Child Care: The Unappreciated and Undersupplied Amenity

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It seems like nowadays the entire DMV shuts down with even the mention of inclement winter weather conditions. Note that I did not say “snow” because Fairfax County Public Schools has cancelled classes for what amounted to rain on a cold day (when I was growing up it seemed like there would need to be at least 6 inches of snow before we even got a 2-hour delay). This presents many parents with considerable hardship as they must quickly arrange for child care or be forced to stay home and use paid time off.

In such times, the presence of a child care facility in your office building or in close proximity is a highly desirable amenity. Unfortunately, many landlords do not see it this way and are either unwilling or unable to accommodate the need. Here are 3 reasons for the lack of child care facilities within most office buildings/markets:

  1. Image – Many landlords will not even consider leasing space in their office buildings to a tenant who business involves children or child care. One reason is that they feel such a tenant/use would be inconsistent with the professional nature of the building; detracting from its reputation and negatively affecting its ability to attract other tenants. This concern is not entirely unfounded but, in my opinion, this outdated perception can be turned from a negative into a positive through effective marketing which presents the use as an amenity for other building tenants.
  2. Common Area Wear and Tear – Along the same lines is the potentially, adverse impact the use could have on the common areas of the building. There are a number of uses generally seen as undesirable for this reason including testing centers, medical, etc. The common element is the high number of visitors which results in increased wear and tear on the common areas. Coupled with the fact that they do not work in the building on a daily basis can contribute to such visitors being less than considerate in their use of such common areas, bathrooms receiving a disproportionate share of the abuse. Building tenants suffer and, as a result, landlords face the possibility of high tenant turnover, difficulties leasing space, and increased operating expenses and/or capital expenditures.
  3. State and Local Codes – Perhaps the largest reason for the dearth of child care amenities in established office markets is the myriad of regulations and requirements governing the operation of such facilities/businesses set forth by state and local officials. Any use involving children undergoes intense scrutiny and code requirements vary based on number of children, age, etc. Zoning is not as much of an issue as are regulations requiring the presence of outdoor facilities. Many office buildings do not have excess or suitable outdoor space for a play area; an issue that is increasingly prevalent in more urban office environments.

In my opinion, this presents a significant opportunity for landlords to differentiate themselves in our competitive marketplace by supplying an unmet demand. Shrewd and forward-thinking landlords would be wise to examine ways to accommodate child care uses by modifying existing common areas and/or parking lots to create required outdoor facilities. The lack of options for daycare tenants could present landlords with the opportunity to unload space(s) in their buildings that have been historically difficult to lease such as lower level space and/or first floor spaces with poor visibility and/or undesirable views.

The result would be a building that is attractive to both companies and individuals. Landlords could market the child care facility as an amenity; allowing companies to remain productive despite school closings by providing their employees with an “in-house” solution. Employees would enjoy the benefit of increased time with their children and decreased time in traffic by eliminating an additional stop on the way to work in rush hour traffic.

What are your thoughts? Is there a daycare in your building? Do you wish there were? Let me know by commenting below or by email me at Ryan@RealMarkets.com

Crystal/Pentagon City Multi-Family Submarket Overview Q1 2019

220 20th st

Crystal City will be one of the homes of Amazon’s new headquarters, and the some 25,000 high-paying jobs that will follow. Hiring is likely to start this year, and then be spread out over the coming years, but the region as a whole is likely to prosper because of it. The city checked off almost every box: public transportation, airport proximity, abundant office space, an educated work force, and a transforming landscape. Attracted to the city because of access to local and regional talent, Amazon workers are expected to be high-paying technology workers that could help absorb much of the supply in and around the submarket.

The inventory expanded by more than 10% from 2015- 18. These properties leased quickly, causing only brief periods of vacancy expansions. Developers look to positive demographic trends to justify another 3% inventory expansion.

The population has grown more than 20% since 2010, one of the strongest rates in the metro. The live/work/play environment draws wealthy, educated renters to the submarket. Government jobs dominate the area, but there is an emerging technology scene, something that the Washington, D.C. metro as a whole is lacking. High living costs are likely to become even more exacerbated with Amazon’s announcement.

