Rolling Termination Rights Now Extend to AAAP Program

AAAPAs of last month, the Automated Advanced Acquisition Program (AAAP) still allowed GSA and interested landlords to enter into leases of 5 years, 10 years or 5 years with a fixed-price five-year renewal option. However, this month saw the most significant revision to the AAAP program in many years – no longer will landlords have the ability to secure this 5+5 lease structure through AAAP. Instead, GSA amended the Request for Lease Proposals (RLP) to now solicit proposals for a 10-year lease with GSA having rolling termination rights after the 5th lease year. The basic 5-year firm (which is hardly ever used) and 10-year firm alternatives remain unchanged, but this AAAP revision is noteworthy because it introduces cancelable lease term into the AAAP for the first time.

The 10 year/5 firm structure has been GSA’s default approach to its non-AAAP lease procurements for many years. Despite congressional pressure on GSA to secure longer lease terms and resistance from private industry, this latest evolution of the AAAP demonstrates GSA’s desire to have the AAAP program “fall in line” with its longstanding national leasing policies and it’s aligned with GSA’s apparent attempt to remove the human element from the business of real estate leasing by automating as much of it as possible. GSA’s continued reliance on cancelable leases is one of the reasons GSA’s average remaining lease term, across its national portfolio, continues to decrease.

Because this 10/5 structure is already familiar territory for virtually all of GSA’s contracting officers, and because AAAP transactions are less susceptible to protests, it is quite likely this latest change will result in an uptick in AAAP leasing activity and further establish the AAAP as GSA’s preferred lease acquisition method for the major metropolitan markets in the United States.

District of Columbia: LEEDing by Example

leed-plaquesRecently adopted standards in the District of Columbia now require new buildings to meet LEED standards. That is, they must meet the Green Building Council’s energy-efficient, environmentally friendly requirements of building design and construction, operation and maintenance, and, what is less easy to control, interaction with the surrounding neighborhood. All new buildings in the District of Columbia must now meet LEED standards or their close equivalents, according to regulations established last spring, while those in neighboring Maryland must conform to less rigid but still challenging environmental requirements, also endorsed by the Green Building Council. Virginia is likely to follow suit soon.

Relatively few projects aim for LEED Gold or Platinum certification, more elite designations. Part has to do with reasons of cost, since meeting those standards can involve layering on all sorts of unanticipated expenses; one gets bragging rights for the special LEED status, but not much else tangible in the way of payback, since building codes are generally in line with LEED in many costly details of the physical plant, such as how much water a toilet uses or whether lights are programmed to go off when a room is not in use. (Most LEED regulations have to do with mechanical and electrical components of buildings.) Part, too, has to do with LEED’s difficult demands, especially in that fitting-in-with-the-neighborhood component. For example, we spoke with one architect who said he lost Gold certification in one outlying county because the schedule of municipal buses bringing workers to the building was not printed to LEED’s liking.

“We had one building that got Gold certification with no problem,” he said. “It sailed right through the process. We had another one, designed exactly the same, that was a nightmare getting approval for. Same standards, same firm, different inspectors, different outcomes. The system isn’t foolproof, and I’m not really convinced that there’s a need to have the merit badge. It adds so much cost and so much energy to any building effort.”

Still, that cost and energy is a requisite in much building work for the federal government. That will even be more so when, on November 13, new regulations by the Department of Energy go into effect that require that new and retrofitted federal buildings meet energy and mechanical requirements according to Green Building standards. The regulations are in concord with Executive Order 13514 and the Energy Independence and Security Act (EISA), and they are being followed by the GSA, which has overall responsibility for federal properties, whether in the District or far beyond.

The relevant DOE document states, in a somewhat circular fashion, “Under the regulations established today, if a Federal agency chooses to use a green building certification system for a new building or major renovation covered by today’s rule, the green building certification system for Federal buildings must meet the certification standards established in today’s rule.”

Dodgy phrasing aside, there has been some resistance to LEED standards on the part of firms and organizations within the building and construction materials industries, largely because of the increased expenses meeting those standards entails. Some of the resistance has to do with inadequate grandfathering of existing stocks of materials such as adhesives and flooring that met standards yesterday, but not today; some, of course, has to do with dislike of federal authority generally. Still, builders and architects have found LEED certification to be a widely understood stamp of approval, and even if it costs a client more, it’s a selling point on the part of those seeking to sell buildings, whether to the government or to private buyers.

Nonetheless, it’s not unusual for builders to choose to exceed the code, functionally meeting LEED standards without the paperwork. It appears, though, that paperwork may become increasingly difficult to avoid. In the case of the District of Columbia, the government requires the rating—a requirement that, all signs now suggest, is likely to become more widespread.

The Trouble with Rising U.S. Debt

Federal Debt Held By The Public

The federal debt held by the public in the second quarter of 2014 was $12.57 trillion. That equates to 72.6% of GDP, down slightly from the post-WWII peak of 74.0% that was recorded in the first quarter of this year. This slight reduction is the only good news that will be reported for the remainder of this article.

Rapidly rising U.S. debt is a problem for all of the reasons normally cited by economists, but for investors of federal government-leased properties there is an additional cause for concern: efforts to contain or reduce the growing debt through spending restrictions have come at the expense of the federal discretionary budget. Unfortunately, this is the same budget from which rent is paid.

