Which Way The Political Wind Blows

During the first half of this year Congress has hosted a number of hearings, both on Capitol Hill and in various cities across the United States, that provide a clear view of its objectives regarding federal real estate. All of these hearings have one goal in common: reduce costs.

This goal is not new of course, but faced with the prospect of ever-increasing federal debt, leaders in both parties have begun to press the issue harder. Listening to the hearings, it is often difficult to distinguish the Republicans from the Democrats. Committee members from both parties recognize that there is room to reduce real estate costs, making the issue one of rare bipartisan agreement and improving the likelihood that progress will be made.

The means by which Congress expects this cost reduction to occur can be grouped generally into three initiatives: 1) dispose of vacant and underutilized properties; 2) reduce reliance on “costly leased space” and; 3) find ways to lower the cost of the space that the government continues to lease. As detailed below, each initiative has its merits and its challenges.

1) Dispose of vacant and underutilized properties

One would expect that disposing of unneeded federal properties would be the simplest means of paring federal real estate costs, especially as there are roughly 77,000 such properties, which cost $1.66 billion annually to maintain. Yet, implementation of an efficient and comprehensive federal property dispositions program remains elusive.

To that end, on June 16th, both chambers of Congress held hearings related to federal real estate. In the morning, the Senate Homeland Security and Governmental Affairs committee hosted a hearing entitled “Federal Real Property Reform: How Cutting Red Tape and Better Management Could Achieve Billions in Savings” and in the afternoon the House Transportation and Infrastructure subcommittee on Economic Development, Public Buildings and Emergency Management held its hearing entitled “Saving Taxpayer Dollars in Federal Real Estate: Reducing the Government’s Space Footprint.”  Senate committee Chairman Ron Johnson set the tone for the day in his opening statement, asking the witnesses to comment on “what is being done today to stop wasting taxpayer dollars on unneeded and unused properties, what can be done to manage and provide reliable data on real property, what more needs to be done to truly see results, and what Congress can be done to make reform a reality.”

It was clear from the testimony that the fundamental challenge is simply identifying which properties need to be disposed. According to David Wise, the U.S. Government Accountability Office (GAO) Director of Physical Infrastructure Issues, federal real property management has remained on his agency’s “High-Risk List” since 2003, largely because the real property data reported by federal agencies are unreliable. Though President George W. Bush created the Federal Real Property Council more than a decade ago to establish and maintain a federal real property database, the data are still insufficient to support asset-level decision making.

Another long-standing challenge is the lengthy and cumbersome disposal process, which requires agencies to engage in any number of studies to determine the status of title, historical and archeological significance, NEPA compliance, hazardous materials mitigation and so forth before disposing of any property. The process also includes special provisions for “public benefit conveyances” – the act of first offering properties to local governments and certain public interest organizations. Chief among these provisions is the McKinney-Vento Homeless Assistance Act, which mandates that federal properties are offered to homeless service providers before they may be sold or otherwise conveyed. As demonstrated in the June 16th hearing testimony, however, McKinney-Vento is a hurdle to disposition that yields very little public benefit relative to the effort it imposes. Since its inception in 1987, the program has transferred just 122 of the 40,000 screened federal properties (0.31%) to homeless service providers. The public benefit conveyance review was required in all cases even though 80% of those 40,000 screened properties were obviously not practical for homeless use due to their location in national forests, on military bases and the like.

Norman Dong, GSA’s Public Buildings Commissioner, pointed to a related problem — that there is little incentive for agencies to engage in the arduous process of property disposals when they receive none of the proceeds from these sales. In Dong’s view, it is essential to compensate the agencies for the resources they must expend to run the dispositions gauntlet from end to end.

There have been recent legislative proposals that would resolve these and the other issues critical to identifying viable dispositions and executing transfers. In 2012 the Civilian Property Realignment Act (CPRA) and the Federal Real Property Asset Management Reform Act were introduced in the House and Senate, respectively. The two bills sought to address the property disposal problem through slightly different approaches, yet neither could attract the support necessary to be enacted.

Given the significant attention put to the dispositions problem in recent hearings and the bipartisan nature of the effort, it seems that Congress is poised to take up the issue yet again. We would expect to see the Civilian Property Realignment Act rekindled, especially as it passed the House when it was originally introduced. And it is possible that McKinney-Vento will be amended to allow for a more rational screening mechanism for potential homeless facilities.

2) Reduce reliance on leased space

Over the years, at nearly every hearing on cutting federal real estate costs one or more participants has issued soundbites regarding “costly leased space” and “reducing reliance on costly leasing.” Listen further and it is clear that one of the primary means by which those participants intend to reduce the government’s reliance on leasing is to shift tenants into federal buildings. This strategy has been featured in congressional hearings, White House budget requests and GAO reports back to the late 1980s (and perhaps further). Yet, the current emphasis on spending reductions has focused Congress on this issue as never before.

In both June 16th hearings, the witnesses noted that restrictions on GSA’s access to the Federal Buildings Fund are impeding the agency’s efforts to draw tenants out of leased space and into the owned inventory. As I observed in an earlier blog article, the counter-intuitive dynamic in federal real estate is that restrictions on GSA’s budget appropriations buttress demand for leased space. This is because GSA lacks the financial resources to fund the renovations to its owned assets that would be necessary to attract and accommodate new federal tenants.

