Montgomery County office market

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Office Market AssessmentMontgomery County, Maryland

Prepared for theMontgomery County Planning Department

June 18, 2015


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i

Contents

Executive Summary..................................................................................................................... iv

Regional Office Vacancies (Second Quarter, 2015) ............................................................... iv

Findings .................................................................................................................................... v

Recommendations .................................................................................................................... v

Introduction .................................................................................................................................... 1

Montgomery County’s Challenge ............................................................................................ 1

I. Forces Changing the Office Market ....................................................................................... 3

Types of Office Tenants ........................................................................................................... 3

Regional and County Employment ......................................................................................... 4

Regional Employment Trends ............................................................................................. 4

Montgomery County Employment Trends .......................................................................... 6

Regional and National Trends in Office Demand ................................................................ 12

Employment-Driven Demand ............................................................................................ 12

Life Sciences Companies .................................................................................................... 12

Changing Office Space Utilization Patterns ..................................................................... 13

Shifting Locational Demand .............................................................................................. 14

Timing of Change ............................................................................................................... 14

Federal Space Cutbacks ..................................................................................................... 15

Supply Forces ......................................................................................................................... 18

Responding to Changing Tenant Preferences ................................................................... 18

Construction in Excess of Demand .................................................................................... 19

Major Vacancies ................................................................................................................. 19

Limited New Construction ................................................................................................. 20

Heavy Competition ............................................................................................................. 20

Office Building Conversions .............................................................................................. 21

Constraints on Conversion ................................................................................................ 21

Conclusions ............................................................................................................................ 23

II. Market Trends and Conditions ........................................................................................... 24

Regional Market .................................................................................................................... 24


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Montgomery County and Competitive Jurisdictions ........................................................... 26

Absorption Trends by Jurisdiction .................................................................................... 28

Class of Space ..................................................................................................................... 31

County Submarket Conditions .............................................................................................. 32

Geographic Distribution .................................................................................................... 33

Submarket Office Market Trends ..................................................................................... 36

Office Clusters by Type.......................................................................................................... 38

Office Typology ................................................................................................................... 38

Metro Station Areas ........................................................................................................... 39

Clusters by Type of Environment ...................................................................................... 41

Historical Trends ................................................................................................................ 44

Regional Comparison ......................................................................................................... 48

Historical Data ................................................................................................................... 49

III. Future Outlook ...................................................................................................................... 51

Vacant Space Projections ...................................................................................................... 51

Tougher Competition ............................................................................................................. 53

New Construction .................................................................................................................. 53

Office Space in the Development Pipeline ............................................................................ 54

Prospects for Large Vacant Campus Developments ........................................................ 55

Conversions to Residential Use ......................................................................................... 55

Fiscal Implications ................................................................................................................. 56

IV. Best Practices ......................................................................................................................... 57

Successful Office Markets ..................................................................................................... 58

Mixed-Use with Great Public Space and Programming – Reston Town Center ............ 58

New Public Infrastructure – NoMa ................................................................................... 59

Urban Mixed-Use in the Suburbs – Mosaic District ........................................................ 60

Great Public Spaces and Mixed-Use – Capitol Riverfront ............................................... 61

Urban Mixed-Use and Cultural Anchors – Shirlington ................................................... 62

Mixed-Use and Civic Anchors – Rockville Town Center .................................................. 63

Reusing Suburban Office Campuses ..................................................................................... 64

Subdivision of Space and Rezoning – Bridgewater, New Jersey ..................................... 65

Conversion to Medical and Mixed-Use – Holmdel, New Jersey ...................................... 65


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Conversion to Medical Use – Middleton, New Jersey ...................................................... 65

Addition of Retail, Hotels and Apartments – Marlborough, Massachusetts .................. 65

Repositioning Office Parks .................................................................................................... 66

Retail and Hotel Addition with Walkable Infrastructure, Burlington, Massachusetts . 66

Addition of Retail, Hotel and Housing, Structured Parking – Henrico County, Virginia............................................................................................................................................. 67

V. Conclusions and Recommendations ................................................................................. 68

Recommendations .................................................................................................................. 70

Enhance Office Environments to Improve Competitiveness ........................................... 70

Reduce the Supply of Non-Competitive Space .................................................................. 72

Increase Demand ................................................................................................................ 73

Setting Priorities .................................................................................................................... 76

Appendix


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Executive SummaryPrepared by Washington, DC-based Partners for Economic Solutions (PES) for theMontgomery County Planning Department, this in-depth market study examines the manyforces changing the regional office market, current conditions in the county and bestpractices for office development.

The goal of the research is to better understand the unprecedented challenges confrontingthe market, including changing tenant preferences, high vacancies, flat rents and slowabsorption of new and relet space. While these trends partly reflect a still-recoveringeconomy, the Washington, DC region has been especially hard hit by cuts in federal

government spending and leasing.

Regional Office Vacancies (Second Quarter, 2015)

A total of 71.5 million square feet of office space currently is vacant throughout theWashington, DC region.

With 20 million square feet of vacant office space, Fairfax County accounts for thelargest share (28 percent) of vacancies region-wide. The District of Columbia has thesecond highest share (22 percent), with 15.6 million square feet.

Montgomery County has nearly 11 million square feet of vacant office space,accounting for 15 percent of regional vacancies.

Prince George’s County has 7 percent of the region’s vacant office space.

In Montgomery County, 12 office buildings totaling 2.1 million square feet of space

are completely vacant. Eight more buildings totaling 1.2 million square feet willbecome vacant this year.

Seven relatively small office buildings totaling 400,000 square feet are now underconstruction in the county. Region-wide, 33 office buildings totaling 7.3 millionsquare feet are under construction.


