REAL ESTATE OUTLOOK SUBURBAN MARYLAND OFFICE MARKET

[Pages:10]REAL ESTATE OUTLOOK

SUBURBAN MARYLAND OFFICE MARKET

SECOND QUARTER 2017

Office market hits bump in the road

Limited demand and cooling rental rates

The Suburban Maryland office market weakened during the second quarter of 2017, as net absorption registered negative 242,000 SF and the direct vacancy rate increased to 14.7%. Asking rents, however, increased 0.1% to $26.76 PSF, despite the increase in vacancy rate. Despite the sluggish outcome of the second quarter, we anticipate the office market to improve through 2018 with the help of a limited pipeline.

ECONOMY

Payroll employment up 2.2% Payroll employment increased by 22,700 jobs during the 12-months ending May 2017 in Suburban Maryland, which is above the 20-year annual average of 12,000. The leisure/hospitality sector was the leader in growth, contributing 8,800 new jobs to the economy. The government sector followed with 4,200 new jobs added during the same time period, which was driven mostly by hiring in the federal government.

The Suburban Maryland unemployment rate was 3.9% at April 2017, down from 4.4% one year prior. The unemployment rate is below the 10-year average of 5.8%. This compares to the Washington metro area unemployment rate of 3.4% and the national rate of 4.4% at April 2017.

We expect economic conditions to remain healthy during the balance of 2017, as consumer and business confidence strengthens. Through 2021, we expect job growth to average 9,500 jobs per year, accounting for 30% of the metro total. We expect the health, technology, construction, and food services industries to fuel job growth in the period ahead.

OFFICE VACANCY AND DEMAND

Market fundamentals falter The direct vacancy rate in Suburban Maryland was 14.7% at June 2017, up 30 basis points from March 2017. The rate remains above the 10-year average vacancy rate of 13.3%. The Class A vacancy rate inched up 10 basis points to 11.5% and the Class B/C market increased even further by 40 basis points to 15.6%.

OFFICE TRENDS

10-YEAR TREND SECOND QUARTER 2017

DIRECT VACANCY

14.7%

Vacancy rate edges up

ABSORPTION

(50,000) SF

Sluggish demand YTD

RENTAL RATES

$26.76 PSF

Up 1.2% YTD

UNDER CONSTRUCTION

169,000 SF

Pipeline dwindling

JOB GROWTH

22,700 jobs

12-months ending May 2017

SUBURBAN MARYLAND OFFICE MARKET

SECOND QUARTER 2017

UNEMPLOYMENT RATE

UNITED STATES

WASHINGTON METRO AREA

SUBURBAN MARYLAND

12%

10%

8%

6%

4%

2%

0% 07 08 09 10 11 12 13 14 15 16 17*

SOURCE: Bureau of Labor Statistics, Transwestern.

PAYROLL JOB GROWTH

UNITED STATES

WASHINGTON METRO AREA

SUBURBAN MARYLAND

3%

2%

1%

0%

-1%

-2%

-3%

-4%

-5% 07 08 09 10 11 12 13 14 15 16 17*

*12-months ending May 2017 SOURCE: Bureau of Labor Statistics, Transwestern.

SUBURBAN MARYLAND OFFICE NET ABSORPTION AND VACANCY

NET ABSORPTION IN MILLIONS

DIRECT VACANCY RATE

1.0

18%

16% 0.5

14%

0.0

12%

-0.5

10%

8% -1.0

6%

-1.5

4%

08 09 10 11 12 13 14 15 16 17*

*At second quarter 2017 SOURCE: CoStar, Transwestern.

Net absorption totaled negative 242,000 SF during the second quarter of 2017. Both Class A and Class B/C registered negative net absorption at 30,000 SF and 212,000 SF, respectively. This compares poorly to the 10-year annual average of positive 169,000 SF.

The Bethesda/Chevy Chase submarket saw the most negative net absorption during the past three months, at negative 82,000 SF. This was due primarily to the University Research Co. vacating 63,000 SF at 7200 Wisconsin Avenue and the Cystic Fibrosis Foundation vacating 40,700 SF at 6931 Arlington Road.

