While many of the impacts from the COVID-19 pandemic have been mitigated, the continued prevalence of remote work continues to impact the commercial real estate market. Earlier this year, we published a weekly chart showing how difficult it is to know the value of commercial office buildings because there are so few sales. This is a big problem for Washington, DC, because the city derives more than $1.1 billion in tax revenue from commercial office buildings, and uncertainty about the value of its buildings increases fiscal risk.
A building's Net Operating Income (NOI) is used to estimate assessed value, and we know that NOI is affected by a building's respective rent growth, vacancy rate, and capitalization rate. We know that rents are falling and vacancy rates are rising across the District's commercial real estate market. However, what we wanted to estimate is how a continued decline in the commercial real estate market could affect the District's financial health. To accomplish this, we modeled three scenarios:
No new leases. In this scenario, we model a continual increase in vacancy rates until they reach the current vacancy rate. The vacancy rate includes space that is currently vacant as well as space that may currently be in use but will soon be vacant unless a new lease is signed. Cap rates increase by 25 basis points (bp). Currently, tax assessors use base cap rates that range from 5.65% for trophy office buildings to 7.25% for Class C buildings. Due to the lack of transactions, it is difficult to know if these are the correct rates. However, the large discounts in sales prices and tax assessments observed in a small number of transactions over the past year suggest that cap rates are rising. We modeled a scenario in which cap rates increase by 25 bp (0.25%). We combine scenarios (1) and (2). This is a likely outcome because high market-level vacancy rates are a sign of systemic risk and drive cap rates higher.
There is significant room for vacancy rates to rise across the area's commercial real estate market.
A building's vacancy rate is the percentage of its available space that is currently vacant. A building's vacancy rate is the percentage of its space that is vacant or will soon be vacant. If a current tenant's lease is about to expire but has not yet been renewed, it will be sold as vacant. Whether it becomes vacant depends on whether that tenant renews their lease or if the owner can find someone else to fill the space.
Vacancy rates indicate that many of Washington DC's commercial real estate submarkets could experience significant increases in vacancy rates. However, the most alarming increases are likely to be in the Downtown submarkets with the highest concentrations of commercial office buildings (the CBD and East End). If leasing activity does not improve, vacancy rates in the East End and Central Business District (CBD) could increase by 7.7 percentage points and 3.3 percentage points, respectively.
The continued decline of Washington DC’s commercial real estate market will have a dramatic impact on tax revenues.
With the fiscal cliff looming in 2024, the consequences are dire. If vacancy rates and cap rates continue to rise, up to $157.7 million in lost tax revenues could result. That amounts to roughly 10% of all revenues collected from commercial real estate in DC and roughly 1.6% of local tax revenues. While these amounts may not seem like much, it will be much harder to close the gap if other revenue sources are also facing headwinds.
If vacancy rates reach vacancy rates, the District could lose up to $102 million in tax revenue per year. The loss in value will be concentrated in the Central Business District and the East End. These two submarkets have the most space and the largest gap between vacancy rates and room availability, so they will lose the most value, resulting in an estimated tax revenue loss of $92 million. That's more than 90 percent of the projected revenue loss.
If cap rates increased 25 basis points 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 the East End, but would not be as severe as the value losses due to the demand metrics used in the previous example. Note that this is a simplified scenario. In reality, cap rates would likely increase much more rapidly in the Central Business District and the East End, as these are areas of weakest demand.
It's not an easy road
The potential loss of tax revenue from a downturn in DC's commercial real estate market would only exacerbate an already tight fiscal situation. Moreover, potential solutions such as mixed-use districts would require significant capital investment and implementation time, two resources in short supply. But in the long term, rethinking how we use our downtown space is necessary for DC to remain economically competitive.
Revitalization requires future development to be geared toward creating mixed-use spaces where people can live and work. When possible, it also requires redeveloping current commercial buildings (either multi-family buildings or non-office commercial leases). Both options require significant capital investment. But mixed-use spaces remain an attractive alternative to older standards that no longer serve the neighborhood's best interests.
Data Notes
Data used in this analysis was collected from the November 2023 issue of CoStar. Submarket shapefiles were also provided by the September 2023 issue of CoStar.