In fact, we’ve already seen the early effects of these cuts. In response to historically high deficits and the resultant rapidly increasing debt, the White House and Congress have both begun imposing austerity measures on the federal inventory. The first of these were space utilization restrictions established by the House of Representatives as part of its prospectus approval process. Shortly thereafter, the White House issued its “Freeze The Footprint” policy, which prohibits agencies from increasing the size of their real estate inventories above the level established in FY 2012. Both of these measures have blunted GSA’s leased inventory growth and we are beginning to see downsizing in the works.

Much of this downsizing is being accomplished through reconfiguration of offices to achieve better space utilization. Occasionally this is taken to the extreme, transforming workplaces into telework environments where most employees don’t come into the office, and those who do are provided temporary workspaces to conduct that day’s activities. The net result is that there is slightly less GSA-leased space now than a year ago.

Discretionary Share of Income

The Heritage Foundation included this graph in its “Federal Spending By The Numbers” report last year, using data from the Congressional Budget Office (CBO) and the Office of Management and Budget (OMB) to forecast the squeeze put on the discretionary budget by entitlement spending and interest on the national debt.

Is this a temporary problem or a persistent one?

Ever optimistic, real estate investors hold out hope that the Ryan-Murray budget agreement and last year’s deficit reduction are signs that the economy is righting itself and that we will soon shift back into growth mode. Yet, that is unlikely.

According to the Congressional Budget Office (CBO) Extended Baseline forecast the national debt is expected to decline over the next few years, but then it will rise again (see chart below). The Extended Baseline estimate is CBO’s rosiest view of future debt because it is based on current law, which includes the expiration of certain tax breaks and medicare reimbursements. In reality, those revenue-reducing provisions are consistently renewed. The Alternative Fiscal Scenario model, which is designed to consider past behavior in anticipating future results, yields a more worrisome trend. The most realistic forecast probably lies somewhere between these two measures but, in any case, the results show that within the next ten years debt will begin to grow again, exceeding current levels and ultimately surpassing the entire size of the U.S. economy.

Federal Debt Trend

From “The 2014 Long-Term Budget Outlook” published July 2014 by the Congressional Budget Office (CBO).

Both parties recognize that the root cause of ever-increasing debt is growth in entitlement spending (primarily Medicare, Medicaid and Social Security) and, to a lesser degree, increased net interest on the national debt. Currently, discretionary spending is a bit less than one-third of the federal budget, and mandatory spending (including net interest) is the other two-thirds. Though the Tea Party and other fiscal conservatives have waged relentless efforts to reduce discretionary spending, those gains toward debt reduction have been easily overwhelmed by entitlement spending. Part of the problem relates to lackluster GDP growth, which limits available revenues, but the big-picture math is pretty simple: bringing the federal budget under control will require statutory changes to contain entitlement spending and/or increase taxes. Looking into the future, Fred Hiatt, Washington Post editorial editor, assessed the situation in an op-ed article last week: “the government will be spending on entitlement programs and interest alone just about what it spends today on the entire budget. Everything else—schools, pre-K, Pell grants, national parks, mass transit, housing subsidies—will get squeezed, or taxes will soar, or both.”

This is why we are unlikely to see a return to inventory growth anytime soon. Creating headroom in the discretionary budget is not possible without entitlement and tax reform, legislation requiring seemingly impossible congressional agreement in the current hyper-partisan political environment. Further, with a presidential election ahead in 2016, any legislative effort at deficit reduction is more likely to be a political statement than a real effort at compromise.

How can this get better?

The Ryan-Murray budget agreement was a two-year resolution. That provides about the most budget stability we’ve seen in the past several years. Further, it’s possible that the Republicans will capture both houses of Congress next month. If that occurs, the result for the federal-leased property market is likely to be positive simply because it consolidates control of the legislative branch with a single party. Split control of 112th and 113th Congress (Republican majority in the House and Democratic majority in the Senate) is a fairly rare circumstance, one that has manifest itself in legislative gridlock. The resulting state of limbo, paired with a slow and fragile economic recovery, has put agencies into a holding pattern, kicking the can with short term leases.

The irony for the feds is that intensifying budget pressure on leasing can be resolved through downsizing and consolidation, yet the budget is too tight to fund those activities. If the November mid-term election unifies congressional control it may provide a clearer path for agencies simply by providing greater predictability to the budgeting process. However, any improvement would be incremental–the government takes a shockingly long time to plan and execute even the simplest of leasing actions.

The trouble with rising debt cannot be enduringly addressed without landmark revisions to tax and spending legislation. Without action it is a certainty that federal real estate will remain subject to cost-cutting. Property investors must hope that our future political leadership finds a solution to this important issue.

Funding Controversy Leaves DHS’s Consolidation Plan in Doubt

master_plan_site_map_2St. Elizabeth’s Hospital, perhaps best known as the psychiatric facility in which the poet Ezra Pound was held for thirteen years after having been convicted of treason, and where would-be presidential assassin John Hinckley has been confined since June 1982, is choice real estate. Occupying more than 180 acres of federal property with a sweeping view of the Capitol, the Tidal Basin, National Airport, and other Washington landmarks, it lies squarely in the path of the District’s eastern development expansion.