The submarket is one of the most expensive in the metro. Properties compete with Rosslyn and Ballston, as well as closer-in submarkets like Southwest/Navy Yard and H Street/NoMa. And even if renters want to live in an older unit, rents are still high. The spread between 3 Star and 4 & 5 Star rents is 13%.

Rent growth underperformed this cycle, likely because of the rise in vacancies. Most supply-heavy submarkets throughout D.C. suffered similarly. Still, rents grew more than 20% from 2010-18, or about 2.3% annually. There was very little difference between growth in a 3 Star property or a 4 & 5 Star property.

All these factors contributed to what might be most impressive: more than $1.7 billion in sales volume from 2010-18. Nothing traded last year, primarily because a handful of companies own the majority of the assets. This makes buying difficult and costly. But a few notable properties are fielding bids, especially those positioned near the future Amazon campus.

Crystal/Pentagon City Submarket Overview Q1 2019

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Crystal City Submarket Overview Q1 2019

Crystal City, long a focal point for defense-related industries, has become a tech hub overnight. With Amazon’s announcement that it will put half of its second North American headquarters here (portions will also bleed over into Pentagon City and the Potomac Yard area of Alexandria), long-lingering pains from Base Realignment and Closure policies and sequestration have been dulled. Vacancies were above 17% as of 18Q4—roughly twice the 2009 rate and well above the long-term average—but it’s hard to see office demand not heat up over the next several quarters. Even prior to the announcement, leasing showed signs of life—Raytheon alone signed for more than 120,000 SF in 2017.

JBG Smith, the biggest winner on the Virginia side of the HQ2 equation (New York City will get the other half), had already committed to transform Crystal City, and was hoping that its Potomac Yard development would breathe life into the Submarket. The mixed-use redevelopment was not only going to include office but retail and apartment buildings as well. Part of Amazon’s agreement requires Virginia to invest in significant infrastructure improvements that should be a rising tide that lifts other office buildings. The state has re-implemented plans to construct a second entrance to the new Potomac Yard metro station, which recently started construction and is due to open in 2022.

Pentagon City Submarket Overview Q1 2019

Pentagon City’s relatively small office inventory recently took on outsized importance in the marketplace. Amazon’s announcement that half of its second North American headquarters will be at the newly-dubbed “National Landing,” which includes portions of Pentagon City, could mean significant growth in this sector in the near future. The e-commerce giant is planning to purchase several parcels of land from JBG Smith near the Bartlett, one of the area’s newer apartment developments that is also home to a Whole Foods Market, which will provide Amazon with room to expand its office footprint.

Construction in Pentagon City has been nonexistent since 2013, when Monument Realty delivered two build-to-suit offices comprising more than 320,000 SF for Boeing. Recent development here has been dominated by multifamily projects. The Altaire, a 5 Star, 451-unit community, delivered in 2018 on the site of a former 239,000-SF office building demolished in 2016. However, Amazon’s anticipated land purchases at Pen Place and Metropolitan Park in Pentagon City could be a catalyst for change. While not yet confirmed, many anticipate that the company will attempt to rezone the parcels (the land is currently zoned for multifamily) and construct office space.

The lack of construction has kept vacancies in Pentagon City extremely low. Low vacancies haven’t kept rents from suffering, though. While growth this year had topped 3% as of mid-November, the recent increase has been an outlier: The submarket has essentially recorded losses every year since 2012, with a lack of demand weighing on landlords’ abilities to push rents.

In a submarket as stagnant as this one, it’s no surprise that only one sale (which involved two buildings) has recorded in the past 10 years. That year, Boeing purchased the two buildings it now occupies from Atlas Capital Group for $138.7 million ($430.64/SF). However, Amazon will likely have an outsized impact here and could entice investors to take another look at Pentagon City.

Commercial Real Estate 101 – Chapter 7: Use Restrictions

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.

Permitted Use

  • Lease provision identifying the allowed business activities that may be conducted in the leased premises by the tenant. Uses can be general or specific; limiting the types of services and or products that can be offered by the tenant. Must be in conformance with zoning rules and regulations.
  • What’s important – Ensuring that the permitted use complies with zoning rules and regulations and that all tenant’s offered services and/or products are covered under general uses, i.e. general office use or are specifically listed.

