Northeast & Southeast DC Multi-Family Submarkets Q4 2018

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Anacostia Southeast Multi-Family Submarket Overview

Anacostia/Southeast is a renter-by-necessity submarket with low vacancy due to the high proportion of renters (70%), stock skewed toward 3 Star or lower-rated properties, and a dearth of market-rate construction. Average rents are among the cheapest in the D.C. metro, and gentrification in eastern D.C. neighborhoods is pushing residents into Anacostia/Southeast. Rent growth averaged about 2.5% from 2013–17, and thanks to key redevelopment projects, investors whose buildings are in the path of revitalization could benefit. Local apartment investors are on a buying spree, hoping that the area could be the next H Street, Shaw, or Petworth. In 2017, the number of sales was one of the metro’s highest, but low pricing resulted in below average volume. Ongoing redevelopment projects include proposals for more than 2,000 apartment units. The most notable development underway is the Skyland Town Center. The project broke ground in late 2016 and should deliver later this year.

Branch Avenue Multi-Family Submarket Overview

Accessibility to employment centers and affordable rents drove a decline in vacancies during 2015 and 2016. But weak demand concentrated in 4 & 5 Star properties in the first half of 2017 forced vacancy to expand last year. Even though Branch Avenue has one of the lowest median home prices in the metro ($200,000), about six in 10 households rent. The submarket’s low median household income and below-average rents kept apartment development muted earlier this cycle.

A major transit-oriented project delivered within walking distance of the Branch Avenue Metro Station and another is on the way. Investment volume was strong for several years. Value-add opportunities drove the $250 million in sales recorded last year.

Brightwood Fort Totten Multi-Family Overview

The submarket’s size provides opportunities for a number of different investors and developers. New, high-end apartments are opening close to D.C.’s emerging neighborhoods (U Street, Shaw, and NoMa). Whereas the older, established properties in Brightwood saw steady rent growth and an uptick in investments. The submarket is serviced by four Metro stations, which allowed developers to build transit-oriented development. For this reason, performance across the submarket is location-specific.

Lower Northeast Multi-Family Submarket Overview

The population in Lower Northeast has grown by 18% since 2010, making it one of the 10 fastest-growing submarkets in the metro. Much of the growth has come from lower-income renters priced out of neighborhoods like Columbia Heights and Shaw who are moving to the submarket for its affordability. Douglas Development’s 15Q3 delivery of the Hecht Warehouse at Ivy City elevated vacancy, but stable demand helped it recover quickly. But vacancy is still worth keeping an eye on, given that it has generally expanded since cyclical lows set in mid-2015 and will face additional pressure since several projects are under construction. Land and redevelopment opportunities have been trading at a much lower price per SF of allowable FAR in Lower Northeast than in other submarkets in D.C., reflective of low rents, with typical transactions trading at cap rates near 7%.

Commercial Real Estate: Inflation Protection

Commercial real estate should be a part of any well diversified investment portfolio, but particularly during inflationary periods. Here are four reasons why commercial real estate is an excellent hedge against inflation:

  1. Most commercial leases include annual rental escalations. These escalations can be a set amount or can explicitly be tied to inflation indexes such as the Consumer Price Index (CPI).
  2. Even without annual rental increases, rental rates are subject to adjustment/renegotiation at the expiration of the lease term. In most cases, rental rates will have increased to meet inflation.
  3. Expenses to operate the property (CAM, taxes, insurance, etc.) are generally passed along to tenants. Therefore, owners are not directly affected by the inflationary increases in these costs.
  4. Higher construction costs resulting from inflation reduce commercial development allowing demand to catch up to supply thus leading to an increase in market rents.

The ability of commercial rents to keep pace with inflation coupled with protections against increases in expenses associated with ownership allow net operating income (NOI) to increase in an inflationary environment. As new development stagnates and the market moves closer to equilibrium, there is also downward pressure on acquisition cap rates which further increases property values.