After serving for more than a century to the treatment of troubled psyches, much of the campus is disused and in disrepair. After having been deemed “endangered” by the National Trust for Historic Preservation, the site has been slated for more than a decade as the future consolidated headquarters of the Department of Homeland Security, an omnibus agency that itself consolidated 22 smaller agencies in the wake of the terrorist attacks of September 11, 2001. The headquarters consolidation effort would entail significant renovation, rebuilding, and new construction, and it is one of the most complex and costly building projects in in the works in Washington, DC.

A report recently issued by the U.S. Senate Committee on Homeland Security and Governmental Affairs notes that DHS is now scattered across more than 50 facilities in Washington, Maryland, and Virginia, “many of which are physically inadequate.” Its authors add that this dispersal makes it difficult for DHS to act in a cohesive, collaborative manner—the very rationale for establishing the department so that diverse law enforcement and national intelligence functions could be brought under one roof to foster what former Secretary Michael Chertoff called a “one-DHS culture.”

When the master plan for the renovation of St. Elizabeth’s was effected in 2009, the total cost was estimated to be $3.4 billion, with a projected move-in date of 2016. That cost has risen to $4.5 billion, the Washington Post reports, and the move-in date, already far behind schedule, is now projected to stretch into 2026—ten years late—if funding trends hold.

That delay is puzzling, given that DHS has long cited headquarters consolidation as a pressing national security need. But for the time being, only one DHS unit, the U.S. Coast Guard headquarters, has taken up residence on the campus.

Meanwhile, the Senate Committee report continues, that pressing need for consolidation remains unaddressed, at least in part because Congress has consistently allocated less funding than requested—$1.2 billion less, in fact, since 2006. This shortfall has led to construction delays and increased costs of various kinds.

The authors observe that in a time of constantly shrinking budgets and economic instability, the temptation exists to shelve “long-term investments that have yet to bear fruit.” They add, though, that conversely, consolidation stands to save millions in taxpayer dollars in the long term through realized efficiencies. Indeed, the authors claim, the savings over the next 30 years could reach a billion dollars: $700 million in saved rent, $210 million in housing more employees in more efficiently designed, morale-boosting new space, and $132 million in the saved cost of having to maintain St. Elizabeth’s as a historic property.

For that and other reasons, the report recommends that the St. Elizabeth’s DHS consolidation project be considered a funding priority. The authors urge that the 2015 request of $323 million for renovation of St. Elizabeth’s be funded. They add that if the allocation is not made, the $348 million that has already been spent will go to waste. At the same time, they note that a revised plan is required to be sure that the project is “well managed and implemented.”

The report also emphasizes the Government Accountability Office’s insistence that property ownership is far less expensive than leasing property to house federal agencies, a stance that has obvious implications for our readership. “Delays in construction at St. Elizabeths have required DHS to continue to lease office space throughout the region,” the authors write. “Most of those offices are paid for through increasingly more expensive operating leases, meaning fewer dollars can be spent on mission operations.”

The Office of Management and Budget is now reviewing a draft revision of the DHS consolidation project. Meanwhile, a report from the GAO released on September 19 suggests that the General Services Administration and DHS consider alternatives to St. Elizabeth’s. It also faults the agencies for poor management of schedules and budgets, calling current estimates unreliable. “Creating reliable cost and schedule estimates for the headquarters consolidation project should be an integral part of DHS and GSA efforts to reassess the project,’’ the report scolds. “Without this information . . . the project risks potential cost overruns, missed deadlines, and performance shortfalls.’’

Congressional Democrats and Republicans, predictably, are divided: Many Republicans are pressing to divert funds from the consolidation to such matters as border security, while many Democrats are urging that the St. Elizabeth’s project be fully funded and completed.

In short, this unfinished business is business as usual, leaving us to continue our speculation as to whether this project will ever be completed.

How to Tell the King Snakes from the Coral Snakes: Due Diligence Tips for GSA-Leased Property Investors

Only one of these illustrations depicts the venomous coral snake. The rest are harmless. (Answer: A…if you are in North America)

You’ve inspected the building and it appears sound. You’ve interviewed the tenants and they seem happy. You’ve toured the market and it triggers no alarms. You’ve done all of your normal due diligence, so you buy. Then, later, when you expect to glide through an easy and lucrative lease renewal, everything goes to hell.

Could you have seen it coming? Maybe.

GSA-leased assets may appear similar but they are often very different. Learning to distinguish good investments from dangerous ones requires a practiced eye. Here are several items every property investor should address when evaluating GSA-leased property investments:

Watch out for consolidation
If your tenant agency is also housed in several buildings in the same market area then it may be vulnerable to a future consolidation action. Sometimes that’s a good thing–like when an agency occupies all of your building and a small piece of a building next door. That is a situation where it’s likely (in the current budget environment) that the agency will chose to reduce its footprint and consolidate into your building. Yet, it’s also common for an agency spread among several locations to ultimately consolidate into a separate, new one. In that instance, you may be the one holding vacant space.

Everyone prefers new buildings (even the feds)
As a follow-on to the point above, the federal government exhibits a demonstrated bias towards new properties, especially when it can be the primary occupant. This is usually because, over time, federal inventory growth eventually necessitates consolidation. Emerging federal mandates, including those aiming to achieve improved space utilization and energy efficient design, naturally favor newer buildings. This doesn’t mean that older buildings cannot be be competitive (especially historic buildings that enjoy certain price advantages). If they meet the technical criteria presented by the government’s lease, then it’s simply a price competition. Yet, everyone likes new space–including the feds–so it’s a mistake to assume that they are a lock for renewal in markets where newer space is plentiful. It’s easy for GSA to cast a procurement such that it disadvantages older buildings.