GSA hopes to coax improved appropriations from Congress by providing case studies of cost savings from consolidation of federal tenants into owned buildings. In his testimony before both congressional committees, Commissioner Dong cited the example of HUD in Minneapolis, where GSA relocated the tenant from leased space into an historic downtown federal building. According to Dong, the move saved the federal government $700,000 in annual lease costs and reduced the agency’s footprint by more than 9,000 square feet. GSA would like to build further on this and has requested $200 million in the FY 2016 budget to fund renovations that would enable additional consolidations.

Funding is tight, however, and is expected to remain so. Congress will likely budget additional funds to help GSA continue to consolidate leased space into owned buildings but not the amount that GSA is requesting. Congress also expects GSA to use its public-private exchange authorities, such as its  “412 Authority”, to negotiate transactions that require fewer (if any) appropriations. GSA is using these authorities to procure a new headquarters for FBI in the Washington, DC metro area and to award a swap-construct contract that will yield a new facility for the Department of Transportation at the Volpe Center in Cambridge, Massachusetts.

Though the Democrats and Republicans are generally in sync regarding their desire to decrease the leased inventory in favor of owed buildings, the largest such project, the DHS headquarters consolidation planned for St. Elizabeths, underscores the political difficulty in funding large-scale federal construction. Though it would ultimately enable DHS to vacate more than 40 leased locations in the Washington, DC metro area, the project has been stalled by repeated appropriations restrictions. In the nine years since the project was first announced, only the US Coast Guard headquarters building has been completed (and it was built with Recovery Act funds). There is little appetite, especially among congressional Republicans, to fund the estimated $3.2 billion to finance the remainder of the consolidation, and congressional leadership has expressed doubt regarding the project’s viability, as evidenced in the Department of Homeland Security Headquarters Consolidation Accountability Act,  introduced this year in both the House and Senate. This Act calls for additional scrutiny of the cost-benefit logic of the project.

While the future of the massive DHS consolidation remains unclear, smaller consolidation projects have been successfully completed. These modest “case studies” have been conducted by GSA using what limited funding they have in an effort to rally additional support. Clearly they have begun to nibble at the edges of the leased inventory. As I noted in a blog article earlier this year, GSA has moved a million square feet from leased space into owned buildings in each of the past two fiscal years. That figure is three times the average of prior years.

3) Find ways to lower the cost of the space the government continues to lease

Still, leased properties, will remain a significant component of the federal inventory. Leases are quicker to acquire and easier to dispose of, tend to be in buildings that are newer and of better quality than most federal buildings and are generally coupled with private-sector funding for tenant alterations.

Congress’s goal is simply to reduce rental costs by improving space utilization and by making better deals. Rep. Lou Barletta has led the charge on rent reduction since he was appointed Chairman of the House Transportation and Infrastructure subcommittee on Economic Development, Public Buildings and Emergency Management. He has hosted 13 hearings and roundtables devoted to federal property issues–both on Capitol Hill and at regional locations throughout the United States. He observes that it is still a tenant’s market in most of the major metros and is a great time to achieve very low rents if GSA is willing to engage in long-term leases. Further, GSA has the right timing to take advantage of this market because half of the leases in its inventory expire in the next five years. His constant refrain: “We don’t want to miss this opportunity”.

Barletta’s approach is pretty practical. Disposing of properties and moving from leased space to owned federal buildings may save money but those initiatives will also require the passage of new laws or increased appropriations. Good leases, on the other hand, can be had right now, and the savings gained from a strategic leasing program arguably will exceed the savings that can be achieved through other cost reduction efforts, at least in the near-term.

Though no legislation is required to enable more effective leasing, Barletta has nonetheless introduced the Public Buildings Reform and Savings Act to prod the effort forward. This bill seeks to implement a streamlined leasing pilot program with the goal of “executing long-term leases with firm terms of 10 years or more and reducing costly holdover and short-term lease extensions, including short firm-term leases” (emphasis added).

Without the force of law it is unclear if or when GSA will adopt a long-term leasing posture. Throughout its recent history, GSA has routinely structured termination rights in three-quarters of its leases. It does this to control its exposure, hedging against the possibility its tenant agencies will cancel their occupancy agreements with GSA and vacate space, leaving GSA on the hook to pay the rent. When Barletta routinely asks hearing and roundtable participants if they will commit to implementing long-term leases of 10 years or more, many artfully dodge the question, but all agree that long, firm-term leases will yield better lease deals.

The federal attraction to short-term leases persists because agencies are under increasing pressure to reduce the amount of real estate they occupy. These space reductions require planning and funding that take extra effort, leading agencies to buy time with lease extensions while they organize themselves.

Agencies are grappling with these planning issues right now. Beginning in 2012, the Office of Management and Budget (OMB) issued a memorandum directing agencies to freeze the size of their leased and owned real property inventories. This Freeze The Footprint policy immediately blunted net demand and it has even caused some reduction in the GSA leased inventory. More recently, OMB issued its Reduce The Footprint mandate. This goes further, requiring agencies to develop 5-year plans.

Summary

Bipartisan efforts to reduce federal real estate costs are likely to intensify. Already this effort has resulted in declining demand for leased space. I expect that trend to continue, especially as it is politically expedient.

Congress also is working to accelerate the most obvious form of cost reduction — for the federal government to rid itself of vacant and underutilized properties. Private-sector property owners would welcome that because federal property dispositions will help agencies achieve their footprint reduction goals before having to reduce leased inventory.

The government will also seek to improve its investment in its remaining assets, though budget constraints and GSA’s limited capacity to plan and execute consolidations will slow the transition away from leased space.