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Why Landlords Don’t Like Reserved Parking

Most properties provide parking for tenants, visitors, and/or customers at certain ratio. This parking ratio, generally expressed as parking space per thousand square feet, is calculated by dividing the total number of parking spaces by the rentable building area. For example, a 100,000 square foot office building with 360 parking spaces has a 3.6/1,000 parking ratio. Minimum ratio requirements are determined by a number of factors including property type, proximity to public transportation, etc. Tenants are allotted a certain number of parking spaces based on the building’s parking ratio. For example, a tenant that occupies 8,000 square feet in a building with a 3.2/1,000 parking ratio would be entitled to 25.6 parking spaces (usually rounded up).

If tenants have a right to a specific number of parking spaces based on the amount of space they occupy, why are landlords often reluctant to provide reserved spaces? The reason is that reserved spaces effectively lower a building’s parking ratio and can negatively impact other tenants, visitors, and/or customers.

When a space is reserved only the person/tenant for whom it is reserved can park there. While this is obvious and the point of reserving spaces it does not tell the entire story. What happens when the tenant is home sick, out of town, etc.? Otherwise perfectly good parking spaces are sit unused/wasted. The landlord runs the risk of creating a situation in which they cannot accommodate additional tenants, visitors, and/or customers even though they have empty parking spaces. You may have experienced this phenomenon and the resulting frustration firsthand, if you’ve ever driven past reserved space after reserved space, level after level as you look for parking in a building parking garage.

As a result, landlords will typically only reserve spaces for highly desirable tenants; those that are taking substantial square footage, national/credit tenants, etc. Even in these situations landlords will limit the number of reserved spaces to a fraction of the amount allotted to the tenant per the building’s parking ratio. In office properties this amenity is typically reserved for executives or officers of the company while in retail they are for the benefit of customers with employee parking areas being located far from or behind the leased premises.

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Georgetown-Uptown Submarkets Q4 2018

Georgetown-Uptown Submarket Cluster

Georgetown Submarket Overview

Stable demand and a dearth of supply helped vacancies decline for years, bringing them well below the metro average. After peaking at about 12% after the recession, they are now in the single digits. But weakening demand over the past year and a half has led to a slight uptick in vacancies. The last delivery here was in 2006, and no projects are under construction. In addition to a lack of developable land, the Historic Preservation Review Board and local Advisory Neighborhood Commissions make building in the Georgetown Submarket difficult.

Nonetheless, rent growth has slowed recently and was negative through the first three quarters of 2018. A handful of buildings in the heart of the submarket generally trade here each year. At about $68 million, volume in 2017 was roughly a third of that in 2016. But sales skyrocketed this year, almost entirely due to one transaction—Global Holdings Group’s $415 million purchase of Washington Harbour, a 561,000-SF, mixed-use building on the Georgetown waterfront.

Uptown Submarket Overview

The vast majority of office space in the Uptown Submarket is in its southeastern portion, near Dupont Circle, Logan Circle, and Adams Morgan. In fact, the area bounded by Rock Creek Park, Irving Street NW, North Capital Street, and P Street NW contains about 40% of the submarket’s stock.

Demand has been relatively flat, but because of a lack of supply, vacancies have remained well below the metro average over the course of the cycle, despite a significant tenant move-out in 2014 that spiked vacancies considerably. Rent growth has slowed since 2014, and rents had declined this year as of mid- October. This has kept office rents in Uptown below those in neighboring D.C. submarkets like Georgetown, West End, CBD, and East End. Nonetheless, sales took off in 2016, reaching $280 million due in large part to the sale of Fannie Mae’s headquarters. Volume in 2017 was much lower—at just over $100 million, it was well below the average of the past few years. Sales this year seem on pace to drop again, with just over $50 million recorded as of mid-October.