Make sure the space utilization is tight–really tight
If you walk the building and note center corridors and lots of spacious hard-walled offices, you have good reason to be concerned. Even open plan layouts may not meet the agencies’ increasingly strict utilization measures. Most federal tenants now aim to achieve space utilization of 170 USF per person or less (sometimes substantially less). If your building doesn’t offer that, expect that you will have to invest more capital upon renewal. If you must compete to renew the tenant, this means that your price advantage may be eroded as well. It pays to know what space design mandates the tenant agency is implementing across the rest of its portfolio.

Space utilization goes beyond just the tenant buildout. The core factor also matter because, though GSA pays rent on a rentable square foot basis it compares lease proposals on a usable square foot basis. Larger core factors can substantially inflate the rent per usable (more technically the “ANSI-BOMA Office Area”) square foot, substantially impeding the building’s competitiveness.

Federal tenants attract one another…except when they don’t
The GSA tends to want to locate its tenant agencies in buildings it can control, which provides obvious security benefits. In “multi-tenant” federal buildings that are home to several government agencies, there is the additional benefit of being able to control all space within the building envelope to accommodate individual tenant expansions and contractions.

Yet, some government tenants don’t co-exist very well. High security, law enforcement tenants, such as FBI, usually want to be segregated–preferably in their own building. Other times the missions of federal agencies are at odds. For example, Citizenship and Immigration Services (CIS) and Immigration and Customs Enforcement (ICE) have historically been co-located because they are both successor agencies to INS. Now these agencies are being separated so that immigrants seeking to pursue citizenship status don’t have to scurry past the offices of the people that might detain and deport them(!).

Public access facilities are on the wane
Under intense budget pressure, public access functions like Social Security field offices and IRS Taxpayer Assistance Centers are increasingly in danger of closure. Take the Social Security Administration (SSA), for example: that agency has closed more than 65 field offices since 2010. SSA is replacing these bricks and mortar outlets with telephone and internet support in an effort to reduce real estate costs. Since SSA doesn’t have a firm plan for how many additional field offices it will close (or downsize) and the timing of those actions, GSA consistently insists on leases with no more than five years of firm term. While the renewal may be certain, asset valuation can be damaged by the relatively short term.

Be wary when the # of tenants is not equal to the # of leases
GSA leases space from lessors and then subleases it to individual federal agencies via occupancy agreements. Sometimes a single lease may accommodate several federal tenants. That’s fine, except that it has recently become common for GSA to demand that the lessor negotiate leases for each individual agency upon renewal. So, a single, full building government lease could later convert to multiple leases. GSA would then have the ability in the future to determine whether it will renew these leases individually, possibly with varying terms. Among other complications, this functionally provides GSA with partial termination rights.

The same can occur in reverse too. Multiple leases may be combined into one, which is often preferable, except that the effort to combine the leases may require short-term extensions to align the expiration dates, delaying the larger lease action and possibly complicating financing. Further, if the combined lease is large enough it may also require congressional prospectus approval. Prospectus approvals include restrictions on maximum rent, maximum size and space utilization. They may also require GSA to establish broad geographies for competition and to negotiate purchase options.

Whether multiple leases are combined into one, or one lease is split into many, the resulting terms may not be what the purchaser bargained for when buying the asset.

Distinguish between contractors and employees
Many GSA offices house contractors, but that is vulnerable to change because decreasing the size of the real estate inventory is the government’s overriding goal right now. Certainly the feds have to provide space for their own people, but they don’t necessarily need to do that for private-sector federal contractors. In an effort to downsize, realign and consolidate, contractors may be asked to find their own space, enabling the government to lease less space in your building.

In GSA’s view, all buildings are equal (when it comes to negotiating rent)
GSA employs blunt tools and metrics like “Bullseye” and the Lease Cost Relative to Market (LCRM) measure to determine the rent it will pay. These were originally meant simply to provide guidance to contracting officers but, predictably, some regions have now established policies requiring that its negotiators meet or improve upon the rent goals established by these automated measures. That’s a problem for property owners for two reasons: 1) the tools don’t evaluate actual competition (or lack thereof) they simply establish rent goals based upon prevailing market rent, and; 2) The prevailing market rent is often established based upon a market geography drawn broadly. For example if your property is downtown and the Bullseye tool establishes a rent negotiation goal based upon prevailing metro area rents, you’re probably in for a frustrating negotiation.

The Contracting Officer matters
GSA gives lots of responsibility to its contracting officers. Even though federal leasing is heavily governed by regulation, law and policy, the skill and attitude of the Contracting Officer (CO) makes a big difference. Unfortunately, there isn’t much consistency in the approach or ability of various COs. Some just aren’t up to the task, can’t control their tenant, won’t think outside the box or, perhaps, they are quick to bully you with the U.S. government’s sovereign rights of holdover and condemnation. Others will happily engage with you to craft creative deals. Knowing something about the COs, how they operate and what results they seek to achieve, is important.

Colliers Releases 2Q’14 North American Office Report

Colliers NA 2Q14 Office Report CoverColliers today released its mid-year report profiling activity in North American office markets. The results are mostly bullish:

Following the negative weather impact on most economic metrics earlier in the year, the U.S. economy rebounded well in subsequent months, adding more than 200,000 jobs per month between February and July and registering real GDP growth of 4.2% in Q2. Increased hiring and rising business confidence bode well for the office market during the remainder of 2014.

