufacturing supply chain mapping to the Pennsylvania Economic Development Association in Harrisburg.   We continue to provide more regular news and updates at the EntreWorks blog at http://entreworks.net/blog.   You can also access blog updates at our Facebook and LinkedIn pages and on Google Plus.