Georgetown-Uptown Multi-Family Submarkets Q4 2018

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Adams Morgan/Columbia Heights Submarket Overview

There are many neighborhoods that can claim to be among D.C.’s most popular, but the Adams Morgan/Columbia Heights submarket boasts a few. Adams Morgan, U Street, Columbia Heights, Mount Pleasant, and Petworth comprise the submarket. While these are older, established submarkets, U Street and Columbia Heights prove that transformation is underway.

The submarket’s inventory expanded by 14% since 2010. U Street is the main beneficiary, delivering more than 1,000 units since 2010. That, combined with retail development, has U Street emerging as a renter’s favorite. But they’ll have to pay the price, as rents in these properties average $3.90/SF.

Rents average $2,000/month, but new supply commands a significant premium. The handful of projects that delivered in Adams Morgan since 2010 average more than $4.10/SF, on par with new deliveries in DuPont, Shaw, H Street, and the Navy Yard. The Hepburn is one of the most recent examples. The project delivered in August 2016, with asking rents averaging $4.80/SF. The project reached full occupancy in five quarters while offering minimal concessions. This premium goes for the other neighborhoods as well.

Columbia Heights and Mount Pleasant average $3.60/SF for new deliveries. Petworth, the most recent emerging neighborhood in the northern part of the submarket, has new deliveries averaging $2.70/SF, about 10% above the neighborhood average.

The submarket has one of the tightest vacancy rates, impressive when considering the amount of new supply. Brief periods of vacancy expansion did occur when new projects delivered, but they were quick to stabilize. It appears the submarket is reaching a new normal. The historical vacancy is about 6.5%. With new demographics and consistent demand trends, it appears the new average could be closer to 5%. The pipeline should remain full in the coming years as developers take advantage of this growing demographic shift, but it could come at the cost of elevated rent growth.

The submarket’s cyclical rent growth is its one blemish. Cumulative growth since 2010 reached 20%, or about 2.5% per year. The majority of that growth was frontloaded in the earlier years of the cycle, when a substantial wave of demand led to occupancy increases. The recent vacancy volatility led to just an average of 2.2% annual gains over the past three years. Most of the positive rent growth was from 1 & 2 Star and 3 Star properties. They make up the bulk of the inventory, and as rents get more expensive at the top-end, many renters look to more affordable options. The spread between a 3 Star and 4 & 5 Star property is large, so owners in these properties still have room to grow. But this slow growth did little to deter investors.

Cyclical volume ranked the submarket in the top 10 at more than $1.5 billion. The majority of those sales came from 4 & 5 Star properties in the early years of the cycle. Sales have been trending down since the peak in 2014, but this year demonstrated that there is still interest when opportunities arise. The Ellington sold for $118 million, and The  Elysium Fourteen sold for $43 million this year, both located near U Street.

Connecticut Ave Northwest Submarket Overview

Historically, the Connecticut Avenue/Northwest Submarket has some of the steadiest apartment fundamentals in the D.C. metro, and despite several jumps in vacancy over the past few years, levels have recovered and are below the metro average. Rent growth has been weak for several years but has shown signs of life so far this year. A rebound in growth could continue since new projects continue to be held up by local neighborhood commissions and lengthy approval processes.

Population growth here lags behind the metro average, and the demographic story is weak compared with those of neighborhoods like Petworth, Shaw, Columbia Heights, or H Street/NoMa. But the submarket could appeal to investors seeking supply-constrained areas skewed to 3 Star inventory that offer value-add opportunities. Plus, the submarket’s ease of access to D.C.’s largest job centers, paired with strong job growth in the region over the past year, bodes well for long-term demand and makes this one of the steadier submarkets in the region.

Georgetown/Wisconsin Ave Submarket Overview

The submarket’s status as one of D.C.’s most desirable submarkets persists, but more from a homeowner’s perception, not a young renter’s. Renters searching for brand new apartments in a vibrant neighborhood that provides nightlife and entertainment typically go to other submarkets, rather than Georgetown/Wisconsin. Demand over the past couple years has been lacking as renters migrate east to hot neighborhoods like H Street/NoMa and Southwest/Navy Yard.