Therefore, one of GSA’s best opportunities for near-term cost reduction is in the leased inventory. But as long as GSA aspires to consolidate its leased space, long firm-term leases will be difficult to achieve. Most tenant agencies don’t seem to have the confidence–whether due to budgetary concerns or mission planning uncertainty–to enter into long-term agreements without generous termination rights.

In the meantime, there still exists a pretty wide gap between the government’s goals and the reality of what GSA has been able to achieve. Yet, the rhetoric issued from congressional and executive leadership indicates which way the political wind blows and where the market is headed.

The Key Sustainable Products Initiative

Is your bathroom tissue squeezably soft? Does your soap leave your hands germ-free? Advertisers lie awake at night worrying about whether consumers are worrying sufficiently about such things. And as for the federal government—well, officials there have been worrying that suppliers and agency managers haven’t been paying quite enough attention to the environment, whence a set of guidelines that has recently come online governing procurements ranging from flooring and insulation materials to hand soap to the little paper liners on top of cafeteria trays.

As a result, as of late in FY15, new regulations are online by way of the Public Buildings Service (PBS) of the General Services Administration (GSA) covering what are called “Key Sustainable Products.” These are defined as the materials and products used in the construction and operation of buildings—and in particular, buildings owned and leased by the federal government.

The product of several related policy and executive orders (particularly EO 13693 Planning for Federal Sustainability in the Next Decade, signed by President Obama on March 19, 2015), the KSP initiative holds that these products and materials are as important as energy use and waste management in the overall “green” operation of federal properties, and it requires that all federal organizations and employees under PBS jurisdiction, as well as contractors, follow guidelines found in the online Green Procurement Compilation. Key sustainable products are defined as those that PBS uses most frequently and for which it (or other agencies, such as the EPA) has developed environmental standards. Among the products listed are nylon carpet, acoustical ceiling tiles, concrete, floor cleaner, interior latex paint, paper towels, and wastebasket liners, along with the aforementioned hand soap, bathroom tissue, and tray liners.

For example, acoustical ceiling tiles in new construction projects must meet California section 01350 standards for low-VOC (volatile organic compound) materials—and not just that, but they must also be at least 20 percent recycled content, be recyclable themselves, and meet USDA Certified BioPreferred guidelines. Bathroom tissue must be at least 25 percent postconsumer recycled content, while concrete must be greater than 25 percent fly ash, a waste product of coal firing, or greater than 15 percent ground granulated blast-furnace slag. And as for carpeting, in the language of one regulatory document: “Face yarn must be 100 percent nylon fiber. Loop Pile shall be 100 percent Bulk Continuous Filament (BCF); cut and loop shall be 100 percent BCF for the loop portion and may be BCF or staple for the cut portion; cut pile carpet shall be staple or BCF.”

There’s some inconsistency built into the standards as they are now set. For example, vendors and suppliers are being actively solicited to provide a range of products, adding to the roster of existing contractors and supply lines. As the GSA notes, almost all the listed products are available at prices less than or equal to their non-sustainable counterparts, conforming to government policies otherwise mandating cost saving. At the moment, though, lessors are not bound by the standards set for wastebasket liners, since products have not yet come onto the market that meet both the environmental and the cost-effectiveness requirements.

General contractors, janitorial-services providers, office-supplies sales personnel, property holders and lessors—the KSP initiative affects a wide range of people and agencies. How thoroughly they comply with the new guidelines remains to be seen—and it will be seen, since the GSA has also instituted a program of audits and “green lease clause” tracking instruments.

For those of you who have been actively leasing over the last couple of months, you may have noticed new lease clauses relating to this policy. We believe GSA’s sustainability policies will continue to evolve, especially as there are other initiatives underway.

Non-Cancelable GSA Leases Are Now Even Scarcer

GSA Leases Cancelable vs Non-CancelableDespite increasing congressional pressure to improve the number of long, firm-term leases, GSA and its tenant agencies have proven that they are not yet serious about weaning themselves from their addiction to termination rights. As measured from the leasing peak in 2010 (note: some of the leases in that year are due to short term Census leases), the number of cancelable leases remains nearly unchanged. Yet, during that same five-year period, the number of non-cancelable leases (>=3,000 RSF*) has declined by a little more than 18%. The net result is that GSA has been executing a smaller proportion of non-cancelable leases in an inventory that is also shrinking.

That unfortunate trend would be mitigated if the leases that were executed achieved longer firm terms. Alas, they are not. In fairness, I have not studied this in detail, but the back-of-the-envelope analysis is as follows: Currently, in the entire United States there are only 129 leases that have remaining non-cancelable terms of 10 years or more. Given that the pile-up of GSA lease expirations is such that the agency is executing approximately 1,100* lease actions annually, it is pretty easy to conclude that the process is yielding an exceedingly low volume of long firm-term leases.

The data in the graph above tracks these figures through the end of the 2014 fiscal year (i.e. 9/30/2014) so the trend could potentially improve when we revisit it again at the end of fiscal 2015. Certainly congressional intervention has ramped up substantially in this past year and we would expect that to have some influence on federal leasing. Yet, so far this fiscal year (looking at the data available through May 2015), we see only a very slight, half percentage point improvement in the ratio of non-cancelable to cancelable leases.

As we’ve discovered in our recent study of lease expiration dates, there is some “seasonality” to GSA leasing. So, we will revisit this again at the end of the year to conclusively determine if Congress is having any influence over GSA’s leasing activities or if the agency is merely paying lip-service to its legislative branch colleagues.

* Throughout this article we base our analysis on GSA leases that are at least 3,000 RSF in order to improve the focus on traditional leases, eliminating many TSA on-airport leases, storage leases, parking leases and other esoteric leases.