During the first half of 2017, the government sector represented the largest share of leasing activity at 38% of all new or re-let deals. The health and nonprofit sectors followed at 22% and 11%, respectively. Notably, the Food and Drug Administration took 62,000 SF at 4041 Powder Mill Road in Beltsville and Family Health Centers leased 14,000 SF at 19851 Observation Drive in Germantown.

OFFICE RENTAL RATES

Asking rents climb 0.1% Average asking rents in the Suburban Maryland office market increased 0.1% during the second quarter to $26.76 PSF. Class A office rents averaged $29.38 PSF, while Class B/C rents averaged $24.50 PSF.

Concession packages remained elevated during the first half of 2017. For a typical 10-year term on a new lease, tenant improvement allowances averaged $61 PSF with 10 months of free rent.

OFFICE SUPPLY AND DEVELOPMENT

Pipeline continues to dwindle There were two deliveries in the second quarter for a total of 51,000 SF. In the Lanham/Landover/Largo submarket Potomac Construction completed 34,000 SF at 7521 Jefferson Avenue, which it will fully occupy. In addition, The Duffie Companies delivered 16,800 SF at 57 Randolph Road in the North Silver Spring/ Route 29 submarket, which is 68% pre-leased by the developer.

There is 169,000 SF of office space under construction or under renovation in two buildings at June 2017, which is well below the 10-year average of 1.5 million SF. The pipeline is currently 72% pre-leased, above the 10-year average pre-lease rate of 52%. Silver Spring has the most underway with one building under construction for 121,174 SF at 100% pre-leased.

2 REAL ESTATE OUTLOOK SUBURBAN MARYLAND OFFICE MARKET Q2 2017

SUBURBAN MARYLAND OFFICE MARKET

SECOND QUARTER 2017

OFFICE INVESTMENT MARKET

Investment sales healthy in Q2

There were five investment sales in the second quarter of 2017. Notably, Glazer Properties purchased 15245 Shady Grove from Meritage Properties for $24.8 million, or $133 PSF, and Promark Real Estate Services purchased 451 Hungerford Drive from HBW Group for $14.5 million, or $145 PSF. In the first half of 2017, sales volume totaled $183 million, or $116 PSF, 68% of which is made up of Class B/C assets. In 2016, investment sales totaled $1.9 billion, or $222 PSF, rocketing past the $610 million, or $168 PSF, achieved in 2015.

SUBURBAN MARYLAND CONTIGUOUS BLOCK ANALYSIS

NUMBER OF BUILDINGS - Q2 2016 NUMBER OF BUILDINGS - Q2 2017 300

250

200

150

275 276

100

50

0 10,000 SF

143 144 20,000 SF

51 52 50,000 SF

20 20 100,000 SF

SOURCE: CoStar, Transwestern.

SUBURBAN MARYLAND OFFICE ASKING RENTAL RATES

CLASS A

CLASS B/C

$40

$35

$30

$25

$20

$15 08 09 10 11 12 13 14 15 16 17*

*At second quarter 2017 SOURCE: CoStar, Transwestern.

SUBURBAN MARYLAND OFFICE DEVELOPMENT PIPELINE MILLION SF

COMPLETED 2.5

UNDER CONSTRUCTION PRE-LEASED

UNDER CONSTRUCTION AVAILABLE

2.0

1.5

1.0

0.5

0.0 07 08 09 10 11 12 13 14 15 16 17*

*Delivered YTD SOURCE: CoStar, Transwestern.

REAL ESTATE OUTLOOK SUBURBAN MARYLAND OFFICE MARKET Q2 2017 3

SUBURBAN MARYLAND OFFICE MARKET

SECOND QUARTER 2017

OFFICE MARKET OUTLOOK

Office market to steadily improve through 2018 We expect market conditions to improve at a gradual pace through 2018. The overall vacancy rate (inclusive of sublease space) should decline to the mid-14% range by year-end 2018, aided by a very limited pipeline. Net absorption during this period will likely be positive, averaging 500,000 SF per year. Although we expect leasing activity to pick up in the period ahead, growth will remain muted compared to past recovery cycles due in part to tenant densification and consolidations. As a result, the market will remain in tenant favor in the nearterm. Select submarkets with a relatively low vacancy rate, controlled pipeline and no significant move-outs on the horizon are poised to recover first. We expect Bethesda/Chevy Chase and Silver Spring to lead the pack. We expect asking rents to rise 1.5% to 2.5% during 2017. The vacancy rate will remain elevated, which will keep rent growth conservative and concession packages elevated. The exception is top-tier space, given rising demand and limited availability for this asset class. n

Suburban Maryland Office Market Indicators

SUBMARKET

Bethesda/Chevy Chase North Bethesda Rockville North Rockville Gaithersburg Germantown Kensington/Wheaton Silver Spring North Silver Spring/Rt. 29 Montgomery County Total Beltsville/Calv./Coll. Park Laurel Greenbelt Lanham/Landover/Largo Bowie/Marlboro/South P.G. Prince George's County Total Frederick County Total

SOURCE: CoStar, Transwestern.