Several projects delivered in recent years, but not anywhere near as much as other areas of the District, largely because the Historic Preservation Review Board (HPRB) and local Advisory Neighborhood Commissions (ANCs) make building in Georgetown/Wisconsin Avenue difficult. Also contributing to the lack of development is the historically low rent growth. Rents in a good year have grown at about inflationary levels, keeping wouldbe developers in other areas of the metro as a means to achieve better yields. This has kept the submarket’s inventory predominately older with few units. The purchase of the Adams-Mason House demonstrates just that: The property was built in 1812 and has just 8 units but sold for more than $530,000/unit.

Commercial Real Estate 101 – Chapter 5: Tenant Options

A lease abstract is a document that summarizes specific, key information from a lease agreement. Leases can be lengthy documents with confusing legalese. Lease abstracts allow users to easily reference and review fundamental lease terms to ensure that both the tenant and landlord are in compliance with applicable obligations, timeframes, etc.

This series will go through a typical lease abstract and explain the various terms and what is important for a tenant to understand.

Tenant Options

Renewal

  • Lease provision detailing tenant’s right to renew the lease at the expiration of the initial lease term. Renewal rights solely benefit the tenant. Can be multiple renewal options.
  • What’s important – Timeframes for giving notice of a tenant’s election to exercise their renewal option. The shorter the timeframe the better for tenant. The method for determining the rental rate for the renewal term can be the then market rate, greater of the then market rate or current escalated rent, or lesser of the then market rate or current escalated rent. Other important terms include annual escalation for renewal term, base year reset, etc.

Expansion

  • Lease provision detailing tenant’s right to expand within the initial lease term or any renewal terms. Expansion rights can include the floor, building, or within the landlord’s portfolio.
  • What’s important – Most landlords will do their best to accommodate a growing tenant; making most expansion options somewhat of a formality. However, expansion options can include provisions allowing the tenant to terminate the lease if the landlord cannot accommodate their growth.

Right of First Offer

  • Lease provision which requires the landlord to offer space to tenant before offering the same to the general public. Tenant has the ability to lease the proffered space first, but landlord retains the right to reject the terms.
  • What’s important – Terms specifying which spaces are covered by the ROFO. The right can be relegated to spaces that are adjacent to the premises or can extend to different floors or even other buildings in the landlord’s portfolio. Details governing the terms that will be deemed acceptable to landlord, timeframe for tenant to exercise its right, and number of times ROFO applies.

Right of First Refusal

  • Lease provision which gives tenant the right to review all other offers on a particular space/property before landlord can lease the space to a third party. Tenant must simply match the highest and best offer.
  • What’s important – This right benefits the tenant more than a simple ROFO by encumbering a space/property. Details governing which spaces/properties are covered by the ROFR, timeframes for tenant to exercise its right, and number of times ROFR applies.

Termination

  • Lease provision which gives tenant the right to terminate the lease.
  • What’s important – Conditions and timeframes under which tenant can exercise its right. Termination rights can stand-alone and be based on landlord’s inability to accommodate tenant’s growth, a timeframe, i.e. after 3 years, etc. or be a condition of landlord default.

Purchase

  • Lease provision giving tenant the right to purchase the premises/property.
  • What’s important – Terms and conditions of the purchase including time, price, etc. Terms primarily benefit the tenant by setting limits on the landlord/owner. Purchase options can dictate the sales price at a future date which means that owners cannot charge more even if the market price is higher at that future date; however, tenants may be able to negotiate a lower purchase price if market prices are lower.

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What Are Pass-Throughs?

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In commercial real estate leases the costs of ownership are generally passed through to the tenant in one form or another depending on the rental structure of the lease. These costs of ownership include operating expenses otherwise known as common area maintenance (CAM), real estate taxes, and insurance. Utilities can be included under operating expenses in full service (gross) leases, but are generally paid directly by the tenant in net leases.