Prohibited Use

  • Lease provision identifying uses that are expressly prohibited in the space, building, and/or project. Prohibited uses can range from general to specific and apply to all tenants or specific tenants. Prohibited uses are generally included in leases to prevent nuisances to other tenants, reduction in property value, and/or increases in required levels of insurance.
  • What’s important – Understanding the implications to tenant’s business. If prohibited uses apply to a particular tenant the more specific the language the better.

Exclusive Use

  • Lease provision restricting a particular use to a specific tenant. Most common in retail leases, exclusivity provisions are a concession granted to tenants to protect them from direct competition from other tenants in the building, center, or project by restricting the sale/offering of particular services or products. The limitations can be broad or specific. Retail landlords have an interest in maintaining a diverse tenant mix to attract the maximum number of customers and promote/protect the profitability and viability of their tenants.
  • What’s important – The scope and scale of the exclusivity terms. For the tenant benefiting from the exclusivity provision the broader the restriction the better. Leases may include a list exclusive services or products and/or limit the amount of sales allowed and/or square footage occupied by the particular service or product. Tenants should verify that their use does not conflict with any preexisting exclusivity clauses in other tenants’ leases.

Radius Restrictions

  • Lease provision prohibiting a tenant from operating a similar business operation with in a particular radius of the leased premises. Primarily found in retail leases, their purpose is to protect the landlord from potential, adverse effects of competition on profitability, percentage rent, likelihood of default, etc.
  • What’s important – Limiting the area and timeframe of the restriction. Tenants should include specific language detailing what constitutes a competing/similar business.

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4 Reasons for Using Debt Financing

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Despite all the talk of cap rates, which refer to the return produced by an investment purchased in cash, most commercial real estate investments are financed. Otherwise known as leverage, most investors prefer to finance a portion of an investment based on their risk profile. The more leverage used the greater the amount of debt relative to equity and thus the greater the risk. Here are the 4 reasons why investors are willing to incur such risk by using debt financing:

  1. Perhaps the most obvious reason is that an investor simply may not have enough cash to purchase an investment in its entirety and requires additional funds to acquire the property.
  2. Even in cases where investors have the funds to purchase an investment in cash, they may choose to use debt financing as part of their larger investment strategy. By using leverage they may acquire more properties thus lowering their risk through diversification. For example, if an investor has $1M in cash they may choose to finance the purchase of 4 properties with a loan-to-value (LTV) ratio of 75%; allowing them to purchase $4M of real estate.
  3. If the financial leverage is positive the use of debt financing increases an investment’s expected return on equity (I discuss the different types of leverage in my article 3 Types of Financial Leverage). If the cost of funds is lower than the cap rate, the return on equity will exceed the return on an all cash purchase.
  4. Because the interest on debt is tax deductible financial leverage increases returns by lowering taxable income. The benefits of financial leverage are often magnified when evaluating an investment on an after-tax basis.

For more information or if you have any questions, please contact Ryan Rauner, CCIM at 703-943-7079 and Ryan@RealMarkets.com

“Burn Down” Provisions

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Burn down provisions do not refer to righteous retribution over the loss of one’s favorite red stapler but rather refer to a strategy for lowering a tenant’s security deposit over the term of the lease.

For the majority of low risk tenants, commercial landlords will require the minimum security deposit of one month’s rent. This monthly number is generally based on the amount payable in the first year of the lease term, but some landlords may require that it be the rent payable in the last year of the lease term. In either case, the security deposit is not subject to reduction.

For tenants that present an element of risk beyond a landlord’s acceptable risk profile, an increased security deposit may be required. This generally takes the form of multiple months’ rent but can also be tied to other economic concessions such as tenant improvement allowances or market conditions such as estimated lease up time. Whatever the reason, an increased security deposit can present tenants with significant financial hardships which may make the deal untenable.

Burn down provisions provide a way for tenants to get back some of that increased security deposit over the term of the lease. Typically they are structured such that, if the tenant is not in default (beyond applicable notice and cure periods, an important distinction), the landlord will return a portion of the security deposit after a certain period of time. This amount can be all at once or staggered over time until the security deposit is reduced to one month’s rent.