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v

Findings

Most jobs created during the economic recovery have been in restaurants, retailers

and health care facilities, rather than in office-based sectors such as professionaland technical services.

Telecommuting, technological advances, more efficient work spaces and practicessuch as hoteling have enabled office tenants to reduce their square footage even asthey expand their workforce.

The most successful office clusters in Montgomery County are part of mixed-use

developments with a strong sense of place and a quality environment. Transit

connectivity is increasingly important to office tenants. This trend is consistent withrecommended land use strategies in recent County plans for White Flint, Bethesda,White Oak and other communities.

Single-use office developments without convenient transit or highway access are

having difficulty in attracting tenants.

Future office development is likely to occur at a much slower pace and beconcentrated in prime locations. Not every location will be able to attract new officedevelopment or maintain former occupancy levels.

Recommendations

Create or retrofit office environments that are attractive to today’s tenants byadding amenities, mixed-uses and improved transit or highway connections.Incentives to renovate offices could be effective for buildings near transit or inmixed-use areas.

Reduce the supply of non-competitive office space by converting vacant office

buildings to housing, hotels or other uses. Policies that facilitate site assembly couldhelp owners of older, small office buildings to redevelop. Plans for approved butunbuilt suburban office parks may need to be revisited. Some projects already have

converted planned office space to residential or other uses, but redirectingdevelopment capacity to more competitive locations should be considered. Zoningimpediments to redevelopment and diversification should be removed.

Increase demand by competing for office tenants more effectively. County economicdevelopment initiatives including business attraction and retention, workforcedevelopment, technical assistance and support for local entrepreneurs should beintensified.


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1

Introduction

The Washington, DC metro region1 is currently experiencing unprecedented challenges inits office market, exemplified by vacancy rates that have risen in the past year from 14.6percent to 15.0 percent,2 more than 70 million square feet of vacant space, average reportedrents that have declined 0.5 percent since 2008, larger than normal concession packages,slow absorption and minimal new construction.

Montgomery County is suffering along with the rest of the region, performing better thanother jurisdictions on some indicators and worse on others. The county’s vacancy rate rosefrom 14.8 percent to 14.9 percent between 2014 and 2015. However, average reported rentsin the county have declined more than 7.8 percent since 2008, and absorption has beenslower than seen in the District of Columbia and Fairfax County. Most new office deliveriesin the past year have been built-to-suit for single tenants.

The region and county have experienced recession-driven office market downturns fordecades. What is different this time is a major realignment as tenants reduce their officespace even as they expand their workforce. That trend will impact local and regional officemarkets for many years into the future.

Montgomery County’s Challenge

As of mid-year 2014, the office inventory includes 11 totally or almost totally vacantbuildings with 2.25 million square feet of space; another nine buildings are almost totallyavailable with 1.4 million square feet.3 All of these buildings are located in office parks orindependent campuses.

High vacancies also threaten the financial viability of individual buildings. They pressureeach landlord who has vacant space to lower rents or increase concession packages in orderto lure tenants, undercutting the building’s cash flow and thus its market value. As morebuildings are affected, these depressed values could have negative implications for theproperty tax base of the county, the City of Gaithersburg, and the City of Rockville.

1 Defined to include the District of Columbia; Montgomery, Arlington, Calvert, Charles, Clarke, Culpeper,Fairfax, Frederick, Loudoun, Prince George’s, Prince William, Rappahannock, Spotsylvania, Stafford andWarren counties; and the cities of Alexandria, Fairfax, Falls Church, Manassas, and Manassas Park.2 Well-leased office buildings have vacancies of three to five percent. A healthy office market that combines awide range of properties would have vacancies of eight to ten percent. 3 As of mid-year 2015, 12 major office buildings totaling 2.1 million square feet stand completely empty, andanother eight buildings are soon to be largely vacant.


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Projected occupancy rates do not suggest any near-term relief in these problems. Only

significant increases in office-based employment, office building demolitions or conversionsto other uses could make a dent in the county’s nearly 11 million square-foot vacant officeinventory.

To bring the county office market back into balance with a vacancy rate of less than 10percent, employment in office-based industries would need to expand by at least 21,900

jobs. That is equal to eight percent of all jobs in office-using industries and more than seventimes the number of total jobs created in the county from 2004 through 2013.

Office development has played a major role in anchoring new developments in the county.That role has shifted now to residential development. Master plans will need to recognize

that shift and may require revisions to accommodate that new reality. Reuse orredevelopment strategies will be needed for some buildings that can no longer competeeffectively for tenants.

The zoning re-write has lowered some of the barriers to repositioning single-use officedistricts by allowing introduction of non-office uses into office park zones. However, moremay need to be done to encourage the required transitions.

Several major single-use office parks will need major injections of new private investmentto compete with walkable mixed-use districts. New infrastructure may be required toprovide quality transit access and roadway improvements to better serve pedestrians.

To provide a better understanding of the many issues involved in office development, thisanalysis has delved deeply into the performance of the county’s office base, focusing onvariations by location and type and class of space.

This report addresses:

forces changing the office market, including employment trends;

trends in office market conditions in the region, county, county subareas, andspecific office clusters;

future prospects for the market;

best practices, the lessons they offer, and the strategies they suggest; and

conclusions and recommendations, emphasizing planning-related strategies.


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I. Forces Changing the Office Market

Several major forces are changing office markets – national, regional, and local. Thissection outlines those forces, distinguishing among those primarily impacting demand andthose affecting supply conditions. Because the forces affect different types of office usersdifferently, the discussion begins with an introduction to the different types of users activein Montgomery County. The second half of the section explores employment trends in moredepth due to their importance in explaining and predicting office demand.