The economic and office market recoveries are broadening to include more markets, including many of those hit particularly hard by the housing bust and financial crisis (e.g. Las Vegas, Orange County, Miami). Half of the U.S. metro areas tracked by Colliers have recovered all of the office-using jobs lost during the recession, and more than three-quarters of the North American office markets posted positive absorption in both Q2 2014 and year-to-date 2014.

Continuing the trend of recent quarters, the North American vacancy rate decreased modestly, by 15 basis points to 13.36% in Q2 2014, and we anticipate a similar trend during the remainder of the year. Once again, the U.S. vacancy rate decreased, by 21 basis points to 13.72%, and the Canadian vacancy rate increased, by 52 basis points to 8.52%. New supply is contributing to the rise in Canadian vacancies, although the overall vacancy rate remains below the 10% level considered indicative of a balanced market.

North American absorption totaled 16.9 MSF in Q2 2014 (17.0 MSF in the US, -83,530 sq. ft. in Canada). In the U.S., the four-quarter trailing quarterly average of more than 17.6 MSF of absorption in Q2 2014 was the highest level during the current recovery. The leading markets in Q2 2014 were Houston, San Francisco, Downtown Manhattan, Orange County, Midtown Manhattan, Atlanta, Dallas, Seattle/Puget Sound, Chicago and Kansas City.

Construction activity continues to trend upward, with 101.8 MSF under construction at mid-year 2014, up from 88.2 MSF at year-end 2013 and 75.7 MSF at mid-year 2013. Oversupply is generally not yet a concern in the U.S., with development activity concentrated primarily in the strongest markets and submarkets. The top markets for construction under way at mid-year 2014 were Houston, Toronto, Calgary, Washington, DC, Dallas, San Jose/Silicon Valley, San Francisco, Seattle/Puget Sound, Boston and Midtown South Manhattan.

North American office investment increased by 25% year-over-year in H1 2014 to $52.9 billion. Interest rates are expected to rise with the end of the Fed’s QE3 bond-buying program in October 2014 and likely rate hikes in 2015.  Nonetheless, spreads between the 10-year Treasury and cap rates for suburban properties and secondary and tertiary markets generally remain wide, which, coupled with improving economic and office market conditions in these areas, should attract a greater amount of investor interest in the coming quarters.  The relative stability and transparency of the North American real estate markets should continue to attract foreign investors to gateway cities and, increasingly, secondary markets in search of higher yields and less competition.

To download the full report, click here.

Spotlight: Smithsonian Institution

SI LogoWhere would you go to see The Spirit of St. Louis, the monoplane that, in 1927, bore Charles Lindbergh on the first nonstop flight from New York to Paris? How about Tony Hawk’s skateboard, which carried him to dozens of victories, to say nothing of a substantial fortune? The skull of a harbor seal sent from Oregon to President Thomas Jefferson by Meriwether Lewis and William Clark’s Corps of Discovery? Tito Puentes’s drums? Julia Child’s kitchen? Dorothy Gale’s ruby slippers?

To see all these things, among millions of other artifacts—more than 176 million, at last count—you would travel to the Smithsonian Institution, an amalgamation of 19 museums and art galleries in the District of Columbia. To that number are added the sprawling National Zoo, as well as numerous research facilities and ancillary museums and storage facilities within and outside the District. The Smithsonian Institution is also first among equals in a network of affiliated museums that now numbers more than 175 institutions throughout the United States, as well as Puerto Rico and Panama.

The Smithsonian Institution (never, properly, Institute) is a place of superlatives. Collectively, it is the most heavily visited museum in the country, with more than 30 million visitors in 2012. Visitors to the most popular destination, the Air and Space Museum, inside which Lindbergh’s plane hangs from the ceiling, numbered more than 8 million in that year. That makes Air and Space the single most visited museum in North America, and though it sometimes vies with another Smithsonian branch, the Museum of Natural History, for that top honor, both usually stand within the top ten most visited museums anywhere in the world, their numbers not far behind the longtime winner, the Louvre in Paris.

The Smithsonian has a curious history to match those superlatives. Its origins lie in an unexpected bequest on the part of an English naturalist, James Smithson, who died in 1829. With no children of his own, and with no prior indication that he was going to do so, he gave the entirety of his estate—a sum amounting to about $500,000 today—to the United States of America, “to found at Washington, under the name of the Smithsonian Institution, an establishment for the increase and diffusion of knowledge.” It took 17 years to organize that establishment, but James Polk finally authorized the legislation that formally brought the Smithsonian into being it in 1846. (Smithson’s tomb, incidentally, is itself one of the exhibits on display.)

Those private origins have bearing on the Smithsonian today. The federal government funds the Smithsonian, but only partially: Its appropriation in 2013 was $775 million, and in 2014 it was $805 million—about 5 percent less than the amount requested of Congress. Admission to the Smithsonian is free, but a combination of commercial enterprises (including a magazine and cable network) and private donations brings in about a third again as much money. The Smithsonian typically returns a small surplus, with its reported earnings in 2013 about $1.3 billion.

