Dulles Corridor Office Q2 2019

Route 28 North Submarket (Dulles/Sterling)

  • RBA: 10,345,907 SF
  • Vacancy Rate: 15.8%
  • 12 Month Net Absorption: (1,700 SF)
  • Average Asking Rent: $26.59
  • 12 Month Rent Growth: 2.4%

The Route 28 North submarket is better known as an industrial submarket. Limited demand for office space here has kept vacancies around 15-17% for the past 2 years; however, positive net absorption coupled with no new deliveries should continue to compress vacancy rates. Despite relatively high vacancy, this submarket has seen rent growth of over 2% for the past 2 years, which ranks it among the highest in the DC metro area. Still, asking rents are affordable when compared to neighboring submarkets. It will be interesting to see the impact of the completion of the Silver Line whose last 3 stops are located in the Route 28 North submarket. If new deliveries do not outpace increased demand we should expect to see further compression a vacancy rates with rent growth keeping pace.

Route 28 South Submarket (Chantilly/Centreville)

  • RBA: 14,342,299 SF
  • Vacancy Rate: 14.8%
  • 12 Month Net Absorption: 363,000 SF
  • Average Asking Rent: $28.20
  • 12 Month Rent Growth: 2.2%

Route 7 Submarket (Ashburn)

  • RBA: 4,738,247 SF
  • Vacancy Rate: 7.5%
  • 12 Month Net Absorption: 2,500 SF
  • Average Asking Rent: $27.65
  • 12 Month Rent Growth: 1.0%

Dulles Corridor Industrial Q2 2019

Route 28 North Submarket (Dulles/Sterling)

  • RBA: 34,922,418 SF
  • Vacancy Rate: 3.6%
  • 12 Month Net Absorption: 2,400,000 SF
  • Average Asking Rent: $12.56
  • 12 Month Rent Growth: 4.0%

The Route 28 North industrial submarket is truly remarkable. With nearly 35 million square feet of industrial space (over 3 times the office inventory), Route 28 North is the largest industrial market in the DC metro area. Vacancy rates are at an astonishing 3.6% and even with 3.4 million square feet under construction at the end of 2018 demand should continue to keep pace with supply. In fact, there is around 7 times more construction underway than the next busiest submarket, a trend that is driven mainly by the area being home to Data Center Alley. Rent growth hit an astonishing 4% in the past 12 months and with Amazon and Google’s continued growth and need for server space, we can expect Route 28 North to continue to prosper.

Route 28 South Submarket (Chantilly/Centreville)

  • RBA: 11,727,092 SF
  • Vacancy Rate: 9.4%
  • 12 Month Net Absorption: 125,000 SF
  • Average Asking Rent: $12.82
  • 12 Month Rent Growth: 4.0%

How Percentage Rent Works


As covered in my article, What is Percentage Rent?, percentage rent is additional rent paid to the landlord which is based on a percentage of gross sales; the key term being “gross” sales. This concept appears relatively straightforward, but in practice its calculation and application require a deeper level of analysis that is unique to each business/tenant. In order to effectively negotiate and benefit from percentage rent, tenants must understand how it works in practice.

Gross sales do not mean gross profits (far from it). Profit is the difference between a business’ gross sales and their operating expenses, which include but are not limited to rent, costs of goods, salaries/payroll, etc. As a result, a business’ expense-to-sales ratio is the most important metric to understand and consider when negotiating percentage rent. A business that generates $1M in gross sales with an expense-to-sales ratio of 70% nets $300k/year in profit. For every dollar of sales the tenant makes $0.30. More on this later…

The amount of gross sales after which percentage rent applies is called the breakpoint. There are 2 ways of determining the breakpoint: naturally and artificially. The natural breakpoint is calculated by dividing the amount of percentage rent (as a percent) by the base annual rent. For example, if landlord and tenant agree to 8% percentage rent with a base rent of $20/SF/yr and 1,000 SF the natural breakpoint is $250,000 in gross sales ($20/SF/yr x 1,000 SF = $20,000/year / 8%). There is an inverse relationship between the amount of percentage rent and the natural breakpoint; meaning the higher the percent the lower the breakpoint. As a result, it stands to reason that the higher percentage rent a tenant is willing to pay the lower base rent the landlord should be willing to accept. The lower the breakpoint the sooner the landlord can offset and exceed any discrepancy between the base rent and market rent.