Types of Office Tenants

Montgomery County offers the full range of office spaces of different classes, age, rent levelsand type of setting from urban centers near Metro stations to bare-bones buildings alongmajor thoroughfares to stand-alone campuses to amenitized office park buildings. Theyattract a wide variety of users with differing needs, budgets and locational criteria. At therisk of over-generalization:

Corporate or agency headquarters look for prestige locations with good regionalaccessibility from which to draw a well-educated workforce. Access to clientbusinesses and/or other companies that support or collaborate with them can beimportant. That can argue for locating within major office clusters, close to a major

client, and/or near a major airport. For some, signage and visibility are important tocorporate image-making.

Contractors often seek close proximity to their major client (e.g., the Pentagon) andflexible lease terms that can accommodate the life of a major contract.

Many smaller companies are less driven by prestige and more constrained byfinances. Their locations often represent a compromise between easy access for theirowners and/or workers and affordable rents.

Support operations, such as back-office operations, tend to locate in less expensiveoffice space accessible by a more local workforce and offering free parking.

Health and other professionals serving the local market depend on access andvisibility to serve local residents; health care providers often cluster near hospitalsto reduce the physicians’ travel times. Their ties to local customers makes them lessmobile and less likely to relocate. Many own their own office building.

Other local service providers – real estate agents, insurance, tax preparers – dependon the local population for their business and will often use a visible location to


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advertise their services and attract customers. They often locate in retail space

and/or own their space.

These tenant groups and individual tenants approach the office market differently andlocation criteria change over time depending on the industry culture (e.g., softwaredevelopment), the company’s stage in its life cycle (e.g., start-up or established), and thestate of the economy. Over the last few years, the growing competition for qualifiedworkers has raised the importance of office environments that can attract tech workers andothers with specialized skills in high demand. This variation in location criteriacomplicates the process of generalizing trends in the office market.

Regional and County Employment

Office demand is driven by employment in sectors that occupy office space. MontgomeryCounty competes within the region for businesses and other organizations to fill its officespace. This section reviews regional and local employment trends and MontgomeryCounty’s shifting competitive position.

Regional Employment Trends

Metropolitan Washington and Montgomery County weathered the Great Recession muchbetter than the rest of the country. The region’s concentration of federal governmentfunctions and its extensive base of contractors and suppliers positioned it to benefit from

the government’s relative employment stability and stimulus spending. Employmentdeclined only 1.6 percent (45,000 jobs) from 2008 to 2009 and then expanded 1.8 percent,adding 50,000 jobs to 2011. The region’s relatively strong economic performance in contrastwith many other parts of the country made it a magnet for in-migration, particularly amongyounger millennial workers leaving college and getting started in their careers.

Since then, the expiration of the stimulus programs, drawdown of American actions in Iraqand Afghanistan, budget wars on Capitol Hill, sequestration and the government shutdownhave taken their toll. The 2013 sequestration imposed significant cuts in governmentcontracting. Failure to reach a comprehensive budget accord for more than three yearscreated great overall uncertainty regarding existing and future Federal government

contracts and directly impacted contractors’ employment levels and their willingness tocommit to long-term leases. With the Bipartisan Budget Act of 2013, the uncertainty hasbeen reduced somewhat, but the budget wars continue to influence the regional economy.The region’s employment growth has slowed from 1.4 and 1.3 percent annual growth in2011 and 2012, respectively, to 1.0 percent in 2013 and 0.5 percent for the 12 months from

August 2013 through July 2014.

Higher-wage jobs traditionally basedin office space are growing more

The region’s and the county’s shiftingeconomies are creating more lower-wage

jobs that don’t require office space.


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As shown in Figure 5,4 comparisons of job growth performance in key industries across

major jurisdictions in the region indicate that the Montgomery County’s share has declinedsomewhat, while Fairfax County, the District of Columbia, and Arlington County haveincreased their shares.

Examining office-using sectors in more detail reveals that some individual subsectors grewin spite of losses in the overall industry.

Health care offices outside of hospitals added almost 1,200 jobs from 2007 to 2012.

Business and technical schools and educational services added more than 300 jobs.

More than 1,400 jobs were created in the office administrative services sector.

Employment in the management, scientific and technical consulting and scientific

research and development services sector increased by 2,400 jobs.

However, these gains were more than eclipsed by losses in other office-using sectors,including most segments of the financial activities sector, legal services, and computersystems design and related services. Appendix Table A-7 shows 2005-2012 employment inoffice-using industries.

The employment losses from 2007 to 2012 were reflected in the number of establishmentsas well. (See Appendix Table A-8.)

The county lost 407 business establishments, a 1.5-percent loss.

The losses happened across the size spectrum with three-quarters having four orfewer employees.

During the same time, though, there was growth among large companies with an

additional nine establishments moving into the category of 500 to 999 employeesand six more companies reaching 1,000 or more employees.

4 These charts reflect the Bureau of the Census’ County Business Patterns data through 2012; the categoriesdiffer slightly from those used by the Bureau of Labor Statistics and the Maryland Department of Labor,Licensing and Regulation in Tables 1 to 3.


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Regional and National Trends in Office Demand

This section discusses a range of region-wide and larger industry forces that arefundamentally changing office demand everywhere.

Employment-Driven Demand

Traditionally, office demand has been driven by the number of people employed inindustries that typically locate in office space. As such, macroeconomic forces and regionalemployment trends have been reliable predictors of demand for office space in MontgomeryCounty. This is no longer the case.

The Great Recession’s impact on business activity and growth affected office demand inmarkets across the country, the region, and the county. The Washington region fared betterthan many other markets as government employment grew with stimulus spending. But asthe stimulus spending wound down, Federal, State, and local government employmentdeclined and the recovery slowed.