So, what does this mean in practice? Basically, when landlords agree to a specific rental rate they are doing so with certain protections that ensure that they will continue to receive that minimum base amount plus annual escalations.

Because the costs of ownership are charged directly to the tenant (independent of the base rent) in net leases, pass-throughs (for the purposes of this conversation) are generally only applicable in full service or gross leases.

In full service leases, the costs of ownership are included in the base annual rent. The expenses in the first year of occupancy set the baseline for the remainder of the term (referred to as Base Year expenses). If these expenses increase in subsequent years the tenant is required to pay the amount of said increase based on their proportionate share of the building or center. While increases in expenses are shown as dollar amounts on a landlord’s balance sheet they are expressed in per square foot terms for the tenant. For example, if costs of ownership for a 10,000 sf building increase from $100,000 to $110,000 (an increase of $10,000) the amount charged to the tenant is expressed as an additional $1.00/sf/yr.

While tenants are always responsible for increases in pass-throughs they do not necessarily get to benefit from a reduction in the costs of ownership. If the base year expenses were $8.00/sf/yr and they decrease to $7.50/SF/yr in year 2 the tenant will simply not be charged any additional rent as opposed to enjoying a $0.50/sf/yr credit. Tenants can try and negotiate such terms but landlords are generally not amenable to such a concession.

Another means of taking advantage of decreases in expenses is by negotiating pass-throughs being charged on a cumulative basis. For example, if the base year expenses were $5.00/sf/yr for CAM, $1.50/sf/yr for real estate taxes, and $0.50/sf/yr for insurance they equal $8.00/sf/yr on a cumulative basis. Many landlords will prefer to charge the tenant for these expenses separately though so that they can benefit from any increases to one expense despite decreases in another. For example, if CAM charges increased by $0.50/sf/yr to $5.50/SF/yr but real estate taxes decreased by $0.50/sf/yr to $1.00/SF/yr the landlord would be able to charge the tenant an additional $0.50/sf/yr for CAM even though the overall expenses stayed the same at $8.00/sf/yr. By negotiating pass-throughs being charged on a cumulative basis the tenant would not be charged anything because the total charges saw a net zero increase.

Depending on the length of a lease term, the spread between a property’s base year expenses and those at the end of the lease term can be significant and have quite an impact on the effective rental rate. There are methods to mitigate this exposure and it is always a good practice to request a history of a property’s expenses to get an idea of how well the building is managed, how much expenses might increase in subsequent years, etc.

As always, when negotiating lease terms it’s recommended to seek the advice of a commercial real estate professional. For more information, questions, or representation services please contact Ryan Rauner at ryan@realtymarkets.com or 703-943-7079.

Annual Escalations: What’s Market?

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One of the reasons that real estate is such a great investment is that it offers inflation protection in the form of annual escalations to the base rent over the term of the lease. Increases in the costs of ownership, i.e. operating expenses, real estate taxes, etc. are also passed along to the tenant (discussed in greater detail in What Are Pass-throughs?).

Tenants must consider the impact of annual escalations when making leasing decisions. For example, if a tenant thinks that market rates will not increase (on a percentage basis) by more than the rental escalation they may prefer a shorter lease term (5 years vs. 10 years) with renewal options so that they can renegotiate their rent to the then market rate at the expiration of their initial lease term.

So, when it comes to annual rental escalations, what’s market? The most commonly used escalation is 3%.

Rent escalations, like most terms, are subject to negotiation. For leases with smaller square footages and/or lower rental rates the impact of the annual escalation is minimal. In the case of larger spaces with high rental rates though, negotiating a lower escalator can result in significant savings over the lease term.

Annual escalations can be negotiated to lower rates, i.e. 2% or can be tied to an index like the CPI. In requesting the escalation be tied to an index the tenant is making a gamble that the index will increase by less than the initially proposed amount, which may not be the case.