Making Sense of Cap Rates for GSA Properties

One of the most important (and perplexing) concepts we run into on a daily basis in the GSA property marketplace is the concept of “cap rate.” The cap rate has long been used as a benchmark for pricing commercial real estate across all product types, but in the 1990s and into the 2000s became more widely applied as the primary tool for property valuation as real estate emerged as a mainstream asset class due to the flood of capital into the sector.

The concept of the cap rate, short for “capitalization rate,” comes from bond pricing, specifically annuity bond pricing, where the annual income from the bond is constant and extends into perpetuity – as expressed in the formula:

Capitalization Rate = Annual Income / Value;

or conversely:

Value = Annual Income / Capitalization Rate.

The important concept here is the word “perpetuity” and the notion that the annual income derived from the asset being valued will continue on forever. Using the cap rate makes sense when applied to multi-tenant office, industrial, retail and multifamily product, because annual or periodic rent escalations within the leases that generate the revenue for these assets, along with overall market inflation, create an environment where Net Operating Income (NOI) is projected to remain stable or increase over time. This is also the case with single-tenant, triple net, long-term leased product where rent escalates and operating expenses are primarily the responsibility of the tenant, making NOI more predictable. In all of the above cases, because of this predictability and upward trend, residual values at the end of the investor’s holding period are much more stable and predictable.

However, within the GSA-leased property marketplace, the variance in GSA lease structures – and resulting annual rent obligation structures within these leases – do not always provide a stream of annual NOIs that are increasing, or even remaining stable, over time. Therefore, the cap rate for a GSA-leased property is meaningless unless it is placed in context.

As a result, a number of different methods have emerged in calculating cap rates for GSA-leased properties. The correctness or incorrectness, or accuracy or inaccuracy, of these various methods then comes down to a matter of individual preference. The problem arises when cap rates among various GSA-leased property transactions are compared, but the methods used to calculate those cap rates are different – or the context or circumstances present within each individual data point vary.

Let’s look at the example of the long-term, GSA-leased asset where the annual rent obligation is flat over time and the expense recoveries are deemed to be sufficient to cover future expense inflation, providing a level NOI over the full lease term. In this instance, dividing the projected Year 1 NOI into the sale price to determine the cap rate, or dividing the NOI by the cap rate to determine value, makes sense.

However, because the vast majority of GSA leases contain soft term (where the GSA has the right to terminate), the annual rent obligation structure will frequently decrease at some point during the lease term. In the case of a newly-commencing GSA lease with a term of 10 years with 5 years firm (non-cancellable), where the shell and operating expense component of rent is flat through the entire lease yet and TI costs are amortized only over the first 5 years of firm term, there is a decrease in the rent obligation in Year 6 – and therefore a projected decrease in NOI during the last 5 years of the lease. A simple example is illustrated below (ignoring inflation/CPI escalation):

For illustrative purposes, if we assume this asset is priced at $3,500,000, based on a determination of the cap rate using the formula Year 1 NOI / Value, the cap rate is 10%. However, the yield drops in Year 6 to 7.86%.

In this case, neither 10% nor 7.86% accurately represent the cap rate of this asset, as the initial yield of 10% is not maintained during Years 6-10 of the lease, and the projected yield starting in Year 6 of 7.86% does not take into account the additional rental income received during the first five years of the lease. As a result, how does the investor convert this uneven cash flow to a cap rate that can be compared to other GSA-leased asset sales? Two methods provide possible solutions to this problem.

The first method separates the component of the pricing of the asset that is attributable to the TI Amortization Rent so that the cap rate can be determined on the remaining NOI – the portion of the NOI that is maintained during the full term of the lease. In the example above, Annual TI Amortization Rent of $75,000, paid monthly over a 5-year period, using 7% as the annual discount rate, has a present value of approximately $315,600. The cap rate is then calculated as follows:

The second, and simpler, method calculates the average projected yield over the lease term. Again using the above example, with a projected yield in Years 1-5 of 10%, and 7.86% in Years 6-10, the average yield over the full 10-year term is 8.93%. This can also be calculated by taking the average projected NOI over the lease term of $312,500, divided by the asset price of $3,500,000.

In certain cases, although occurring much less frequently, there are GSA leases in which the annual rent obligation increases during the lease term, even though the TI component “de-amortizes” after the firm term of the lease. An example is illustrated below (ignoring inflation/CPI escalation):

For illustrative purposes, if we assume this asset is priced at $4,250,000, based on a determination of the cap rate using the formula Year 1 NOI / Value, the cap rate is 8.24%. However, the yield increases in Year 6 to 8.82%. In this case, it would be perfectly acceptable to use 8.24% as the cap rate for this asset. However, this does not take into account the increased yield beginning in Year 6, and the fact that an investor may accept a lower initial yield in anticipation of a future increase – as compared to the initial yield for a 10 year lease term that is flat for the full lease term. The alternative again is to calculate the average yield over the full lease term. With a projected yield of 8.24% for Years 1-5 and 8.82% for Years 6-10, the average yield over the full lease term is 8.53%.

In looking at all of the example above, it is easy to see how challenging it can be to compare published cap rates across the full spectrum of GSA-leased asset sales in determining a “market cap rate” for a particular GSA-leased asset being evaluated, by looking only at remaining lease term in addition to other factors such as location, agency, and deal size. With the vast array of lease and rent structures across the GSA lease inventory, it is important for each investor to determine the cap rate methodology that is the most relevant to their own particular investment requirements.