Artificial breakpoints are just that; artificial. Landlord and tenant simply agree to an amount of gross sales after which percentage rent applies. Artificial breakpoints are more for the benefit of the tenant because they can structure the terms based on their own projections and guarantee a minimum level of profit before having to share a percentage of said profits. This ties directly into the importance of expense-to-sales ratios because the percentage of shared profits is significantly higher than the percentage rent paid on gross sales.

Using the previous example of a business with a 70% expense-to-sales ratio we can calculate the actual cost of percentage rent. If the tenant agrees to pay 6% on gross sales above the natural breakpoint of $1M and generates $1.1M they will owe the landlord $6k in additional rent ($100k x 6% = $6k). On its face, 6% may not seem like much, but when applied in the context of the expense-to-sales ratio this amount is magnified. The tenant’s profit is 30% of the additional $100k in gross sales or $30k. Percentage rent is based on gross sales not profit so instead of netting $30k the tenant is only taking home $24k ($30k – $6k = $24k). This makes the true impact of the percentage rent 20% ($6k / $30k = 20%).

This is not to say that percentage rent is always negative. On the contrary, it can be an extremely useful tool in customizing lease terms to fit a tenant’s specific needs and business model. The percentage, breakpoint, and base rent can all be negotiated until a deal is reached that benefits both landlord and tenant. For tenants it is crucial to understand their expense-to-sales ratio  so that they can negotiate terms that minimize their fixed expenses (rent) all while maintaining a minimum level of gross profit.

Losing Money to Make Money

When is it okay to lose money to make money? Hmmm… depends on how much, I guess. How about this: When is it okay to break even? Now we’re talking.

If a landlord can rent a property for 3 years at $12/sf per year but must spend $30/sf for build out and the cost of ownership is $2/sf per year, should they do it? The answer is: it depends.

  • $12/sf x 3 years = $36/SF
  • $36/SF – $30/SF = $6/SF
  • $6/SF – $6/SF [$2/sf x 3 years] = $0/SF

Based on these simple calculations the landlord nets nothing; making it seem like the deal is not worth doing. Real estate investment is not simple though and requires complex and detailed analysis to guide decision making from acquisition to disposition. An understanding of the overarching principles that guide such decisions is crucial for successful investing because they can turn nothing ($0) into something. This is the foundation of asset management.

Here are some of the factors to consider when making a decision that, at first glance, appears to result in a loss or, at best, a net zero:

Tax law

Do you know how much you can deduct from your taxable income based on cost recovery/depreciation on improvements? Are you aware of the 20% deduction straight off the top as a result of the new tax code? What’s the difference between a repair and an improvement as it relates to the time period over which the costs can be deducted?


Financial leverage allows investors to do more by using someone else’s money. While there is always risk involved, financing has the power to increase returns by lowering taxable income through the mortgage interest deduction and amortization of loan points as well as through positive leverage (the greater the spread between the cost of funds and the asset’s return the greater the increase).

Business structure

When are losses good? Answer, when they offset profits elsewhere and can reduce that taxable income for an overall gain. Do you know how to structure your real estate holdings so that you can keep more money from profitable assets while investing in and/or taking losses in others?

Market conditions

I could make at least 10 other bullets if I parsed this out. Here’s the basic concept… if you can buy a property below market, great. If you can buy a property at a good price (market or below) and add value that will produce disproportionate returns, BINGO. You don’t invest in a dog of a property… you invest in a property that has upside potential. There’s a difference.


The tenant is leasing space… the landlord is investing in them. There are the tangibles like financial statements and leasing history that should guide decision making. That being said… when I was working at Lehman Brothers… (just kidding). Landlords MUST make decisions based on a comprehensive risk analysis. The good part is in the upside. I’m sure Microsoft’s financials looked questionable at some point (we all know Apple’s did). The point is that people enter into contracts and we will never get away from the intangible elements that make us trust someone or want to take a chance on them. You do what you can to mitigate your losses, but when you make a good bet and it pays off, everyone wins.