This downward trend was accelerated through major Federal budget cuts and thesequestration cuts imposed by the Budget Control Act of 2011. The cutbacks affected bothdirect government and contractor employment as contracts were canceled or not renewed.

As a result many of the region’s major contractors have restructured their organizations,reduced their workforce and consolidated into smaller blocks of office space. Lingering

uncertainty about Federal funding reduces contractors’ willingness to commit to long-termleases.

The national and regional economic recovery has been slower than in previous recessions,and the Washington region’s recovery has been undercut by its dependence on Federalspending. Key office-using sectors – professional, scientific and technical services,information, and financial activities – have been slow to recover, limiting demand.

Life Sciences Companies

Specific to the Montgomery County office market is demand from the biotechnology and

related life science industries, which have been a major force in the I-270 corridor officemarket. Over the last decade, the industry’s volatility has impacted office demand. Theindustry’s pattern of mergers and acquisitions has had varying effects. AstraZeneca’sacquisition of MedImmune has been associated with continued growth whereasGlaxoSmithKline’s acquisition of Human Genome Sciences resulted in staff reductions andrelocations, creating new office vacancies. Fluctuating availability of financing for biotechcompanies also has affected the industry’s growth.


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buildings with a total of 3.67 million usable

square feet5 (Appendix Table A-2). Its geographicdistribution is shown in Figure 1.

GSA is adopting many of the new office designconcepts, telecommuting, and other techniques toimprove the efficiency of government-owned space. At the GSA headquarters in the Districtof Columbia, the agency brought back employees out of leased space, increasing the numberof employees from 2,200 to 3,300 in the same amount of space following renovations.

Where private space leases are still most appropriate, space requirements are reduced 10 to25 percent from the amount of space previously leased. For example, GSA was authorized

by Congress to seek a 345,000 square-foot lease for NIH, replacing three blocks of leasedspace that had a total of 435,000 square feet. A second prospectus is seeking 194,000 squarefeet of space for the NIH Office of Director to replace four current leases with a total of250,000 square feet. Appendix Table A-3 lists the major lease prospectuses for MontgomeryCounty leases approved by Congress from 2009 to 2014.

The strategy to shift more Federal operations to government-owned space is playing out inMontgomery County with the phased construction of new facilities for the Food & Drug

Administration on its new White Oak campus. While several divisions have moved already,others are in leased space awaiting construction of new facilities. Each building’sconstruction must be approved by Congress in the annual budget process. In the meantime,FDA is leaving 231,500 square feet of private office space to take excess space at the

Nuclear Regulatory Commission in Rockville.

Going forward, the impacts of theFreeze the Footprint program arelikely to be most significant over thenext year with the expiration of 3.6million rentable square feet ofleases in 2014, 2015, and 2016. (SeeFigure 2.) Of that total space,actions have been taken on 2.0million square feet of leases. They

include renewal of 802,000 squarefeet at the Parklawn Building,vacating 636,000 square feet formoves into the Parklawn Buildingor government-owned space, and517,000 square feet of leases out for

5 Roughly equivalent to 4.2 million rentable square feet of space.

Continued GSA lease

consolidations could eliminate1.1 million square feet ofprivate office leases by 2017.

Photo credit: GSA


24/106

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19

Construction in Excess of Demand

The region’s and county’s current high vacancy rates reflect extensive construction in theearly- and mid-2000s that had been premised on continuation of healthy growth in thetechnology and government contractor sectors. When absorption lagged due to the economicdownturn, the subsequent constraints on Federal spending and the slowing of thebiotechnology sector, the new space exceeded demand.

The downturn in demand was greater and lasted longer than expected due to thecombination of forces discussed above. In the county, more than 12.3 million square feet ofspace were delivered from 2002 to 2013 (a net addition of 11.1 million after discounting fordemolition) relative to absorption of 7.7 million square feet.

What distinguishes the market’s performance this time is that the demand for office spacehas been much slower in the recovery from the Great Recession, allowing the largeoverhang of vacant space to persist much longer than would have been expected.

Major Vacancies

The county has 10 buildings with 2.0 million square feet of space that are completely oralmost totally vacant. The 540,000 square-foot Comsat Building on I-270 south ofClarksburg was vacated when Comsat was acquired by Lockheed Martin and moved toother space. Vitro Corporation had occupied a 265,000 square-foot building in Aspen Hill,

which has since sat vacant for four years. Eight of the vacant buildings are Class Abuildings. Several were vacated by GSA tenants, including the National Cancer Institute.

Appendix Table A-4 lists 30 buildings with at least 100,000 square feet of vacant oravailable space. Another nine buildings with 1.4 million square feet are completelyavailable though not yet vacant. All of the totally vacant or available office buildings are inoffice parks or campuses. Three spaces of 100,000 square feet or more are available inWhite Flint and downtown Silver Spring. The rest are in single-use office districts.

At least four buildings were returned to their lenders as a result of losing a major tenant orfailing to lease up. The lenders then disposed of those buildings at prices of $80 to $100 persquare foot as compared with replacement costs of $250 or more per square foot. These

“bargain prices” allow the buyers to make substantial improvements to upgrade thebuildings’ systems and finishes while still offering low rents with large concessionpackages. Those rent levels for renovated space will likely allow them to attract tenantsfrom other office parks, spreading vacancies among other buildings and suppressing therent increases required to support new construction.


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20

Limited New Construction

Given the high vacancy rates, only two new speculativeoffice buildings are under construction countywide. Inboth cases, superior locations in mixed-use environmentsconvinced their developers that they could succeed inspite of the overall overhang of vacant space.