For example, a tenant desires to enter into a 5-year lease from a landlord who, after reviewing the tenant’s financials, will require a 3-month security deposit to mitigate their risk. The tenant, not wanting to have that cash tied up for the entire term of the lease, can try to negotiate a burn down provision so that on the first anniversary of the lease commencement date the landlord will return a portion of the security deposit in the amount of 2 months’ rent. The landlord may push back and modify the terms so that only one month’s rent is returned on the 1st anniversary of the lease commencement date and the additional month on the 2nd anniversary of the lease commencement date.

Due to the time value of money, the tenant will want as much of the security deposit refunded as quickly as possible while the landlord will want to hold onto as much of the money as possible for the longest period of time. As always it’s recommended to seek the advice of an experienced commercial broker who understands both the tenant’s and landlord’s needs and can thus structure terms that satisfy both.

For more information or if you have any questions, please contact Ryan Rauner, CCIM at 703-943-7079 and Ryan@RealMarkets.com

Rosslyn-Ballston Corridor Overview Q1 2019

Rosslyn, Virginia skyline

Ballston Submarket Overview

Ballston has historically been able to attract tenants in various industries, ranging from government and major public companies to smaller firms because of its highly accessible regional location. But a spate of recent tenant relocations has driven negative absorption and rising vacancy. Consequently, rent growth was minimal from 2012–17, with losses in three of those six years, and losses have continued this year. After a long pause in construction, Shooshan Co. broke ground on 4040 Wilson Blvd. in early 2018, a project that will include a mix of office, residential, and retail. Investors have maintained an interest in Ballston, and while volume has declined since 2015, Two Liberty Center sold in November 2017 for more than $72 million.

Clarendon/Courthouse Submarket Overview

Wedged between Rosslyn and the Ballston and Virginia Square Submarkets, Clarendon/Courthouse is more often thought of as residential area than a business center. However, the submarket has more than 6 million SF of inventory and is home to a host of government tenants and contractors. The submarket has two Metro stops along the central stretch of the Rosslyn-Ballston Corridor, and a heavier concentration of retail and residential uses than Rosslyn and Ballston.

Fundamentals suffered significantly in 2015, with several notable tenant move-outs sending vacancies above 15% and causing rents to decline. Demand has rebounded since, though, and vacancies are now back below the metro average. The drop in vacancies allowed rents to recover slightly from 2016–17, but consistent, meaningful gains are elusive here, as demonstrated by the drop in rents through the first three quarters of 2018. Office deliveries have been relatively muted here—with the exception of a 175,000-SF property that completed this year, the last deliveries were in 2014. As of early 18Q4, there were no projects under construction. Sales were strong in Clarendon/Courthouse from 2014–15, with more than $200 million in sales each year. Volume dropped for several years after, but rebounded in 2018—as of early October, volume was at about $164 million.

Rosslyn Submarket Overview

BRAC, sequestration, and Arlington County’s reluctance to offer competitive incentives to potential employers contributed to the massively negative absorption in the early and middle years of this cycle, as well as to the persistently high vacancy today. But Nestlé’s move into Monday Properties’ 1812 North Moore St., which brought 750 jobs to the submarket, was a huge win. It also put a dent in vacancy, which has decreased steadily since peaking in 2014. And in April 2018, Deloitte announced expansion plans, taking 115,000 SF at Waterview Tower, space formerly occupied by CEB.

The submarkets high vacancy rate still weighs on rents, which have struggled to find meaningful growth since the early years of the cycle. Despite these woes, investors haven’t backed out of Rosslyn, still finding appeal in the submarket’s Metro accessibility and proximity to an educated workforce. Volume surpassed $702 million in 2017—nearly twice the two previous years’ total. While sales this year are not on pace to match those in 2017, they’ve still been solid; as of early October, volume was at $350 million, though it was the result of just a couple of transaction.