INVENTORY

11,654,099 10,765,098

8,483,331 12,380,046

6,386,461 2,730,085 1,333,234 6,849,072 3,492,988 64,074,414 6,135,212 2,579,823 3,016,041 4,944,867 4,982,613 21,658,556 6,810,541 92,543,511

UNDER CONSTRUCTION

0 0 0 0 0 0 0 121,724 0 121,724 0 0 0 0 0 0 47,727 169,451

Q2 NET ABSORPTION

(82,000) 43,000

(76,000) (62,000)

0 5,000 (9,000) (5,000) (28,000) (214,000) (43,000) 8,000 15,000 (38,000) 10,000 (48,000) 20,000 (242,000)

YTD NET ABSORPTION

(82,000) (11,000) (25,000) (95,000)

20,000 30,000 (7,000) 15,000 (28,000) (183,000) 31,000

5,000 30,000 (38,000) 30,000 58,000 75,000 (50,000)

DIRECT VACANCY

7.4% 18.7% 12.7% 16.4% 12.0% 14.1% 27.3%

9.8% 9.6% 13.3% 20.5% 12.2% 28.0% 23.0% 14.6% 19.8% 11.9% 14.7%

SUBLEASE S PA C E

1.6% 0.2% 0.3% 1.5% 0.0% 0.1% 0.1% 0.3% 0.3% 0.7% 0.0% 0.0% 0.1% 0.1% 0.0% 0.0% 0.1% 0.5%

T O TA L VACANCY

9.0% 18.9% 13.0% 17.9% 12.0% 14.2% 27.4% 10.1%

9.9% 14.0% 20.5% 12.2% 28.1% 23.1% 14.6% 19.8% 12.0% 15.2%

AVERAGE RATE PSF

$38.08 $28.27 $29.71 $26.98 $22.35 $24.78 $24.80 $28.11 $23.80 $28.30 $22.27 $20.30 $21.31 $21.51 $22.82 $21.83 $21.97 $26.76

4 REAL ESTATE OUTLOOK SUBURBAN MARYLAND OFFICE MARKET Q2 2017

SUBURBAN MARYLAND OFFICE MARKET

SECOND QUARTER 2017

Suburban Maryland Office Market Indicators

PROPERTY CLASS

Class A Class B/C Total

SOURCE: CoStar, Transwestern.

INVENTORY

20,417,542 72,125,969 92,543,511

UNDER CONSTRUCTION

121,724 47,727

169,451

Q2 NET ABSORPTION

(30,000) (211,000) (242,000)

YTD ABSORPTION

39,000 (87,000) (50,000)

DIRECT VACANCY

11.5% 15.6% 14.7%

SUBLEASE S PA C E

0.5% 0.5% 0.5%

OVERALL VACANCY

12.0% 16.1% 15.2%

AVERAGE RATE PSF

$29.38 $24.50 $26.76

Suburban Maryland Office Market Notable Lease Transactions

TENANT

DEAL TYPE

Kaiser Permanente

Pre-Lease

Hughes Network Systems

Renewal

GSA

New Lease

Citron Cooperman & Co.

Sublease

Long & Foster Real Estate

Renewal

Family Health Centers

New Lease

Recorded Books

New Lease

SOURCE: CoStar, County Newsletters, Washington Business Journal, Washington Post, Transwestern.