In other cases, tenants may be able to negotiate a stepped rental schedule and/or no escalations for a set number of years. In the case of a stepped rental schedule, a tenant may negotiate a below market rate at the beginning of the lease term that will increase by a higher percentage annually or by set amounts in subsequent years for the purposes of keeping their rental obligations artificially low as they business grows. Another possibility is to negotiate no increases for a set number of years with the rent escalating at the end of that time by a predetermined amount. That predetermined amount could simply be the market escalation, i.e. 3% annually or compounded over the years in which there were no escalations. For example, if the market escalation is typically 3% a tenant could negotiate no increases over the first 5 years of the lease with the rent escalating by 15% at the beginning of year 6.

Finally, another less used option would be to average the rent over the term of the lease and negotiate a fixed rent over the term. The landlord would realize benefits on the front end of the lease with the tenant benefiting on the back end. For example, if a tenant is leasing space for 5 years with a base rent of $20.00/sf/yr with 3% annual escalations the rent would be $22.51/sf/yr in year 5. The average rent, however, would be $21.24/sf/yr. In year 1 of the lease the tenant would be paying $1.24/sf/yr more but in year 5 would be paying $1.27/sf/yr less. While uncommon, this structure provides consistency on a tenant’s balance sheet.

As always, when negotiating lease terms it’s recommended to seek the advice of a commercial real estate professional. For more information, questions, or representation services please contact Ryan Rauner at ryan@realtymarkets.com or 703-943-7079.

But I Don’t Want to Personally Guarantee the Lease!

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I get it. You’re not alone. No one wants to sign a personal guaranty. No one wants the anxiety of knowing that their personal assets are on the line. The unfortunate reality is that landlords will sometimes require a personal guaranty as a precondition to leasing space to the tenant.

But why me? Personal guaranty requirements were not always as common as they are today; having increased markedly since the recession in 2008. Most new businesses are required to personally secure the lease because they lack a leasing history and/or multiple years of financials. Landlords may also require some type of personal guaranty from a tenant that is requesting tenant improvements that are costly and/or potentially unusable by subsequent tenants. Basically, landlords are accounting for their perceived risk in leasing to a particular tenant and the losses they may incur as a result thereof.

If landlords are really just interested in mitigating their risk, what other options are available to a tenant that doesn’t want to sign a personal guaranty?

I’ve had clients/tenants propose paying a certain number of months’ rent up front, even offering up to a year’s rent in advance, but terms such as these are not as appealing to landlords as one may think nor are they necessarily advantageous to the tenant. A tenant’s ignorance of the present value of money shows a lack of financial sophistication and planning which is vital in running a viable business. They are presenting themselves as a greater risk by proposing such terms. The tenant is also tying up capital that might be more effectively deployed to grow the business.

Another potential option in lieu of a personal guaranty is an increased security deposit. Nearly all commercial leases require the tenant to deposit some amount with the landlord at lease signing to secure its obligations under the lease (including but not limited to rent, repairs to damage made by tenant, etc.). Security deposits are typically measured in “months of rent” with the minimum amount generally being one month’s rent; however, landlords may require more based on the riskiness of the tenant. For a security deposit to be accepted in place of a personal guaranty the amount would need to be significant. This option presents the same issue as the previous example. Capital could and should be used to grow the business. Additionally, security deposits are typically held by the landlord for the entire lease term and are not applied towards rent.

Perhaps the best option is to try to limit the amount of the guaranty and/or negotiate a time limit after which the guaranty expires. The default amount of a personal guaranty is the entire lease value, but tenants can attempt to limit the amount to a certain number of months’ rent, the tenant improvement allowance, etc. They can also request that certain costs be excluded from the amount such as CAM. Another way to mitigate the exposure of a personal guaranty is to limit how long it applies. For example, a tenant signs a 5-year lease with a personal guaranty that will expire on the 3rd anniversary of the lease or rent commencement date (after 3 years); barring any tenant defaults.

Personal guarantees can be scary but may also be required. Tenants can and should push back, but at the end of the day what’s most important is that the individual(s) signing the lease fully understand(s) their financial commitments and exposure.