Long-Term Leased Investment Properties Are Becoming More Scarce

It is a well-accepted fact that the federal leased space market is shrinking. This is troublesome, yet for investors the real question has been whether the shrinking inventory has also made investment opportunities more scarce. The answer, unfortunately, is yes.

The graph above shows the total number of buildings at each point in time over the past decade that: 1) had at least 15,000 RSF of GSA-leased space; 2) were at least 85% leased by the federal government, and; 3) had more than 10 years of remaining lease term (without regard for cancelation rights). This analysis focuses only on the GSA-leased portion of the federal portfolio, but we believe this is a valid representation of the federally leased property sector on the whole.

We found that the overall number of these “long-term” GSA-leased buildings has been declining for more than three years. In January 2013, an investor looking for the types of properties described above would find 222 buildings in the U.S. At July of this year, that number has dropped to 169 buildings.

In large part, the selection of prime federal investment properties is dwindling due to the fact that GSA is now very rarely engaging in new lease-construct (i.e. build-to-suit) projects. Lease-constructs yield the longest leases, typically 15 to 20 years, whereas leases in existing buildings are generally capped at 15 years, and more likely at 10.

Budgetary austerity is the driving influence in federal real estate, and GSA, as a matter of policy, has substantially slowed its pursuit of new construction. So, as the lease terms on lease-construct properties burn off, there are few new projects to replenish the supply. The effect of this is apparent in the graph above. The reduction in the number of long-term leased investment properties has been fueled entirely by the dwindling number of lease-constructs. Based upon the paltry number of new buildings under construction currently, it’s easy to project that long-term leased properties will become even more scarce.

None of this suggests, however, that GSA doesn’t have need for long-term leases. It does, and it will, especially as agencies attempt to reduce their footprint by improving space utilization. Increasing utilization generally requires substantial workplace reconfiguration–and that requires tenant improvement capital, something that is only available from lessors in exchange for long-term leases. In fact, the number of long-term leases in existing (non build-to-suit) buildings has increased. This is clear if we take the graph above and reverse the stacking.

What does it all mean?

The chief reason to invest in GSA-leased properties is to harness the underlying United States of America credit. Yet, that credit isn’t worth much unless coupled with substantial lease term. This explains the allure of lease-construct projects. They are attractive to investors because they typically have longer leases and those contracts are more often non-cancelable, a feature that is otherwise uncommon among the rank-and-file GSA leases. Another reason lease-constructs are so important is that they are purpose-built buildings, often with mission-critical features. It is widely assumed that lease-construct properties benefit from higher renewal probability.

With lease-constructs growing scarce, traditional credit-driven investors are being nudged out of their comfort zone. The growing scarcity of long-term leased buildings has served to substantially compress cap rates for that tranche of product, making them far more expensive than they were just a few years ago. Further, the declining number of these buildings has made it difficult to stay true to an investment strategy focused solely on such assets.

Increasingly, investors are now searching for good buys with high renewal probabilities, even if they have shorter remaining lease terms currently. These properties are also more plentiful. For example, investors willing to purchase buildings with at least seven years of lease term remaining will find that there are twice as many as those with ten years.

The reduced availability of long-term leased investments is wringing passive investors out of the market and favoring those that understand how to properly assess renewal probability. It is also making it more difficult for new investors to enter the sector because their capital generally requires them to acquire a base of long-term, stabilized assets before exploring “riskier” territory.

On the whole, this is producing consolidation of ownership among a relative few, experienced investors. But even those investors will have to adapt to this evolving market, at least for a while.