While many impacts of the Covid-19 pandemic have eased, the sustained prevalence of remote work continues to affect the commercial real estate market. Earlier this year, we published a chart of the week on how difficult it is to know what commercial offices are valued at because there are so few sales occurring. This matters greatly in D.C. because the city collects over $1.1 billion in tax revenue from commercial office buildings, and uncertainty about building values adds to fiscal risks.
We know that a building’s net operating income (NOI) is used in valuation estimates, and the NOI is impacted by the building’s respective rent growth, vacancy rate, and capitalization rate. We know that rents are down and vacancy rates are up across the commercial real estate market in the District. What we wanted to estimate, however, is what the broader impacts of a continued decline in the commercial real estate market could have on the District’s fiscal health. To do this, we modeled three potential scenarios:
- No new leasing. In this scenario, we model continued increase in vacancy rates until they hit the current availability rates. 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.
- A 25 basis point (bp) increase in cap rates. Currently, tax assessors are using base cap rates that vary between 5.65 percent for trophy office buildings and 7.25 percent for Class C buildings. Because of a lack of transactions, it is hard to know if these are the correct rates. But deep discounts between sale prices and taxable assessments that we have observed in a handful of transactions in the last year suggest that cap rates are higher. We modeled a scenario with a 25 bp (0.25 percent) increase in cap rates.
- Combine scenario (1) and (2). This is a likely outcome since high and market-level vacancy rates signal systemic risk, which will reinforce higher cap rates.
There is a large margin for possible increases in vacancy rates across the District’s commercial real estate market
A building’s vacancy rate is the share of its leasable space that is currently vacant. A building’s availability rate is the percentage of space which is either vacant or will soon become vacant. If a current tenant’s lease is about to end, but has yet to be renewed, it is marketed as available. Whether or not it becomes vacant depends on whether that tenant renews their lease or the owner’s ability to find someone else to fill the space.
Availability rates show that for many of D.C.’s commercial real estate submarkets, there is potential for a large increase in vacancy rates. Most alarming, however, is the margin of potential increases in the downtown submarkets (CBD and East End) where most commercial office buildings are. East End and the Central Business District (CBD) both could see their vacancy rates increase by 7.7 and 3.3 percentage points, respectively, if leasing activity does not improve.
A continual decline in D.C.’s commercial real estate market will have drastic consequences on its tax revenue stream.
In the face of a looming fiscal cliff in 2024, the results are grim: a potential loss up to $157.7 million in tax revenue if vacancy rates and cap rates continue to increase. This is about 10 percent of all revenue collected from commercial property in D.C. and approximately 1.6 percent of local tax revenue. While these amounts may not look too high, the gaps are much more difficult to fill when other sources of revenue are also experiencing headwinds.
If vacancy rates reach availability rates, the District could lose up to $102 million per year in tax revenue. The value losses would be concentrated in the Central Business District and East End. These two submarkets have the most space, the biggest gaps between vacancy and availability rates, and therefore stand to lose the most value, resulting in an estimated tax revenue loss of $92 million. This is over 90 percent of the projected revenue loss.
If cap rates increase by 25 bp across the board, the District could lose up to $56 million in tax revenue. The losses would still be concentrated in the Central Business District and East End, but not as intensely as a value loss driven the demand metric used in the previous example. Remember, this is a simplified scenario. In reality, cap rates in the Central Business District and East End could increase much more rapidly since these are the neighborhoods where the demand has been weakest.
No easy way forward
The potential loss in tax revenue from D.C’s struggling commercial real estate market only adds to the District’s already dire financial situation. Furthermore, potential remedies, such as mixed-use neighborhoods, will take a large amount of capital invested and time to implement – two resources in short supply. However, reimagining how we use our downtown spaces will be required in the long term for the District to remain economically competitive.
Revitalization would require future developments to be geared toward creating a mixed-use space where people can live and work. When possible, redeveloping current commercial buildings (either into multifamily buildings or non-office commercial leases) would also be required. Both options require a large amount of capital investment. However, a mixed-use space remains an attractive option in lieu of an old norm that no longer serves the best interests of the District.
Data Notes
Data used in this analysis was gathered from CoStar November 2023. Shapefiles for the submarkets were also provided by CoStar September 2023.