Repositioning/Investing for the Future

Not all acquisitions are class A properties. Oftentimes, the foundation of a good deal is acquiring a property that can benefit from capital improvements and at a price that reflects such a need. Through such repositioning, investors are able to raise rents and attract higher quality tenants, thereby increasing the asset’s market value. Some investors may choose to perform capital improvements prior to leasing the property, but such a large capital outlay may not be an option for everyone.

It is my position that the best course of action is to aggressively lease up the property by listing it at slightly below market rents but only agreeing to short lease terms, i.e. 3 years and agreeing to renewal options at the then market rate. This applies primarily to office space and landlords should only agree to expenditures on improvements that can easily be reused by subsequent tenants. This strategy allows landlords to offset the costs of the necessary capital improvements to reposition the asset within a short timeframe.

Therefore, that “ZERO” from the previous example isn’t actually zero simply based on write-offs, alone. The question is then not “when is it okay to lose money?” but rather “is this a good investment?” Will my actions/decisions/investments yield positive results/returns over the projected holding period? If the answer is “yes,” you do it.

Prince William County Submarkets Q2 2019

Route 29/I-66 Corridor

  • RBA: 3,276,672 SF
  • Vacancy Rate: 9.4%
  • 12 Month Net Absorption: (14,000 SF)
  • Average Asking Rent: $26.33
  • 12 Month Rent Growth: 1.1%

The Route 29/I-66 Corridor, better known as Gainesville and Haymarket, is an interesting submarket. Housing prices have forced development westward and, as a result, this submarket is poised for significant growth and appreciation. Whether due to I-66’s notorious traffic or greater demand further north in areas like South Riding and Ashburn, Gainesville and Haymarket have yet to see significant commercial development. The submarket’s vacancy rate is well below the metro average; however, rent growth has not seen a proportionate rise as a result. It’s yet to be seen if a lack of demand is, indeed, the cause or if a lack of appropriate supply forces tenants to look at other submarkets.

Manassas Submarket

  • RBA: 2,635,011 SF
  • Vacancy Rate: 4.4%
  • 12 Month Net Absorption: (58,300 SF)
  • Average Asking Rent: $21.38
  • 12 Month Rent Growth: 0.8%

Manassas is a large market from a geographic standpoint, technically stretching from Yorkshire to Quantico, but the total inventory is small at just over 2.6 million square feet, the majority of which is concentrated in the northern portion of the submarket, and over half of which is comprised of 1 & 2 Star properties. The vacancy rate is well below the metro average and has been for some time. This is due to Manassas being one of the most affordable submarkets in the DC metro area. Despite the low demand for space in the submarket, it’s low supply and lack of deliveries is another reason for its low vacancy. Manassas is home to one of the areas larger industrial submarkets, which dwarves its office inventory at 6,679,401 SF.

manassas submarket map.png

How “Gross Up” Provisions Benefit Landlords/Owners


In commercial leasing, certain provisions generally are to the benefit of either the tenant or the landlord (rarely both). Gross up provisions are one of the few exceptions as they serve the interests of both parties. In my article, How “Gross Up” Provisions Benefit Tenants, I explained how they prevent large increases in passthroughs caused by rises in occupancy levels and the associated growth in operating expenses. Tenants have an incentive for their base year expenses to be as high as possible to lower the likelihood of any increases in subsequent lease years, but how does it benefit a landlord to artificially inflate their expenses?

There are many risks associated with commercial real estate investing/ownership (outlined in my article Risky Business: Factors to Consider When Investing in Commercial Real Estate), but perhaps the most dangerous is the unknown. Investors cannot create accurate projections with incomplete information, and if owners/landlords do not account for all the costs of ownership the assumptions under which they purchase assets will be wrong; leading to overpaying, lower than expected returns, etc.

Rental rates are driven by the market. The difference between the market rate and the costs of ownership is the landlord’s profit. The higher the expenses the lower the profit margin. If landlords want to maximize their profit while remaining competitive in the market (all things being equal), they are incentivized to keep their expenses as low as possible. If that’s the case, it again begs the question of why it benefits landlords to overstate/gross up their expenses.