This operational blend of private and public sources of funding is of long standing, reflecting the Smithsonian’s historic status as an “independent establishment in the executive branch,” as it is referred to in the Federal Property and Administrative Services Act of 1988. In practice, however, the Smithsonian is a charitable trust that operates more or less independently of the three branches of government, causing Supreme Court Chief Justice William Howard Taft to deem it “a private institution under the guardianship of the government.” Wise lawyers and jurists have despaired of placing the Smithsonian more precisely within the web of departments and agencies within the government, and though the Smithsonian is widely considered a federal agency, it is not entirely subject to the regulations governing federal property under the terms of that Act.

To be sure, it works closely with the General Services Administration in matters such as procuring physical plant improvements, building new structures and renovating existing ones, and the like. “We have to assume that we’re operating according to federal guidelines in things like awarding contracts to the lowest bidder,” remarks one Smithsonian official. “But then there are all sorts of variations in how we do things that come about precisely because we’re a trust. It really depends on what we’re doing, what we’re spending money on, and how much we’re spending. Getting clarity on this just isn’t easy, and it never has been.”

If clarity isn’t easy to attain, there’s much to administer: The Smithsonian employs more than 6,750 full-time workers, occupies at least 2.7 million square feet of space (the precise figure varies depending on whom you ask) in dozens of buildings, and generates annual revenues that would make many a corporation happy. Plus, it’s open every day but Christmas, so that there’s always something going on at the Smithsonian—a constant hub of activity, all devoted to that increase and diffusion of knowledge of which Mr. Smithson spoke.

The Smithsonian "castle" building was designed by the famed architect James Renwick and completed in 1855. Today it houses the Institution's administrative offices and the Smithsonian Information Center. Located inside the north entrance is the crypt of James Smithson.

The Smithsonian Institution “Castle” Building was the first Smithsonian building, designed by James Renwick and completed in 1855. Today it houses the Institution’s administrative offices and the Smithsonian Information Center. Located inside the north entrance is the crypt of James Smithson.

Lease Patterns, and What They Tell Us

Yr Blt x Remain Term
Looking at remaining term of federal leases relative to building age, an interesting pattern emerges: the leases appear in “waves”. The scattergraph above shows office buildings that are at least 85% leased by federal tenants. We’ve plotted every building based on its age and the remaining term of its government-leased space. The size of each dot corresponds with the overall amount of leased SF in the building it represents.

One can see that the government-leased buildings are generally oriented in three distinct diagonal lines, and if you stare a bit longer you begin to see the possibility of a fourth and maybe even a truncated fifth line of data points.  There’s a pretty simple reason for the trend that also has interesting implications for investors.

Understanding the trend
GSA leases tend to occur in 5-year increments. Especially among newly built buildings and lease-construct projects, the lease terms are usually 10, 15 or 20 years. Look back at the graph and you will clearly see that trend. Follow along the very top of the graph, which includes data for buildings built this year, 2014, and you will see each of the waves starts with dots at 10, 15 and 20 years. Those are fresh leases in new buildings.

Each year as these new buildings age, the remaining term of their leases decreases. Each building ages one year and its remaining lease term gets a year shorter. The building ages another year and the remaining term decreases another year, and so forth. This explains why the lines develop into diagonal trails. Yet, when we look further down the vertical axis at buildings that are more than 15 to 20 years old (ie. when their original leases have expired) the orderly trails now become more jumbled. This is because the government is not as consistent in its renewals. They may often renew space for 5, 10 or 15-year increments, but increasingly they also lapse into short term leases (or, more rarely, superseding leases). These soften the well-defined trend we see among newer buildings but vestiges of the trend still exist in the data where the government engages in traditional renewals, most often 5- or 10-year terms.

Implications for investors
This is kind of interesting, but what does it mean? First, it suggests that many of the government-leased buildings in the inventory were originally leased when they were new. This is especially true of buildings originally leased for 15 or 20 years. Leases that long are generally reserved for lease-construct projects. Looking back at the graph, it is apparent that older buildings rarely have remaining lease terms of 15 or more years.

Second, the government favors new buildings (who doesn’t?). This doesn’t mean that federal tenants won’t remain in-place for decades but the lease terms will usually never again reach the length of the original term. More significantly, the trend suggests that when government relocates it usually doesn’t move older buildings. Though we view the federal government as the quintessential “price-driven” tenant it is fairly rare for them to trade down in building quality, especially for their long-term leases.

The trend also indicates why investors can very nearly guess the vintage of fully leased government properties. Wonder why so many buildings built in 1994, 1999 and 2004 are up for renewal now? It’s probably because they were built 10, 15 or 20 years ago, respectively. Next year we’ll work on leases from the class of 1995, 2000 and 2005. You can reliably guess at the provenance of most federally leased buildings.

Most importantly, we get a glimpse of what will begin to occur once the pipeline of lease-construct projects is fully exhausted. If the lease-construct spigot remains shut off (as it is now, by policy) then average lease terms will get ever-shorter and eventually the leasing cycle will begin churning a bit faster. Further, with leasing no longer focused on new buildings, the pattern of long waves will be broken. As leases grow shorter, the availability of long-term leased investments will also dwindle. For a while, capital will aggressively chase this dwindling number of long-term leased properties leading, possibly, to more cap rate compression.