GSA Occupancy of New Buildings Has Dwindled

Long-time participants in the federal sector have clearly sensed that the volume of new lease-construct (i.e. build-to-suit) projects has declined substantially in recent years and that the government has been engaged in a spirited game of kick-the-can, leading to an unusually high volume of short term extensions. The result of these two factors is that the volume of space GSA occupies in new buildings is at an all-time low.

Looking at the graph above, we can see that the square footage GSA occupies in buildings delivered this year (estimated) and last year is substantially lower than any other time in the past two decades. Admittedly, GSA occupancy of 2014 and 2015 vintage buildings may increase a bit over time but it is unlikely reach the levels achieved in the other years of this historical trend. The reason is that buildings leased primarily by the federal government are often lease-construct projects, and the volume of such projects is on the wane.

Some observations:

1. The majority of buildings 85%+ leased by GSA (those buildings depicted in the graph) are lease-constructs. This is true in most of the years of this analysis.

2. The exception to the observation above is that period from 2003 to 2006, following the formation of the Department of Homeland Security. In that instance the federal government needed to acquire a lot of space quickly, an effort that generally favored existing buildings.

3.  The volume of space occupied in the 1990s is probably a little understated in this graph as some GSA tenants that originally occupied buildings of that era may have since exited. However, the volume of new lease-construct projects increased after 1995 in reaction to security concerns in the wake of the Murrah Building bombing. Generally speaking, lease-construct projects are 15- to 20-year leased so the shape of this trend should be pretty accurate.

4. As measured by building age, occupancy of GSA-leased space has generally declined since 2007, and especially in buildings constructed in the past 2-3 years. This correlates with the surge in short-term leasing that began in the late 2000s and which has persisted to the present. The anomalous data in 2009 and 2013 are due to delivery of two of the largest leased projects in GSA’s inventory. In 2009, the 1.36 MSF Constitution Center project delivered in Washington, DC (it was originally leased by SEC but later backfilled by other agencies). In 2013, a new 1.5 MSF NNSA facility delivered in the suburbs of Kansas City.  We do not anticipate any other projects of this scale in the near term.

5. This may be a statement of the obvious, but it must be noted that real estate leasing is a lagging indicator. In the era since the nadir of the Global Financial Crisis, budget constraints, rising debt and other factors have led GSA to substantially scale back construction of new leased facilities. Nonetheless, the volume of GSA-leased square footage in newer buildings is buoyed by deliveries of lease-construct projects that were initiated years ago. Looking forward, we do not see much construction underway, nor do we see many new lease-construct procurements.

6. Despite the grim observations before this, the GSA leasing market is structurally poised for a recovery. The reasons are two-fold: First, there is a huge pile-up of leases, such that one-fourth of the inventory expires in the next two years. This pile-up is due to a variety of factors but one of them is that the agencies have been challenged to initially freeze, and now reduce, their space inventories. Planning for this has caused agencies to engage in short-term extensions but it will eventually lead to long-term leases that should bolster occupancy in newer buildings. Second, mandates from both the President and Congress to improve sustainability will favor newer, energy efficient buildings. We can’t say that this will lead to more construction but it should ultimately increase occupancy in newer product.

Freeze. Measure. Reduce: New Steps for Downsizing Federal Real Estate

In 2012, the Obama administration’s Freeze the Footprint policy order mandated that the federal government reduce its real estate footprint and curb its accumulation of unused or underused properties. The following year, the Office of Management and Budget (OMB) issued guidance on how these reductions should be planned. Since then, the federal government reduced its real-estate footprint by 21.4 million square feet, disposing of 7,350 buildings in FY 2014 alone. Reductions in real property inventory, according to the OMB, accounted for savings of more than $17 million in operating costs.

Last month, on March 25th, the Obama administration followed up with two wide-ranging documents: the National Strategy for Real Property and its accompanying Reduce the Footprint management procedures memorandum. Together, they require federal agencies not just to freeze growth but also to better measure their use of space through tools such as the Federal Real Property Profile and ultimately, reduce the inventory, cutting back on real property holdings by “prioritizing actions to consolidate, co-locate, and dispose of properties.”

OMB has also announced that with the General Services Administration (GSA) it has developed and implemented new analytical tools to facilitate data-driven decision making, tools that are meant to be fully in place by the end of FY 2015. By the terms of the National Strategy, the first of these tools will be online by the end of this month.

By those terms, too, each federal agency is required to submit a draft five-year Real Property Efficiency Plan by July 20, with the final plan completed by September 10. These plans will embrace policy standards specifying space requirements and setting reduction targets.

The White House adds that new legislation will likely be required in order to streamline existing regulations for the disposal of property. It notes that existing requirements for selling federal property involve twenty discrete steps, creating an administrative burden that increases both cost and time spent. The administration proposes that this legislation follow the Civilian Property Realignment Act (CPRA), first proposed by the President in 2011.

As with any federal plan, it seems, there are loopholes woven into the very fabric of the National Strategy. For instance, if an agency has fewer than 200 warehouses, then it does not have to submit reduction targets for its warehouse portfolio. Neither do agencies have to retrofit their holdings to accommodate the requirements for per-employee office space that are set forth in the new policy. In addition, as a memorandum from the OMB puts it, “there may be circumstances where an agency experiences mission changes leading it to exceed its square-footage baseline in a given year.”

OMB plans to make data on the freeze-and-reduce program available annually on the performance.gov website.

