Although many of the effects of the coronavirus disease (Covid-19) pandemic have eased, the continued prevalence of remote work continues to impact the commercial real estate market. Earlier this year, we published our Chart of the Week about how difficult it is to know the value of commercial offices because sales numbers are so low. This is critical for D.C. because the city collects more than $1.1 billion in tax revenue from commercial office buildings, and uncertainty about building values increases fiscal risk.
A building’s net operating income (NOI) is used in the valuation estimate, and NOI is known to be affected by the building’s respective rent growth, vacancy rate, and capitalization rate. We know that rents are decreasing and vacancy rates are increasing across the commercial real estate market in the District. But what we wanted to estimate is what broader impact a continued decline in the commercial real estate market could have on the district’s financial health. To do this, he modeled three potential scenarios:
- There are no new leases. This scenario models the vacancy rate continuing to increase until it reaches the current vacancy rate. Availability includes space that is currently vacant and space that may be currently occupied but will soon become vacant unless a new lease is signed.
- The cap rate will be increased by 25 basis points (bp). Currently, tax assessors use base cap rates that vary between 5.65 percent for trophy office buildings and 7.25 percent for Class C buildings. Due to the small number of transactions, it is difficult to know whether these rates are correct. However, the large discounts between sales prices and taxable valuations observed in a small number of transactions last year suggest higher cap rates. We modeled a scenario where the cap rate increases by 25bp (0.25%).
- Combine scenarios (1) and (2). This is a likely outcome, as high market-level vacancy rates signal systemic risk, reinforcing cap rate increases.
Vacancy rates are likely to increase across the region’s commercial real estate market
A building’s vacancy rate is the percentage of leasable area that is currently vacant. A building’s vacancy rate is the percentage of space that is vacant or soon to be vacant. If a current tenant’s lease is about to end, but has not yet been renewed, that tenant will be sold as available. Availability depends on whether the tenant renews the lease or the owner finds someone else to fill the space.
Vacancy rates indicate that vacancy rates could increase significantly in many of D.C.’s commercial real estate submarkets. But most alarming is the potential increase in the downtown submarkets (CBD and East End), where most commercial office buildings are located. If rental activity does not improve, vacancy rates in the East End and CBD could rise by 7.7 percentage points and 3.3 percentage points, respectively.
The continued decline in D.C.’s commercial real estate market will dramatically impact tax revenue sources.
In the face of a looming fiscal cliff in 2024, the consequences are grim. If vacancy rates and cap rates continue to rise, up to $157.7 million in tax revenue could be lost. This represents approximately 10 percent of all revenue collected from commercial real estate in Washington, D.C., and approximately 1.6 percent of local tax revenue. These amounts may not seem like a lot, but it’s much harder to bridge the gap when other sources of income are also facing headwinds.
If the vacancy rate reaches the vacancy rate, the district could lose up to $102 million a year in tax revenue. The loss of value will be concentrated in the central business district and East End. These two submarkets have the most space and the largest difference between vacancy rates and vacancy rates, and therefore have the most potential to lose value, resulting in an estimated $92 million in lost tax revenue. . This represents more than 90% of the expected revenue loss.
If cap rates were to increase by 25 basis points across the board, school districts could lose up to $56 million in tax revenue. The losses are still concentrated in the central business district and East End, but they are not as severe as the value losses that caused the demand metrics used in the previous example. Please note that this is a simplified scenario. In fact, the Central Business District and East End are areas where demand is weakest, so cap rates could rise even faster.
There’s no easy way forward
The potential loss of tax revenue from the downturn in Washington, D.C.’s commercial real estate market will only worsen the district’s already dire financial situation. In addition, potential remedies such as mixed-use zones require large amounts of capital to be invested, are time-consuming to implement, and are under-resourced. But in the long run, if the district is to remain economically competitive, it will need to rethink how it uses downtown space.
Revitalization will require future development to create mixed-use spaces where people can live and work. Where possible, it will also be necessary to redevelop current commercial buildings (into multifamily buildings or non-office commercial leases). Both options require significant capital investment. However, mixed-use spaces remain an attractive alternative to old standards that are no longer in the district’s interests.
data memo
The data used in this analysis was collected from CoStar November 2023. Submarket shapefiles were also provided from his CoStar September 2023.