One final implication (and an important point of note for GSA): Investors certainly do not invest in government-leased assets because they like the underlying lease structure.  They do it because they like the underlying credit. Long-term federally leased buildings are a relative safe haven for risk-averse capital, viewed as a better return than investing in T-bills, but with similar risk profile. Short-term leases, however, don’t provide the safety investors seek, regardless of the credit quality. Decreasing availability of long-term leased product will send cheap capital off to explore other property sectors. For GSA, that means that rent could ultimately become more expensive.**

* There are some interesting exceptions to the wave pattern. Among them is 1275 First Street, NE, a brand new building in Washington, DC that was leased to GSA for a short-term swing space related to the Stimulus-funded renovations of GSA’s headquarters. I think that lessor hoped that momentum would set in if they could get the government into their building (and they may eventually be proven correct). Also, a new lease-construct project to house NOAA in College Park, Maryland, was restricted to an unusual 13-year lease term to keep it from budget scoring as a capital lease. Further, due to unique complications, this new building sat vacant for a few years before it was ultimately occupied. 

** This is primarily true of secondary and tertiary markets that aren’t normally the focus of institutional capital investors. In the largest major metropolitan areas, investor interest is unlikely to subside.

GSA Swap-Construct Exchanges

GAO Swap-Construct Report CoverIt’s a simple proposition: Build us a new building, even something as simple as a parking garage, and you can have the old one.

That old building might be an office tower, a courthouse, or some other large public structure. It might even be another parking garage. We say “might be” because, to judge by three current projects of the Government Services Agency, the rules for what it calls “swap-construct exchanges” are just beginning to be formulated—and the agency has much work to do in improving the processes these exchanges entail.

Notes the Government Accountability Office in its recent report “Federal Real Property: GSA Should Better Target Its Use of Swap-Construct Exchanges,” there is an ever-increasing need to replace and modernize federal buildings of many kinds. Because of a tightening budget, among other considerations, the resources to do so are not always available. A swap-construct exchange is thus a vehicle by which agencies can transfer title to certain federal properties in return either for new buildings or “constructed assets” or, in some cases, for construction services in building new properties or renovating existing ones.

The GSA has conducted two swap-construct exchanges since 2000, one in San Antonio and one in Atlanta, using properties that were determined to be underutilized in exchange for much-needed new parking garages. The exchanges, according to their recipients, took longer than expected—three years and five years, respectively—to complete, which the GSA explains as the result of “lack of experience” with this novel arrangement. Admittedly, as the report notes, the decision-making process is elaborate, involving requests for proposals, solicitations, property appraisals, studies, reviews, and then—if all has gone well—the award of a contract “for a swap-construct exchange where the property recipient will provide constructed asset or perform prescribed construction services for the federal government in return for the title to one or more federal properties.”

Swap-Construct Profiles

Since 2012, the GSA has issued calls for proposals for six swap-construct exchanges. Three are now active, and three are no longer being pursued. The most ambitious is a projected exchange of the Federal Bureau of Investigation headquarters in Washington, DC, built in 1971. Even at some 2 million square feet, it is not large enough to house all headquarters staff, with the result that the FBI is seeking a new headquarters building with sufficient space for all. The GSA proposes to exchange federal buildings and land in exchange for this new headquarters, whose location is yet to be determined.

Another active project is also set in the District of Columbia, this one involving the exchange of property in the Federal Triangle South area, including two buildings housing the Federal Aviation Administration and one housing units of the GSA itself, for construction services. The third is in Colorado, entailing the exchange of undeveloped federal property in Lakewood for construction services at the Denver Federal Center.

Other swaps in Baltimore, Los Angeles, and Miami are on hold because of a perceived lack of market interest. The GAO observes that this may reflect a weakness of swap-construct in areas that have plentiful real estate alternatives to underutilized federal facilities, but the report also notes that the GSA’s expectations may not have been clearly stated in floating proposals for the exchanges, with no clear indication given of what would be expected in return for the transfer of those properties.

The two projects that have been completed were initiated by private companies and not by the GSA itself. The GAO report recommends that the GSA better identify its needs and expectations before a swap is proposed, that these details be made part of any request for information, and that the agency “develop criteria for determining when to solicit market interest in a swap-construct exchange.”

The GAO report notes that the GSA has ample statutory authority to exchange federal property, and that in 2005 it was specifically charged with exchanging federal property for construction services. Nearly ten years later, the GSA is just embarking on that swap-construct mission. Indeed, as the report notes, the agency is still preparing “guidance specific to exchanges for services,” suggesting that it may be some time before the report’s recommendations can be put into place. Stay tuned.

Top GSA Property Owners (2014 Edition)

Top 10 Owners

Last year we published our inaugural list of the ten largest owners of GSA-leased properties. In this article we chronicle the top 10 list again, along with a few new honorable mentions. The ranking looks a lot like last year’s but we see some pending property trades that could shake things up in 2015.

Some notes regarding this list:

  • We have ranked owners by square footage and not rent or any other measure because square footage is the most unimpeachable metric available to us.
  • Our ranking is based solely on GSA-leased properties, so it doesn’t include owners of buildings leased directly by agencies under their delegated, statutory or independent authority. However, we track those leases too and in some instances we’ve noted how the rankings might change if we took this analysis further.
  • We have only tallied leases that have commenced. If a lease has been awarded but not yet commenced (as in a lease-construct project, for example) we haven’t counted that in this list.
  • Determining “ownership” is tricky business. We have typically defined the owners as those operating partners who are the face of these properties–the people who ultimately manage the assets. However, we recognize that in most instances there are behind-the-scenes equity partners whose ownership stake is far larger than the operating partners’. We have not attempted to identify these equity partners in this list.
  • If you think we’ve mis-counted your portfolio, email me or leave a comment below.