For example, the speculative office building currently under construction in the Pike &Rose development in White Flint was able to lure Bank of America Merrill Lynch to movefrom a Tower Oaks location on I-270 to higher-rent space because the environment wouldbe more attractive to its employees and customers. The reduction from 60,000 to 43,000

square feet with the move offset the higher per-square-foot rents. Federal RealtyInvestment Trust had access to internal financing and needed the office building for acomplete first-phase development of its retail environment.

Speculative building is likely to remain limited with developers and their lenders andinvestors waiting for pre-leasing before proceeding with new buildings. This will greatlyimpact pipeline projects approved for development but not yet built. Such projects proposeconstruction of an additional 22.7 million square feet of office space, much of which is insingle-use auto-reliant office parks. Over the last three years, amended site plans haveremoved 558,000 square feet of office space from the pipeline.

Heavy Competition

Throughout the region, individual jurisdictions and developers are intensely competitive.Developers are offering larger incentive packages, including greater allowances for tenantimprovements, months of free rent, moving expenses and other incentives.

Other jurisdictions also have stepped up their incentive packages for majoremployers/tenants, including Federal agencies. For example, Alexandria providedsubstantial incentives (rumored to be worth tens of millions) to entice the National ScienceFoundation to relocate from Arlington6.

6 Jonathan O’Connell, “National Science Foundation headquarters to move to Eisenhower Avenue in Alexandria.” Washington Post Capital Business Blog 6/7/2013 as posted onhttp://www.washingtonpost.com/blogs/capital-business/post/national-science-foundation-headquarters-to-move-to-eisenhower-avenue-in-alexandria/2013/06/07/636b61d0-cf82-11e2-8845-d970ccb04497_blog.html

Speculative building islikely to remain limitedfor several years.


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21

Office Building Conversions

Responding to the somewhat bleak outlook for vacant office buildings over the near term,some owners of older Class B or C office buildings across the country have responded to lackof market potential caused by the flight to quality by converting their buildings toresidential use. This has happened most often in downtown settings with buildings thathave experienced high vacancies at low rents for a long period of time and are facing majorcapital costs to bring them up to modern standards. Most conversions have been toresidential or hotel uses. One creative reuse opportunity is for a school. Fairfax Countyrecently purchased and retrofitted 6245 Leesburg Pike in Falls Church for use as a 700-pupil elementary school.

Montgomery County has seen at least three older buildings converted from office toresidential use:

the former CSC office building in downtown Silver Spring converted to a HamptonInn and a Homewood Suites by Hilton;

the Computer Building in downtown Wheaton currently being converted to a 194-unit apartment building with ground-floor retail space; and

1320 Fenwick Lane in downtown Silver Spring in the process of building permitapproval for residential conversion.

Constraints on Conversion

Conversion requires residential demand from prospective tenantswilling to pay market rents that can support the costs of conversion.That demand has typically been seen in downtown and other close-inlocations near to employment centers, restaurants, andentertainment that allow short commutes in live, work, and playenvironments.

One of the key reasons why the county has not seen more conversionsrelates to the economics of conversion. Converting an office building

typically requires demolition of the existing interiors, reconfiguringthe existing spaces, extending plumbing throughout the building,upgrading electrical and heating, air conditioning and ventilationsystems, and installing new fire stairs to meet building codes. Thefuture potential rents and occupancy need to be high enough toprovide an adequate return on that investment.

Conversion ofoffice buildingscan reduce thevacant spaceinventory, butonly a few

buildings aresuitably designedand located to

justify theinvestment.


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22

Not every building is suited to conversion. Residential codes and markets require access to

light and air, which can be hard to provide in large-floorplate office buildings where muchof the interior space is too far from windows.

Developers often find it less expensive to demolish the existing office building and build anew structure designed specifically for residential use. Conversion of an existing building ismost warranted when the building has a particular charm, historic designation that allowsuse of historic tax credits, and/or the potential to bypass difficult development approvals.For example, the CSC building was reused because it was much larger than the then-current zoning would allow on the site.

Not every owner of an obsolete building that might be suitable for conversion will be

interested in pursuing that potential. Such a major undertaking involves major costs andrisks best managed by experienced developers that specialize in residential products andadaptive reuse. Until the current owners are willing to sell the building at a reasonableprice that will allow profitable reuse, conversion is unlikely to proceed.

For buildings that still have reasonable occupancy levels, the opportunity costs of tearingdown and replacing a building can be daunting even if it can be replaced by a biggerbuilding with better rents.

The analysis of Bethesda’s Apex Building prepared for the Purple Line station planningdemonstrated that the existing building’s value at a 1.55 FAR was greater than the value ofthe cleared site with an FAR of 5.0. Bolan Smart Associates estimated the current value at

roughly $45 million for the building itself plus a $20 million value for the unused FAR thatwould be available at demolition assumed for 2025, discounted to 2013. That total value of$65 million compared with a land value of $60 million for a 5.0 FAR building constructed by2016. Though a replacement building would generate significant revenues, cash flow wouldstop for at least two years, demolition and relocation costs would be incurred, and thefuture revenue would require substantial investment in new construction.

Older office buildings may stillhave more value “as is” thanafter reuse or redevelopmentgiven the costs, time and risksinvolved in new construction.


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23

Conclusions

Both demand and supply forces are causing fundamental shifts in the region’s and county’soffice markets. Cyclically low levels of demand are being magnified by structural changes inthe market. More office jobs will not necessarily result in fewer office vacancies.

The trends of office consolidation in urban locations with rising vacancies in suburban officebuildings are happening across the country, forcing reevaluation of many long-acceptedexpectations and patterns. The growing preferences for open, flexible office space in mixed-use settings that offer walkability and connectivity are shifting the competitiveness of muchof the county’s office inventory.

