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.

Notes From GSA’s Annual “Lease Turnover Analysis”

At the end of each fiscal year GSA produces an analysis of its leasing activity that provides an interesting glimpse into the federal real estate sector. This spreadsheet report, the Lease Turnover Analysis, seeks to address many of the questions lessors commonly ask about the probability that GSA will renew leases, vacate them or even terminate them. I imagine that, tired of fielding endless calls from property owners, GSA began publishing this analysis as a proactive measure to battle the onslaught of inquiry.

That inquiry, of course, includes my own. Recently, I’ve spent some time reviewing the study and talking to GSA, and here are five observations:

1. The Shift into Federally Owned Space is No Longer Just Talk
In each of the past two fiscal years, GSA has moved more than a million SF of leases into federal buildings. In the nine years prior (GSA tracks this stat back to FY 2014), that figure averaged a little less than 350,000 SF.

One reason for the sudden increase probably relates back the passage of the American Recovery and Reinvestment Act of 2009 (aka the Stimulus). GSA received $5.55 billion in Stimulus funds that were mostly used for building energy efficiency retrofits and renovations of federal buildings and courthouses. Now many of those projects are completed and they are pulling tenants in from leased space.

Another reason would be the 2005 Base Closure and Realignment (BRAC). The BRAC process resulted in an estimated military spending increase of $35 billion to close bases across the United States and to build new federal facilities to accommodate the consolidated and realigned military structure. By law, the BRAC process was meant to be fully completed by September 2011 but, as a practical matter, many of the affected DoD leased buildings were not completely vacated until 2013.

Both the Stimulus and BRAC are one-time or intermittent events, so the pace of this shift to federally owned space could slow. Yet we expect it to persist so long as GSA receives improved funding for new construction and alterations as it has recently.

2.  Most Leases Simply Extend
It’s unusual that GSA lease extensions are far more common than new leases. In fact, lease extensions account for two-thirds of all of the GSA “renewals” across the inventory.

To understand this better, one must first recognize that GSA’s analysis categorizes all “renewals” by three types, those that are: 1) Extended; 2) Renewed, or; 3) Replaced. By GSA’s definition, an Extension is any lease action that extends the term of a current lease. This is done through some form of amendment and it can include changes to other terms too, including rent. A Renewal, in GSA parlance, is meant to describe the specific instance where GSA exercises a previously contracted renewal option. Finally, a Replacing Lease is a new lease, written on a fresh lease form and provided with a new lease number.

GSA’s volume of lease extensions seems suspiciously high, but in an article last year we noted that much of GSA’s leasing activity has been lately comprised of short term extensions. Add to that long term extensions and perhaps the preponderance of lease extensions should not be surprising.

Going forward, we don’t expect much change.  GSA is facing a huge pile-up of lease expirations such that one-fourth of all GSA leases expire in the next two years. GSA will struggle to manage the load and probably continue to extend leases as a strategic measure to work through the backlog.

3. Renewal Probability is Lower Than You’d Expect (except that it really isn’t)
To me, one of the most striking statistics in GSA’s study is the “renewal” probability (which we define here as the total of all leases where the government extended, exercised a renewal option or signed a replacing lease in the same building). For leases expiring in FY2014, the incidence of renewal was just 77%. In fact, in the 14 years GSA has performed this analysis, renewal probability (weighted by square footage) has averaged at about this figure, though it has ranged as low as 65% and as high as 84%.

The 77% renewal factor is deceiving because it represents the average for the entire portfolio. Therefore, it includes leases that are known, for example, to be subject to future consolidations. In those instances renewal probability may be near zero, so the likelihood of renewals in the remainder of the inventory would be much higher. Further, as we’ve often discussed with property investors, the probability of renewal in newer, purpose-built buildings is probably higher still.

Unfortunately, GSA’s study does not seek to explore renewal probabilities by tranche, but it’s a project that has been on our team’s back burner for quite a while.  Maybe we’ll get to that this year.

4. Unexpected Terminations are Probably Rare
In FY 2014, 1.3% of GSA leases were terminated during the soft term (as measured by square footage). Another 0.3% were terminated during the firm term, presumably through buyout negotiations or, possibly, default. We concern ourselves mostly with the former number as it reflects GSA’s propensity to exercise its termination rights.

A 1.3% rate of termination isn’t that high but it seems a little more ominous when one considers that GSA is reporting the annual rate of termination. So, if your lease has five years of soft term that indicates a probability of termination closer to 6.5% (calculated roughly as 1.3% x 5 years). Figure also that about one-quarter of GSA’s leases have no termination right at all then, back-of-the-envelope, it’s starting to look like your lease could be exposed to almost a 9% probability of termination during its soft term.