How the Murrah Building Bombing Changed Federal Facilities Security

Twenty years ago, on April 19th, 1995, Timothy McVeigh parked a rented Ryder truck at the curb, directly in front of the Alfred P. Murrah Federal Building in downtown Oklahoma City. In the back of that truck was a 4,800 pound bomb, improvised using primarily fertilizer and fuel oil. McVeigh, having set the fuse, calmly exited the truck and walked away. At 9:02 AM, local time, the explosive mix detonated, causing one-third of the Murrah Building to collapse. 168 lives were lost, including 15 children in a daycare center on the second floor. Another 680 people in and around the building were injured. The Oklahoma City Bombing, as it became commonly known, was the most devastating terrorist event on U.S. soil up to that point (and it remains the worst domestic terrorism act committed by a U.S. citizen).

The day following the bombing, President Clinton ordered the Department of Justice to conduct an immediate vulnerability assessment of federal facilities. It was this report that established five security levels for federal facilities, where Level I is the lowest and Level V is the highest (though Level V was reserved for uniquely secure facilities such as CIA headquarters and the Pentagon). It also recommended 52 physical and operational security criteria to improve facilities protection, recommended that the Federal Protective Service be upgraded to improve its oversight of facilities security, and it recommended the formation of a committee to establish security policies and oversee their implementation. It was this final recommendation that was most impactful because it led President Clinton to issue Executive Order 12977, which directed that an Interagency Security Committee (ISC) be established to write standards for federal facilities. The ISC still exists and the standards it has issued have had substantial impact on federal leasing over the past two decades.

It should be noted that most federal facilities have had enhanced security long before the Murrah Building bombing. The threats were already well known based on previous incidents overseas, including the 1983 suicide bombing of a military barracks in Beirut, which killed 241 Marines, and domestically, including the 1993 attempt by militant Islamists to take down the World Trade Center north tower by detonating a truck bomb in the parking garage. Yet, the Murrah event was the catalyst for a portfolio-wide assessment of domestic federal buildings and the universal application of minimum security standards.

Those security standards were initially applied only to federally owned buildings, where GSA could implement new protocols and physical security upgrades unilaterally. Developing standards for leased space took much longer. In fact, it wasn’t until nearly a decade after the Oklahoma City Bombing that the ISC formally enacted its Security Standards for Leased Space. That report established minimum standards to be applied to all new GSA leases and also to most federal agencies procuring space under delegated or statutory authority. Notably, the ISC standards did not apply to Department of Defense facilities, which continued to adhere to a stricter standard (though in December, 2012, DoD adopted the ISC standards for its leased buildings).

The first generation of ISC security standards were focused heavily on threats involving vehicle-borne bombs. In an explosion, building window glass is blown inwards and the shards can be injurious or lethal to the human occupants inside. Therefore, the ISC stipulated that all but the smallest federal offices be outfitted with shatter-resistant window film. Further, as the blast force of a bomb degrades rapidly with distance, the earliest security standards mandated standoff distance for most new construction. Though the standards did not require standoff for existing buildings, some agencies clearly felt the need to establish enhanced physical security and this touched off a wave of new construction after the Oklahoma City bombing and again after the 9/11 attacks.

The other considerable impact of the security standards was the widespread implementation of building access control, including federal control over parking and building entries with magnetometers, x-ray machines and armed guards. While this level of security is typical for buildings that are fully occupied by the government, the early ISC standards required it in any building that had at least 150,000 SF of federal tenancy. Yet, in instances where the government occupied multi-tenant buildings, implementation of the government’s desired security was often impractical.

Heightened concern over security and the requirements imposed by the ISC standards weakened the incumbent advantage of many buildings as security concerns made federal tenants more difficult to retain upon their lease expirations. The most stark example of this is FBI, which constructed more than three dozen new field offices across the United States between 1998 and the present. By and large, these new field offices featured 100′ standoff distances, secured perimeters, including vehicle-resistant fencing or other protective barriers, filmed or laminated window glazing to withstand substantial blast pressures and structural design to prevent progressive collapse of the building.

Ultimately, however, these same security mandates made some federal tenants more captive. Using FBI as an example again, the building design described above is entirely unique to secure government facilities. Upon renewal of these leases, there is no relocation option for the federal tenant unless another costly new facility is constructed. Without competition, the incumbent lessor has significant negotiating leverage.

The early standards were focused exclusively on the size of the target, based on square footage and population: Buildings with more than 150,000 SF of federal tenancy or more than 450 federal employees were deemed Level IV, buildings with 80,000 SF to 150,000 SF of federal tenancy or 151 to 450 federal employees were deemed Level III, and so forth. Thankfully, the security standards have evolved to better match the necessary level of protection to the level of risk. The facility security assessment now considers factors beyond just facility size and population–like symbolism, the threat to the tenant agencies (ex. law enforcement agencies warrant higher security) and mission criticality. Large buildings occupied by rank-and-file agencies for relatively vanilla uses are now typically designated Level III, whereas they would have been deemed Level IV a decade prior.

In fact, generally, the federal government appears more willing to recognize that security needs to be balanced against other factors. In the current budget environment, one of these factors is cost. An Interagency Security Committee report published late last year, entitled Best Practices for Working with Lessors: An Interagency Security Committee Guide, included the rational observation that, “In most facilities, it is neither common to find anything close to perfect security nor is perfect security an economically feasible objective.” This observation is encouraging because the premium cost of facilities protection can be high and the security enhancements often add little to the value of the asset for anyone other than federal tenants. It is also why OMB ruled years ago that security costs must be accounted for separately from rent (and it is why federal lease proposals typically require specific delineation of security related pricing).