The fundamental office demand typically generated by employment growth has been mutedby economic shifts. The region’s and county’s dependence on Federal government andrelated employment has left them vulnerable to government budget cuts. Economicdevelopment to grow and diversify the economy is increasingly important and pressing.


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24

II. Market Trends and Conditions

The regional and county office markets have responded to and been impacted by theregional employment trends. However, the correlation between changes in employment andin the office market is not direct. Structural changes in the relationship between office-using employment and occupied office space, manifested as square feet per employee, isplaying a much greater role in affecting office demand, leading to rising vacancies even intimes of relatively stable job counts.

Also contributing to high vacancies is the effect of office market cycles, which tend to

exaggerate the economic cycles as supply often expands beyond the demand. Given the leadtimes involved in developing a major office building, buildings started in prosperous timesoften deliver during the recession. At the same time that companies may be sheddingemployees and/or office space, new office space is added to the inventory, increasing overallvacancies.

This section examines office absorption and occupancy trends for the region, the county,county subareas and individual office clusters throughout the county and region to providecontext, quantify changes, and reveal patterns by type of office locations. A similar analysisof vacancy rates in office clusters in the District of Columbia, Alexandria and Arlington,Fairfax, and Prince George’s counties demonstrate similar patterns.

Regional Market

The metropolitan area office market as a whole includes 480 million square feet of space, ofwhich 15.1 percent is located in Montgomery County. Shown in Figure 6 and AppendixTable A-9, the market has seen the addition of 110 million square feet (29.4 percent) fromthe beginning of 2000 through the end of 2013. During the same period, occupied spaceexpanded by 62 million square feet (17.8 percent). The market lost occupancy following thedot.com boom/bust and the start of the Great Recession. Net absorption (the change in thetotal square feet of occupied space) turned negative in 2009 and has remained very low forthe last three years (392,000 to 677,000 square feet annually).

The region continued to construct new space at a high rate from 2005 to 2009, moreconsistent with its performance earlier in the decade. Vacancy rates increased substantiallyfrom 6.0 percent in 2000, a tight market, to 11.7 percent in 2002 following the dot.com boomand bust before recovering to 8.5 percent in 2005. Since then, vacancy rates have risensharply to 14.1 percent in 2013. Montgomery County followed the same pattern as theregion but with somewhat less rebound from the 2009 low point to 2013 levels.


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26

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34/106

Montgo

percentcompareof 5.0 mMontgo

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Figure 7

ery Count

f the regios with 14.6llion squarery Count

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t inventoryand a 6.1-p during thpacts of thds since 20

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representsercent incr dot.com b Great Rec0.

27

e metropol

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a 17.0-percase sinceom to 87.7

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35/106

Absorp

Figure 8annual2001-20

Absorptagain faabsorptiof the B

Figure 8

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illustratesbsorption.2 aftermat

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28

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36/106

Reviewi

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Figure 10

g total abs

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ently, thoure, actuallyof 2014. (Seirfax Coun

orption tre

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gh, Montgolosing 159,e Figure 10y absorbed

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29

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d net absoquare feetabsorbed i

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38/106

Class o

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Figure 13

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31

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rcent Classs A inventoillion squae 13.

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39/106

Vacancy

with Clthe samthe Clas

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32

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40/106

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concentratd in smalleet into 12 sfollowing b

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33

hat can be

s, and landing size wsigned to ahis need foors to waither than b

ends withi

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s county snt – than a also haves reflects t uses, a wahe I-270 Cg. Table 5

developed (

prices inflill respondhieve full or a timely luntil a builild specula

n 12 count

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41/106

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As showBethesdsubmarbuildingcounty’sRockvill

rents are h

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the decadethe path oeir business and thosed office dotomac. T

encies that

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ighest in B

The Outlyiences camity to exec

nvestment A space a

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have attrac

ix Table A Bethesda/C 83 percentr quality fiut more th

ent in Gait

thesda/Ch

g Countyus.) Theseutive housiin finishesross the co

s differentousing devs are influlued executo the norton is furth

ted suppor

14, Classhevy Chas of the couishes and i

an 21 perceersburg, a

34

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42/106

35

Map 1 provides a snapshot of vacancy and rent rates by geographic submarket. Rents are

highest in Bethesda/Chevy Chase, North Bethesda/Potomac, Rockville, and Silver Spring.The lowest rents are in the I-270 Corridor North, Gaithersburg, and North SilverSpring/Route 29 submarkets. The Outlying County West submarket name is something of amisnomer. Its inventory is larger than would be expected for a largely rural portion of thecounty – 896,000 square feet of office space. Three buildings in the former Human GenomeSciences campus in the Great Seneca Science Corridor constitute 73 percent of that space.Though only 3.9 percent of the submarket’s space is reported as vacant, the HGS propertyis being marketed currently. Bethesda/Chevy Chase, Gaithersburg, Silver Spring, andRockville have the lowest vacancy rates ranging from 9.4 to 12.2 percent. Vacancy rates arehighest in the I-270 Corridor North, Kensington/Wheaton, North Bethesda/Potomac,Germantown, and North Rockville submarkets.

Map 1


43/106

Submar

Map 2 s2013. Tof new cWheatoexperiendeclinedGermanspace al

Map 2

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36

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d in those f

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44/106

Map 3 sextendi2007, neand Ger

Map 3

ows that ng up I-270w deliverie

antown.

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tion was s002-2006

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37

read acroseriod. Witore focused

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and

urg,


45/106

38

Office Clusters by Type

Because the submarket statistics obscure some of the variation that happens within eachsubmarket, this final trends analysis considers more fine-grained geographic breakdowns ofclusters within submarkets. These clusters provide additional insights into the performanceof different types of office environments and locations.