THE OWNERS:

1. Government Properties Income Trust (NYSE:GOV)
Government Properties Income Trust remains the undisputed leader in the government-leased property sector. The REIT owns 91 buildings totaling 11 MSF. Some of this space is leased to state agencies and non-GSA federal agencies so, for the purposes of this ranking, GOV controls 5.75 MSF of GSA-leased space in 52 buildings. The firm remains an active buyer of government properties.

2. JBG Companies
JBG is, hands-down, the most active property developer in the Washington, DC area so it is no surprise that it would also be an active builder and owner of GSA-leased buildings. Though JBG sold four GSA-leased office buildings over the past year, it also delivered new build-to-suit projects for the National Institute for Allergy and Infectious Diseases (491,000 SF) and the Social Security Administration (538,000 SF).

3. Vornado Realty Trust (NYSE: VNO)
If there is an award for resilience, Vornado would win it. The firm, which has significant holdings near the Pentagon, was one of the worst to suffer from Department of Defense relocations due to BRAC.  Though BRAC was enacted into law in 2005, most of the space vacated by DoD went dark last year. In response, Vornado has been aggressively courting new GSA tenants.  Earlier this year it was awarded the 183,000 SF U.S. Fish and Wildlife Service lease in Falls Church, Virginia, and it was also awarded a 75,000 SF Department of Labor lease in Crystal City, Virginia. We don’t yet count these in our ranking stats, but they should further solidify Vornado’s position on this list as those awarded leases become active.

4. UrbanAmerica Advisors
Since 2007 UrbanAmerica has owned a portfolio 14 properties that are primarily leased by GSA. The firm is now moving to dispose of those assets and next year we can expect the contract purchaser, Princeton Holdings to replace UrbanAmerica on this list.

5. NGP V
NGP (formerly National Government Properties) returns again to our ranking based upon their ownership of 40 GSA-leased properties. These properties are owned by NGP’s fifth fund (thus the roman numeral “V” in their name), which has been pretty much completed.  The firm is completing fundraising on its 6th fund, and should be ready to begin buying properties again before the end of this year.

6. LCOR
LCOR makes this list again based on its role as the face of investment group of high net worth individuals that own the 2.4 MSF headquarters of the U.S. Patent and Trademark Office, the largest GSA lease in the United States. Last year, LCOR was also credited with the new 358,000 SF lease-construct project for the Nuclear Regulatory Commission (NRC) in Montgomery County, Maryland. That building has since traded to its equity partner, USAA Realty (see below).

7. Saban Capital Group
Saban Capital is an L.A.-based private investment firm founded by billionaire Haim Saban. Though most of Saban’s investments are in the entertainment, communication and media industries, the firm made its entry into the government property sector in 2010 with the purchase of the Record Realty Trust portfolio. Saban now owns 24 GSA-leased properties.

8. Boston Properties (NYSE: BXP)
Boston Properties owns 20 GSA-leased office buildings, nearly all of them in the Washington, DC area. However, that will soon change. Its largest holding, the 700,000 SF, 3-building Patriots Park project in Reston, Virginia, is under contract to a Korean investor.

9. Space Center, Inc.
Space Center provides underground records storage in facilities carved from underground limestone formations in the Kansas City suburbs. The naturally cool, humidity-controlled environment is perfectly suited to archival storage for agencies such as the National Archives and Records Administration, IRS and the Social Security Administration. These agencies have proven to be stable, long-term tenants, maintaining Space Center’s position on this list.

10. HPI Capital
HPI Capital was #10 on the list last year, and would be again this year had it not been for the sale of a single property: a 153,000 SF NARA records facility in Pittsfield, Massachusetts. The HPI portfolio also features a number of direct agency leases that we do not count in this ranking. Overall, HPI owns 15 government-leased buildings with 1.5 MSF of GSA-leased square feet.

HONORABLE MENTIONS:

USAA Realty
USAA has been a quiet, and dominant investor, in the federal space for years.  The firm has invested equity in several GSA lease-construct projects and now it has purchased several of those outright, along with some other strategic investments. With its acquisition earlier this year of the 358,000 SF Three White Flint, leased to primarily to FDA in North Bethesda, Maryland, USAA is poised to appear in the top 10 ranking next year.

CenterPoint Properties
Centerpoint merits an honorable mention this year due to the delivery of a single, yet remarkable, build-to-suit asset: the National Nuclear Security Administration (NNSA) campus located south of Kansas City. This $750 million, 1.5 MSF facility replaces the the NNSA plant at the Bannister Federal Complex. (see “Greetings From Kansas City”)

Easterly Partners
Easterly Partners is a Washington, DC-based real estate investment firm established solely for the purpose of federal property investment. In just a few years the firm has amassed a portfolio of 15 properties, including three new purchases since we published this list last year. At the rate it is currently underwriting investments, we expect Easterly to crack the list of “top 10″ investors next year.

Elman Investors
One of the earliest dedicated investors of government-leased properties is Lee Elman who has been buying and selling assets leased by federal, state and municipal government tenants for the past two decades. Elman Investors recently closed on their 80th government-leased property. Few investors have been as active over the long run, especially in the past few years.

Updates were made to this article to correct the size of JBG’s and NGP’s holdings and to add the venerable Lee Elman (Elman Investors) to the honorable mentions.