Security also finds itself increasingly at odds with the federal government’s efforts at improved sustainability and carbon footprint reduction. As an example, federal sustainability guidelines encourage locations near mass transportation. Yet, secure compounds can only be found in suburban locations that are accessible exclusively by car. It was this tension between security and sustainability that ultimately contributed to DoD’s decision to abandon their Anti-Terrorism/Force Protection standards and migrate to the ISC criteria, at least for leased buildings.

One thing is certain: security standards will continue to evolve in response to many factors, including terrorist and criminal threats, budget demands, sustainability goals and the practical circumstances of multi-tenancy. Yet, as the Murrah Building bombing established, the threats are real and security will remain a prominent factor in federal leasing. If there is any good that can be divined from that fateful day, April 19, 1995, it is that it established the ISC and a framework for federal facilities security that is capable of adapting to the changing environment.

An Executive Order Mandates Energy Savings

Solar panels installed atop DOE’s Forrestal Building headquarters in Washington, DC.

It’s hardly news that the largest single consumer of energy in the United States is the federal government, with its stock of 360,000 buildings and 650,000 fleet vehicles. What is surprising, though, is the extent to which that consumption has implications that are both environmental and economic, not just in terms of dollars spent but also in terms of habitat loss, melting ice caps, and rising sea levels.

While President Barack Obama’s executive order “Planning for Federal Sustainability in the Next Decade,” issued on March 19, isn’t exactly a game-changer, it draws attention to all those matters. Building on several earlier executive orders, it orders federal agencies to reduce greenhouse gas emissions by 40 percent over a 2008 baseline and to increase their use of energy from renewable sources such as solar- and wind-generated electricity by 30 percent. Other provisions include the reduction of water usage, greater energy efficiencies, and the reduction of energy usage overall, to be achieved by means large and small, whether by cutting down on photocopying or by installing biomass furnaces. These improvements, overall, are expected to cut energy spending by $18 billion over the next decade.

The government’s direct contribution to greenhouse gas emissions is small: by most reckonings, it stands at less than 1 percent. Even so, given the government’s role as a driver, not just by virtue of the $445 billion it spends annually on goods and services but also because of the regulations it can enact across the economy, the order is already having cascading effects. IBM, Northrop Grumman, and General Electric, among other companies, have announced emissions-curbing plans of their own.

Of particular interest to our readers are the provisions in the order relating to building performance and energy. It requires that new federal buildings greater than 5,000 square feet be energy net zero, generating as much energy as they consume, by 2020, a requirement emblematized by the recent addition of solar panels to the roof of the U.S. Department of Energy headquarters in Washington. Additionally, it mandates that all new agency lease solicitations of buildings of more than 10,000 rentable square feet include criteria for energy efficiency, with the implication that buildings that do not meet the revised standards will not be eligible for lease.

These standards, now under the rubric “Guiding Principles for Federal Leadership in High Performance and Sustainable Buildings,” are to be developed, according to the terms of the executive order, by the Council on Environmental Quality and the Office of Management and Budget. The guiding principles are supposed to be promulgated within 150 days of the order’s issuance—by midsummer, that is. We’ll be on the lookout for specifics in the months to come.

The Pareto Principle and Federal Property Investment

Pareto Distibution 100kIn 1906, Vilfredo Pareto observed that 80% of Italy’s land was owned by 20% of its population. Eventually this observation was memorialized as the Pareto Principle or, more commonly, the “80-20 rule” because of its near-universal application to describe many phenomena, such as where 80% of a country’s wealth is held by 20% of its citizens, where 80% of a company’s sales come from 20% of its customers, where 80% of internet page views are on 20% of websites and so forth. Of course, the ratio isn’t always 80-20 but it is always lopsided such that the data highlights, as Pareto put it, “the predictable imbalance” or “the vital few and the trivial many”.

Clearly this is true in federal property ownership. In the graph below we took 3,848 owners of federal property and graphed the square footage of federal leases each of them hold in their respective inventories. When we set each of these 3,848 narrow columns cheek by jowl, an area chart in the classic Power Law shape emerges. Simply put, the Power Law shape is one that has a very tall spiked “head” at the left side and a long “tail” trailing to the right.

This is the same graph shown at the top of this article except that it is "zoomed out" to show all 3,848 property owners. The 98 property owners shown in red own as much federally leased real estate as all other owners. Note that the "tail" to this graph is very long and very thin. Two-thirds of property owners hold less than 20,000 SF of federal leases.

This is the same graph shown at the top of this article except that it is “zoomed out” to show all 3,848 property owners. The 98 property owners shown in red own as much federally leased real estate as all other owners combined. Note that the “tail” to this graph is very long and very, very thin. Two-thirds of property owners hold less than 20,000 SF of federal leases.

This is the Pareto Principle at work: the 98 largest owners (just 2.6% of all federal property owners*) control as much federally leased real estate as all other owners combined. Even Pareto would find that astonishing.

Astonishing, yes, but what does it mean? Well, a few things:

1.  Federal real estate ownership is substantially aggregated.  The 10 largest federal property owners hold almost 16% of all federally leased properties. This, the “vital few” will, by and large, remain a pretty small group. The reason for this is that new fund investors are inevitably focused on entering the federal sector through purchases of long-term leased properties. Yet, those investments are increasingly scarce because the new lease-construct projects, which generate the longest initial lease terms, have largely dried up and each year the remaining term of those projects burns off. Instead, much leasing right now is of the short term, “kick the can” variety. This creates a barrier to entry for new investors that need to lead with long-term leased investments. It is also creating some growth in the head of the trend where many of those investors have already generated portfolios substantial enough that they are able to speculate a bit on more plentiful shorter-term leased investments.