Office Typology

To help better understand the market variations, this analysis breaks offices into atypology with the expectation that different areas have performed better or worse over thepast decade. The categories represent a matrix that matches the type of building andsetting with its locational attributes relative to transit and highway access. Proximity toMetro stations is the region’s locational distinction with the greatest impact. This analysisdistinguishes between:

Metro-adjacent locations within one-quarter mile of a Metro station;

Metro-proximate locations within one-quarter to one-half mile of a Metro station;

highway locations within 1,000 feet of I-270 or the Beltway (I-495); and

other locations not proximate to a Metro station or highway.

Among the types of buildings and settings, the distinctions include:

business districts or major mixed-use developments with at least 50,000 square feetof retail space and 200 residential units within one-quarter mile;

office/business parks with a cluster of office uses within an organized and controlledenvironment;

industrial/flex cluster in an organized industrial park or historically industrialdistrict; and

freestanding office buildings, typically located along major thoroughfares.

Table 6 summarizes the county’s office inventory for each type of space focusing onbuildings with at least 10,000 square feet of office space. Just over 30 percent of the totalinventory is located in mixed-use business districts, of which almost two-thirds is withinone-quarter mile of a Metro station and another 28 percent is within one-quarter to one-half mile. Single-use office parks and clusters represent 37 percent of the overall inventory;of that total, 38 percent of the space is located within 1,000 feet of I-270 or the Beltway.


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Office s

Freestalocated

The varioffice buof a Metbetweenalong I-building

Metro S

The officauto-oriareas wione-quato one-hRockvillmile wapercent

ace in indu

ding buildway from

ation in vaildings (10,ro station ademand a70 and thes that are 1

tation Are

e market pnted portith significater mile (elf mile wa Metro sta

king distas compare

strial/flex

ngs constitetro and t

ancy rates000 squarere experiend supply.Beltway h00 percent

s

erforms verns of the cont office insy walkingking distantion areas,ce. Silver S with 16.2

istricts acc

te 31 perce major hi

underscorefeet or morcing vacanct the sameve 18 percvacant.

y differentlunty. Vacaentories. C distance) oce shows macancy rat

pring Metrpercent am

39

unts for le

nt of the ighways.

s the impore) in mixedies of 8.1 ptime, officent of their

within Mncies are somparing pf the Metroajor differees are sign station ar

ong buildin

ss than two

ventory wi

tance of th-use districrcent, refl

buildings ispace vaca

tro stationown in Taerformanc station tonces. In allficantly hiea buildinggs farther

percent of

th 60 perce

se locations within octing a rean single-ust, includin

areas thanle 7 for sixof office b

those betwbut Bethesher beyonds have vacway. In W

the invento

t of that s

al factors.e-quartersonable bal businessseveral

it does inMetro statiildings witen one-quada andthe quartencies of onlite Flint, t

ry.

ace

argeile

ancearks

oreonhinrter

r-y 7.5he


47/106

compari

farther

In Bethin buildioccupanand thediscrepabuildingPlaza II

HoweveWheatooffice bucommerresidentvitality.distancedepends

on is 2.7 p

ut.

sda, farthengs, whichy. The higir Rights

ncy is lowes farther aopened in

, a Metro s, Forest Gl

ildings. Inial areas, tal uses. AsOnly Whea from I-270largely on

rcent vaca

r-out buildimay reflecter vacanciuilding th at 8.1 peray from th013 and is

tation alonen, Glenmoome cases,he limited simportantlton has a cland I-495 cuto travel.

cies for clo

ngs have 7. recently ds in close-it have beeent for close Metro stastill under

is not suff nt, Grosvethat reflecupply of suy, they lacuster of resonstrain th

40

se-in buildi

5-percent vlivered buin Bethesdan undergoie-in buildition. This roing its ini

cient to suor, and Shs the zoninitable sites, the mix oftaurants ae areas’ m

ngs versus

acancies vedings thatmay relateg renovatigs as compeflects thetial lease-u

port a sigdy Grove

g, the natu, and the nuses that cd retail. Frketability

12.5 perce

rsus 11.4 phave not y to 7550 Wins. In Roc

ared with 6act that Ro.

ificant officave not dee and qualture of the

reate businr Wheatonfor a work

t for those

rcent for ct reached f sconsin Avville, the.4 percentckville Met

e cluster.eloped majty of nearbsurroundiess areaand Glenm

force that s

ose-ullnue

orro

oryg

onttill


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Cluster

Twenty-within cMap 4.

These clcounty’sclusters

Map 4

by Type

two clusterusters tha

usters reprtotal officeand the su

of Environ

better def share acce

sent 49.8inventory.markets d

ment

ne the coussibility an

illion squppendix T

fined by C

41

ty’s officeenvironm

re feet of oable A-16 pStar.

arket by gental chara

fice space,rovides a c

rouping off cteristics,

or 68 perceoss-walk b

ce buildings shown in

t of thetween the

s

e


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The cou

Gaitheruse enviarea. Th30 perce

Mixed uother neparks aParkwaWesTec

Three pnortheaand Mo

Table 8

ty’s mixed

burg, Kensronments aese mixed-nt of the co

se districtsarby officed office dis/Rockvilleoffice par

imary offict of the W.tgomery In

ummarize

use busine

ington, Roct the Kentlse districts

unty’s inve

typically feuildings. T

tricts, whicike area,

, Germant

e clusters dGude Drivdustrial Pa

key chara

s districts

kville, Silvnds and th include rotory.

ture lowerheir perfor include Ruince Orcwn, and Cl

eveloped in/Rockvillerk with 2 p

teristics of

42

nclude the

r Spring, ae Washingghly 22.1

vacancy raance cont

ock Spring,ard Road,arksburg (

industrial/ike intersercent of th

these smal

traditional

nd Wheatoonian andillion squ

tes and renrasts withoffice areahady Grov6 percent

flex areas iction, E. Ge county’s

ler clusters

downtown

as well asthe evolvinre feet of o

ts typicallyhat of sing along I-27e Life Scief the count

clude Craude Drive affice space.