North Arlington/East Falls Church

Virginia Square

Rosslyn-Ballston Corridor Multi-Family Overview Q1 2019

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Ballston

Ballston is still shaking off a two-year slowdown. Negative absorption and new deliveries caused vacancy expansion, which slowed rent growth. This vacancy volatility is due to the submarket’s small apartment inventory. Lease up in recently delivered projects suggests demand will absorb new units. Developers continue to build, which poses potential risk. Rent growth was slow to recover earlier this year, but at the start of 18Q4, continues to trend upward. Investors are paying attention, as two sales last quarter went for top dollar. One deal posted a 4.4% cap rate.

Rosslyn

New supply this cycle is trying to change the submarket’s reputation for being a place of work (and hardly that, as about one-quarter of its office space is vacant), rather than living or entertainment. Rosslyn’s high-end apartment inventory grew by 25% since 2010; Nestle relocated to Rosslyn last year, bringing 750 jobs, which helped spur demand; and an additional 3% of the current inventory was under construction at the end of 2018. Rent growth outperformed this cycle, despite elevated office vacancies and new supply. Tight historical occupancies and above-average rent growth have caught the attention of investors: Since 2010, more than $1 billion has changed hands.

Commercial Real Estate 101 – Chapter 6: Landlord 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.

Termination

  • Lease provision giving landlord the right to terminate a tenant’s leasehold interest in a property. Landlord termination options can be an independent lease provision and/or a right reserved by the landlord pursuant to tenant’s default, damage by fire/casualty, condemnation, taking by eminent domain, etc.
  • What’s important – Understanding what conditions trigger a landlord’s right to terminate the lease and the timeframes associated with each.

Relocation

  • Lease provision giving landlord the right to relocate a tenant within the floor, building, or project. Most leases contain relocation provisions as a way for landlords to accommodate larger tenants and/or existing tenants’ growth.
  • What’s important – Relocation rights solely benefit the landlord. Moving costs are generally covered by the landlord; however, amounts of coverage can vary greatly. Tenants can negotiate additional moving cost concessions such as landlord paying for new business cards, marketing materials, etc. There are costs to the tenant associated with relocation that extend beyond monetary considerations ranging from mere inconvenience to decreased visibility in the case of retail space. Tenants will want to negotiate the maximum amount of time for notice and actual relocation. Crucially important is the description of what constitutes comparable space. Points of negotiation can include: same number of windowed offices, same floor or higher, elevator lobby exposure, same visibility within a retail center, same square footage or greater, etc. In the case that the square footage is increased as a result of relocation, tenants should try and negotiate no increase in rent and/or prorata share.

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3 Types of Financial Leverage

Real estate

Financial leverage refers to the use of borrowed funds to acquire an investment.  There are a number of reasons to use debt financing to purchase real estate but for the purposes of this discussion I will focus on the impact that leverage can have on before-tax and after-tax returns.

The 3 types of leverage are:

  1. Positive or favorable leverage
  2. Neutral leverage, and
  3. Negative or unfavorable leverage

Positive leverage is when the costs of funds is lower than the expected return on an investment. Neutral leverage is when the cost of funds is equal an investment’s expected return. Negative leverage, therefore, is when the costs of funds exceeds the expected return. When leverage is positive/favorable investors will use debt financing to acquire an asset because, if projections are accurate, the leveraged return will exceed the unleveraged return.

There is risk involved with using debt financing. Risk increases with leverage and, therefore, so does an investor’s expected return on equity to offset that risk. Because investment performance is based on projections an investor’s actual return may be less than expected in which case the use of leverage can have dramatic impacts.

The examples below show how both positive and negative leverage can affect an investment’s return compared to the unleveraged yield.

  • Purchase Price: $1,000,000
  • Cap rate: 6%
  • Net Operating Income (NOI): $60,000/year (constant over holding period)
  • Holding Period: 5 years
  • Sales Price: $1,000,000

Unleveraged

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The unleveraged return is for this investment is 6%.

Positive leverage

  • Cost of Funds: 5% (interest only)
  • Loan to Value: 75%

positive lev irr

The return when using favorable leverage increases to 9%.

Negative Leverage

  • Cost of Funds: 7% (interest only)
  • Loan to Value: 75%

negative lev irr

The return when using unfavorable leverage drops to 3%.