2.  For the rest of the pack, catching up to the ever-spikier head is also complicated by the fact that the tail is so thin. If you were the 99th largest property owner and wanted to become the largest, you’d have to buy the portfolios of the next 20 owners (#100-#119). Of course, that is unlikely and those portfolios may not be appealing. Aggregating a substantial inventory requires real work and it favors investors that devote substantial resources to buying properties, often one at a time. It demands sustained focus because there are few shortcuts to the head of the pack.

3. Pareto noted that the 80-20 distribution evolves in large part because “the rich get richer”. This is true in the federal property sector as well, partly for the reasons outlined above and also because the restricted flow of new investors with solid track records provides the lead investors with a marked advantage. In a sector where pricing tends to cluster tightly for stable assets, larger investors’ track records often tip deals their way. Further, among off-market transactions the reliability of execution offered by the larger investors provides them with one of the precious few seats at the negotiating table. This may not be fair, or even rational, given the number of eager buyers out there, yet it is a dynamic that often prevails in the clubby federal sector.

The Pareto Principle is here to stay and as portfolios at the “head” of the Power Law curve continue to get larger the capital supporting them becomes more institutional. In some respects this has been good for the sector because it has improved pricing overall. But for sellers the message is this: there are plenty of qualified buyers out on that long, long tail. Don’t ignore them.

* We track most owners of federal property of all kinds in the United States but we centered this analysis largely on a 215 million SF tranche that includes all GSA-leased building owners, along with a slug of properties leased by agencies with statutory or delegated authority. Among the properties we did not include are U.S. Postal Service properties, VA medical facilities and most of the facilities leased “subject to annual appropriations”. Though, had we included these, the Paretian distribution and all of this article’s conclusions would have remained very much the same.

The Energy Savings and Industrial Competitiveness Act—Redux

In the 113th Congress last year, Senator Jeanne Shaheen (D-NH) and Senator Rob Portman (R-OR) introduced the Energy Savings and Industrial Competitiveness Act, S. 2262, a 136-page bill intended to update previous legislation on energy efficiency in commercial and residential buildings. Among other things, it would require the General Services Administration (GSA) “to develop and publish model leasing provisions and best practices for use in leasing documents that designate a federal agency as a landlord or tenant to encourage building owners and tenants to invest in cost-effective energy efficiency measures.”

S. 2262 also introduced the voluntary Tenant Star Program, which we have written about earlier. This program would “recognize tenants in commercial buildings that voluntarily achieve high levels of energy efficiency in separate spaces.” The bill would also direct the Department of Energy to gather and publish data “relevant to lowering energy consumption” in commercial and other buildings.

Conservative groups mounted a campaign against S. 2262, arguing, in the words of one, Heritage Action, that “today’s federal voluntary programs often become tomorrow’s mandates.” Some also objected that energy efficiency was being forced unfairly onto the housing finance sector, with potentially negative effects on building valuation and the appraisal process.

In any event, S. 2262 was caught in a procedural tangle when, in late June 2014, Senator Mitch McConnell (R-KY) demanded amendments on energy policy, while Senator Harry Reid (D-NV) in turn demanded a vote on the bill as written. As the record reads, “Senator McConnell objected to the modification. Senator Reid objected to the original request.” And there the matter rested—or, more precisely, died.

Now reintroduced, the Energy Efficiency Improvement Act of 2015, to quote from Senator Portman’s web page, “includes four simple but effective provisions that have been scored by the Congressional Budget Office to be budget neutral.” The bill includes four titles: –

  • Title I establishes a voluntary, market-driven approach to aligning the interests of commercial building owners and their tenants to reduce energy consumption.
  • Title II exempts certain electric resistance water heaters used for demand response from pending Department of Energy regulation.
  • Title III requires federal agencies to coordinate with OMB, DOE, and EPA to develop an implementation strategy—that includes best practices, measurement, and verification techniques—for the maintenance, purchase, and use of energy-efficient and energy saving information technologies.
  • Title IV requires that federally-leased buildings without Energy Star labels benchmark and disclose their energy usage data, where practical.

These titles are elaborated in the text of the bill. Among other things, for instance, the bill requires improvements in energy efficiency and building codes, involving the Department of Energy in providing technical and material assistance, including data. The Better Buildings provision of the bill also authorizes the Tenant Star Program and requires DOE “to complete a study on feasible approaches to improving the energy efficiency of tenant-occupied spaces in commercial buildings.”

In a separate section, DOE is also required to “conduct an ongoing review into private sector green building certification systems and to work with other agencies to determine which certification system would encourage the most comprehensive and environmentally sound approach to certifying buildings.” And, as before, the bill includes several provisions to improve energy efficiency in federal buildings and “requires federal mortgage agencies to include energy efficiency as a factor in determining the value and affordability of a home.”

According to proponents, the Portman-Shaheen bill is projected to create 192,000 jobs and save $16.2 billion annually while reducing CO2 emissions substantially by the year 2030. It has found numerous cosponsors in both parties, among them Senator Kelly Ayotte (R-NH), Senator Michael Bennet (D-CO), Susan Collins (R-ME), Lisa Murkowski (R-AK), Mark Warner (D-VA), and Roger Wicker (R-MS). Numerous national energy groups have voiced support for the bill as well. We will report on developments as the bill moves through the Senate.