.

in Bethes

the new m White Fli

ffice space,

higher thae-use office0, the Monces Center,’s space).

bs Brancht Taft Cour

a,

xed-t

or

n

rose,

Wayt,


50/106

43

Vacancy rates are markedly lower in mixed-use districts as compared with office parks,

industrial districts and freestanding buildings, ranging from 4.7 percent in downtownKensington to 13.7 percent in downtown Wheaton.

The Washingtonian and White Flint clusters have current vacancy rates of 8.3 and 6.8percent, respectively. Average direct rents are higher in several of these districts, including$37.63 in downtown Bethesda, $32.77 in downtown Rockville and $34.02 in theWashingtonian, despite having older inventories with median years built ranging from1923 in downtown Gaithersburg to 1961-1966 in Silver Spring, Wheaton, Bethesda, andKensington.

Office buildings in single-use environments, including office parks, show much higher

vacancy rates, generally ranging from 17 to 21 percent. The highest rate is the 32-percentvacancy rate in the I-270/Wootton Parkway cluster (Tower Oaks). These clusters aregenerally 20 to 30 years newer than the traditional downtowns with median year builtranging from 1980 for the Montrose Parkway/Rockville Pike cluster to 2001 for the QuinceOrchard Road cluster.

Reflecting their newer stock, locations accessible to I-270 and, in some cases, lab space(which is much more expensive to build than ordinary office space and commands higherrents), average rents are in the low $30s for the Rock Spring Park, I-270 at WoottonParkway and Montrose Parkway/Rockville Pike clusters. Other clusters have average rentsranging from $23.77 in the Quince Orchard Road cluster to $27.37 in Shady Grove LifeSciences cluster.

Industrial/flex clusters show varying vacancies, ranging from 9.6 percent in Crabbs BranchWay cluster at Shady Grove to 28.6 percent in the East Gude Drive cluster due in part todifferences in the quality of the surrounding environment and the age of the building stock.Rents range from $20.61 to $22.48 per square foot.


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Histori

Table 9compareuse auto

Each clucompletmixed-usame pepercent

al Trends

rovides va vacancy r-oriented o

ster showsly. Howeve

se districtsriod, the sige points.

ancy ratete trends fofice district

significantr, calculatisaw a decligle-use offi

rends for 1r Metro-ses.

variation og a lineare in vacan

ce district i

44

994 to Secoved mixed-

er time, aaverage ovies of roug

ncreased t

nd Quarteruse enviro

d their trer time shohly five pereir vacanci

2014. Figuments to t

ds do not cs that the

centage poies by rough

res 16 andose of sing

orrelateMetro-servnts. Over tly 10

7e-

de


52/106

Figure 16

Figure 17

45


53/106

Historic

districtssecond q

Tv

f

1

These tcompeteabsorpti

Figure 18

l data for

reduced thuarter of 2

he Washinacancies fr

hite Flint,om 13.9 to

owntown1.2 to 4.7 p

ree district. Appendixon, vacanc

he clusters

eir office va14. The be

tonian, whm 28.1 to 8

which fille6.8 percent

ockville, wrcent.

s all benefiTable A-17rates and

over the p

cancies frot performi

ich absorbe.3 percent;

524,000 s; and

ich absorb

ted from nprovides hiverage ren

46

st five year

10.9 percg mixed-u

d 180,000 s

uare feet o

ed 223,000

w construcstoric datats for the l

s show tha

ent in 2009e business

quare feet

f space and

square feet

tion, whichfor changesst 20 years

mixed-use

to 9.2 percdistricts w

of space to

reduced its

to reduce v

allowed th in invento.

business

nt in there:

educe its

vacancy r

acancies fr

em to bettey and

te

m

r


54/106

During

their vaoffice pa11.5 to 2absorptivacating

There wParkwalosses, t

I-

f

Figure 19

he same 20

ancies frorks and clu0.2 percenton. Overall, buildings.

ere major o, WesTecho clusters

270 from

et; and

ermantow

09-Second

15.3 to 18sters. In th was due to these clus

cupancy loBusiness Phad signifi

. Gude Dri

, which ab

uarter 20

.9 percent.Shady Gr

the additioers lost 15

sses in theark off USant positiv

e to Shad

orbed 161,

47

4 period, o

igure 19 sve Life Scin of 736,00,000 squar

ontrose P9 and the

e absorptio

Grove Roa

00 square

ffice parks

ows absorences Park0 square fee feet of occ

arkway, thock Sprin:

d, which a

feet.

and cluster

tion trendcluster, thet without c

upied spac

e I-270 atclusters.

sorbed 446

increased

for single- increase frommensur with GSA

oottonespite thes

,000 square

useomte

e


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Region

These pregion. Arlingtobroken iexceptiosubmarin partic

l Compari

tterns areable 10 pr

n County, tnto the sans. Vacanciets have seular.

son

not uniquevides sumhe Districte broad cates createden recent c

to Montgoary infor

of Columbiegories. Thy BRAC acnstruction

48

ery Countation abou, Fairfax C

e results shtions skewthat has o

. They aret major offiounty, andow markedthe statistiershot de

evident else clusters iPrince Geo similarities for Arlinand, Rossl

where in tn Alexandrrge’s Counts with a feton. Somen and Tys

eia,y

ns,

Montgomery County office market

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