ADDRESS

4000 Garden City Drive 100 Lake Forest Blvd

4041 Powder Mill Road 2 Bethesda Metro

4650 East-West Highway 19851 Observation Drive

8400 Corporate Drive

SUBMARKET

Lanham/Landover/Largo Gaithersburg

Beltsville/Calv./Coll. Park Bethesda/Chevy Chase Bethesda/Chevy Chase Germantown

Lanham/Landover/Largo

SQUARE FEET

173,000 111,000

62,000 20,000 19,000 14,000 10,000

Suburban Maryland Office Market Construction Activity

SUBMARKET

Silver Spring Frederick County Total

SOURCE: CoStar, Transwestern

SQUARE FEET UNDER CONSTRUCTION/RENOVATION

121,724 47,727

169,451

PERCENT PRE-LEASED

100% 0%

72%

C O N TA C T

Elizabeth Norton Managing Research Director | Mid-Atlantic 202.775.7026 elizabeth.norton@

Brandt Scheidemantel Research Associate | Mid-Atlantic 202.775.7048 brandt.scheidemantel@

METHODOLOGY

The information in this report is the result of a compilation of information on office properties located in Suburban Maryland. This report includes single-tenant, multi-tenant and owner-user office properties 15,000 SF and larger, excluding properties owned by a government agency.

6700 Rockledge Drive, Suite 500A Bethesda, Maryland 20817

T 301.571.0900

Copyright ? 2016 Transwestern. All rights reserved. No part of this work may be reproduced or distributed to third parties without written permission of the copyright owner. The information contained in this report was gathered by Transwestern from CoStar and other primary and secondary sources believed to be reliable. Transwestern, however, makes no representation concerning the accuracy or completeness of such information and expressly disclaims any responsibility for any inaccuracy contained herein.

REAL ESTATE OUTLOOK

SUBURBAN MARYLAND FLEX/INDUSTRIAL MARKET

SECOND QUARTER 2017

Flex/industrial market rebounds during Q2

Net absorption slightly positive and asking rents edge up

The Suburban Maryland flex/industrial market strengthened during the second quarter of 2017, registering positive net absorption of 50,000 SF. Despite the positive absorption, the direct vacancy rate edged up 30 basis points to 8.3%, due to the delivery of 1200 Claybrick Road, which was only 60% pre-leased. Asking rents increased 0.8% during the second quarter to $8.11 PSF. The pipeline as of June 2017 totaled 820,000 SF, of which 49% is pre-leased.

ECONOMY

Payroll employment up 2.2% Payroll employment increased by 22,700 jobs during the 12 months ending May 2017 in Suburban Maryland, which is above the 20-year annual average of 12,000. The leisure/hospitality sector was the leader in growth, contributing 8,800 new jobs to the economy. The government sector followed with 4,200 new jobs added during the same time period, which was driven mostly by hiring in the federal government.

The Suburban Maryland unemployment rate was 3.9% at April 2017, down from 4.4% one year prior. The unemployment rate is below the 10-year average of 5.8%. This compares to the Washington metro area unemployment rate of 3.4% and the national rate of 4.4% at April 2017.

We expect economic conditions to remain healthy during the balance of 2017, as consumer and business confidence strengthens. Through 2021, we expect job growth to average 9,500 jobs per year, accounting for 30% of the metro total. We expect the health, technology, construction, and food services industries to fuel job growth in the period ahead.

FLEX/INDUSTRIAL TRENDS

10-YEAR TREND SECOND QUARTER 2017

DIRECT VACANCY

8.3%

Vacancy ticks up in Q2

ABSORPTION

7,000 SF

Limited demand YTD

RENTAL RATES

$8.11 PSF

Asking rents down 0.6% YTD

UNDER CONSTRUCTION

820,000 SF

Healthy pipeline

JOB GROWTH

22,700 jobs

12-months ending May 2017

SUBURBAN MARYLAND FLEX/INDUSTRIAL MARKET

SECOND QUARTER 2017

SUBURBAN MARYLAND FLEX/INDUSTRIAL NET ABSORPTION AND VACANCY

NET ABSORPTION IN MILLIONS

DIRECT VACANCY RATE

2.5

12%

2.0

11%

1.5

10%

1.0

9%

0.5

8%

0.0

7%

-0.5

6%

-1.0

5%

-1.5

4%

08 09 10 11 12 13 14 15 16 17*

*At second quarter 2017 SOURCE: CoStar, Transwestern.

SUBURBAN MARYLAND FLEX/INDUSTRIAL ASKING RENTAL RATES

$14

BULK WAREHOUSE FLEX/WAREHOUSE FLEX/R&D

$12

$10 $8

$6

$4

$2

$0 07 08 09 10 11 12 13 14 15 16 17*

*At second quarter 2017 SOURCE: CoStar, Transwestern.