However, as with renewal probability, looking only at the broad measure can be deceiving. This is primarily because most terminations are by design. For example, our team is working on three lease actions right now where we are expecting the Government to terminate its lease and vacate. We have have purposely provided a window of soft term in which the Government can do that. In light of the fact that most terminations are expected, typically in the extended term at the end of a lease when it is in its final death throes, we can feel confident that unexpected terminations are very rare.

5.  Big Leases are “Stickier”
For investors of GSA-leased properties, an intriguing section of GSA’s analysis is the table (recreated below) that projects the number of years GSA can be expected to remain in its leased buildings based upon the turnover probability in the year of analysis. As we noted in an earlier article, turnover probability is not renewal probability. Rather, it is a figure that reflects the percentage of all leases in GSA’s inventory that remain active from one year to the next, regardless of their expiration dates. Normally, turnover in the GSA lease portfolio is 95%, plus or minus a couple percentage points. Using the turnover probability one can project the anticipated number of years GSA will maintain its leased space.

GSA’s analysis concludes that, on average, its leases have an overall life of 14.6 years. Yet, when you weight turnover instead by square footage, that figure leaps to 23.3 years (though the projected years figure has been more subdued since the Global Financial Crisis). The obvious conclusion is that larger leases tend to stay in-place longer and, we’d bet, bigger leases in buildings predominantly leased and controlled by federal tenants are especially sticky. The implications of this tend to support the strategy of many of the fund buyers focused on purchasing federal properties for long-term stable cash flow.

CPI Has Declined, and So Has Your Rent

CPI-W IndexThe Bureau of Labor Statistics recently posted the January 2015 Consumer Price Index (CPI) figures and the results show that the measure declined 0.1% from a year ago*. This would be of little consequence to most non-economists but federal landlords must take note because the decline in CPI–for most GSA-leased properties–means a decline in rental income.

First a little background on the CPI’s role in federal leasing. Most GSA leases–nearly all, in fact–include a clause that ties operating cost reimbursements to the change in CPI. This is one of those many GSA lease clauses that are foreign to property investors new to the federal sector. In GSA leases, an operating cost base is established based on budgeted operating expenses but GSA does not reimburse actual cost increases above that base. GSA’s operating cost reimbursement (paid as “adjusted rent”) is calculated simply on the change in CPI. If, for example, your actual operating expenses increase 2% in a given year but the CPI decreases 0.1%, you’re out of luck.

A 0.1% reduction computed on the operating cost base (which itself is only a portion of the full-service rent) causes a negligible rent reduction. So, why do we care? The reason is that it highlights a disconnect between the Government’s reimbursement method and the actual costs of operating commercial buildings.

The recent decline in CPI is driven primarily by the plummeting price of oil. The price of oil is a major component of CPI and it also has pass-through effects on other elements of the CPI (lower oil prices reduce the costs to produce and distribute other goods). However, oil price reductions don’t necessarily translate to operating cost reductions in commercial properties, primarily because their impact is largely indirect: oil is rarely used to generate the electricity utilities provide to commercial buildings. Oil is also rarely used to heat commercial buildings. Though oil prices may drive down CPI, both directly and indirectly, they do not reduce building operating costs to the same degree so property owners must face dreaded “NOI leakage”, where costs are increasing faster than reimbursements.

Polling our property management team this appears to, anecdotally, be the case. Our Colliers Government Solutions team manages more than 40 properties leased by the federal government and we haven’t seen negative growth in operating costs, nor are we budgeting for it.

That leads us to wonder how long CPI will remain in decline. So far, only the January CPI has decreased from the year prior. Therefore, rent reductions will occur only in those GSA leases with February anniversary dates (GSA establishes the CPI Index base as the month prior to the month of lease commencement). However, if history is any guide, the trend will ultimately affect most property owners. Since the end of World War II there have been only three periods in which CPI declined year-over-year. All three periods were roughly a year in duration, suggesting that declining CPI could cause most GSA leases to suffer some reduction in net rent.

That said, this is a uniquely confusing time and, predictably, there is a lot of disagreement over whether we are really headed into a prolonged period of deflation or whether the CPI index is simply experiencing a oil price-induced blip on a path towards a more healthy rate of inflation. In support of the latter argument, the Core CPI Index (net of energy and food prices) has remained positive. Further, there is now solid job growth in the United States and the Fed is (so far) holding interest rates down in its quest to spur economic growth. On the other hand, CPI generally has been declining since the mid-1980s, wage growth is anemic, oil prices may stay low for some time and the strengthening dollar might actually hinder inflation.

Who really knows? All we can advise is that GSA-leased property owners watch their nickels and dimes this year.

*Throughout this article I refer specifically to the CPI-W (Consumer Price Index for Urban Wage Earners and Clerical Workers). The CPI-W is the CPI index utilized by GSA to calculate operating cost adjustments. The CPI-U (Consumer Price Index for all Urban Consumers) is more often cited by economists and the press, and it also decreased.