SUBURBAN MARYLAND FLEX/INDUSTRIAL DEVELOPMENT PIPELINE MILLION SF

COMPLETED

2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0

07 08

UNDER CONSTRUCTION PRE-LEASED UNDER CONSTRUCTION AVAILABLE 09 10 11 12 13 14 15 16 17*

*Delivered YTD SOURCE: CoStar, Transwestern.

FLEX/INDUSTRIAL VACANCY AND DEMAND

Sluggish start to the year The direct vacancy rate was 8.3% at June 2017, up 30 basis points from three months prior. This compares favorably to the 10-year average of 9.8%.

Net absorption totaled positive 50,000 SF during the second quarter of 2017, which brings the first half net absorption to just 7,000 SF. During 2016, net absorption totaled 2 million SF, which is significantly higher than the 10-year annual absorption average of 632,000 SF.

The vacancy rate increased due in part to the delivery of 1200 Claybrick Road, a 216,000 SF distribution facility that had only leased 60%, or 130,000 SF, to Starbucks.

Prince George's County experienced the weakest net absorption at negative 84,000 SF during the past three months. This was due primarily to hhgregg vacating 393,000 SF at 14301 Mattawoman Drive, which contributed significantly to the negative net absorption during the quarter. Both Montgomery County and Frederick County fared better with positive 67,000 SF each, in the absence of any major move-outs.

2 REAL ESTATE OUTLOOK SUBURBAN MARYLAND FLEX/INDUSTRIAL MARKET Q2 2017

SUBURBAN MARYLAND FLEX/INDUSTRIAL MARKET

SECOND QUARTER 2017

FLEX/INDUSTRIAL RENTAL RATES

Rents up 0.8% during Q2 Flex/industrial asking rents averaged $8.11 PSF at June 2017, a 0.8% increase since the end of the first quarter. Montgomery County experienced the greatest increase in rents at 2.4% whereas Prince George's County and Frederick County asking rents were stagnant in the second quarter.

FLEX /INDUSTRIAL SUPPLY AND DEVELOPMENT

Pipeline limited Two buildings delivered during the second quarter of 2017. The U.S. Holocaust Memorial Museum completed 103,000 SF at 4800 Macroni Drive in Prince George's County, which came online fully leased. In addition, Liberty Property Trust delivered 216,000 SF at 1200 Claybrick Road, which was 60% pre-leased to Starbucks. Projects under construction or renovation in the Suburban Maryland flex/industrial market totaled 820,000 SF at 49% preleased at June 2017. Notably, Matan Companies has 323,000 SF under construction at its Wedgewood West industrial development site at New Design and English Muff Road in Frederick County and SunCap Property Group has 330,000 SF under construction at 800 North Frederick Avenue, which will be a new FedEx distribution center.

FLEX/INDUSTRIAL INVESTMENT MARKET

Modest activity There were five flex/industrial investment sales during the first half of 2017. Notably, Transwestern's Mid-Atlantic Capital Markets Group brokered the sale of 10100 Willowdale Road for $13.1 million, or $133 PSF, to an affiliate of Industrial Property Trust. Investment sales during the first half totaled $44.8 million, or $87 PSF, compared to $211 million, or $111 PSF, in 2016.

FLEX/INDUSTRIAL MARKET OUTLOOK

Vacancy to edge down during 2017 We expect the Suburban Maryland flex/industrial market to perform moderately well during 2017. We expect the overall vacancy rate to decline slightly to the low-8% range by December 2017. Given the vacancy rate is below the 10-year average, we expect asking rents to rise 1.5% to 2.5% during 2017. Although the current pipeline is controlled, it could expand over the next 12 months as tenants are seeking newer product with efficient layouts and adequate truck court depths. Flex/industrial tenants in the District of Columbia could be lured to Suburban Maryland in search of cheaper rates and newer product. We expect investment activity will pick up over the next 12 months as investors seek assets in a market well positioned to capture the growing demand for product in the Washington/Baltimore Corridor. n

REAL ESTATE OUTLOOK SUBURBAN MARYLAND FLEX/INDUSTRIAL MARKET Q2 2017 3

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