One reason is the principle of erring on the side of safety. When analyzing whether or not to purchase an asset and at what price, investors must calculate the property’s potential net operating income (how much money they will make after expenses based on market rents and projected occupancy levels). The expenses, associated with tenancy, increase much quicker than market rents. If the market rate is $30/SF/yr and at 50% occupancy the costs of occupancy are $10/SF/yr ($4/SF/yr in variable operating expenses) but are $14/SF/yr at 100% occupancy ($8/SF/yr in variable operating expenses; indicating an additional $4/SF.yr), an investor would base their acquisition decisions on a net profit of $12/SF/yr NOT $16/SF/yr. The net operating income a property can generate over the holding period is the foundation of an investment decision.

Another reason is that landlords do not want to develop a bad reputation within the market. Landlords charge tenants for increases in operating expenses over the amount set in their base year. If landlords to not make allowances for increases in expenses that are a direct result of increased occupancy, they will be “overcharging” their existing tenants by making them absorb the costs brought about by the occupancy of new tenants. Ignorance is no excuse here and landlords that force their tenants to deal with the ramifications of their own negligence will not have tenants for long.

Finally, gross up provisions help landlords from a straight economic standpoint. To best illustrate this point, I present the following example:

Tenant A occupies 10,000 SF in a 100,000 SF building. Their proportionate share is 10%. The building at full occupancy has $500,000 in expenses that are passed through to the tenants. Therefore, Tenant A is responsible for $50,000 in expenses. The remaining tenants in the building are responsible for the remaining $450,000 (90% x $500,000 = $450,000). The landlord is responsible for $0 in expenses because the building is fully occupied.

If Tenant A still occupies 10,000 SF in the building, but the building is now only 50% occupied and expenses are thus only $250,000, the math changes substantially. Tenant A still only has a 10% proportionate share of the expenses. Based on the new expenses they pay only $25,000. The remaining tenants comprise 40% of the building and thus pay only $100,000 (40% x $250,000 = $100,000). This leaves the landlord with a bill of $125,000 (50% x $250,000 = $125,000). Had the landlord grossed up their expenses to account for the vacancy they could have included those costs in the asking rent charged to the tenants in their base year; owing little to nothing because they would have made allowances for increases attributed to leasing activity.

Gross up provisions help landlords stabilize projections of net operating income by already adding in the cost of increased expenses. When costs are already considered the additional revenue from increased occupancy directly adds to the bottom line.

How “Gross Up” Provisions Benefit Tenants


Gross up provisions serve to mitigate the adverse impact of fluctuations in operating costs to the benefit of both landlords and tenants. It may seem counterintuitive that artificially inflating operating expenses is in the best interest of the tenant, but in this article I will show why tenants should ensure that gross up provisions are always included in their full service leases.

In full service leases, all the costs of occupancy are included in the quoted rental rate. Operating expenses (including janitorial, trash removal, utilities, etc.), real estate taxes, and insurance are all covered under base rent. Tenants are only responsible for increases in the costs of ownership above amount set in their first year of occupancy (base year). If tenants do not have gross up provisions in their leases they are at risk of significant increases in their rental obligation as buildings move from vacancy to full occupancy. The example below illustrates this point:

A tenant signs a new lease in a building that is 50% occupied without a gross up provision. The rent is $20/SF/yr which includes $6/SF/yr in costs of ownership with $2/SF/yr of that attributable to variable operating expenses. The tenant pays $20/SF/yr, the landlord nets $14/SF/yr, and the tenant’s base year expenses/costs of ownership are $6/SF/yr.

For the sake of simplicity, we will assume that there are no annual increases in the base rental rate. In year 2 the building is leased up to full occupancy. As a result of the increased number of tenants, variable operating expenses increase by $2/SF/yr to $4/SF/yr ($8/SF/yr total). Simply as a consequence of the building leasing up, a factor outside the tenant’s control, the cost of ownership has doubled. The tenant will be charged an additional $2/SF/yr as additional rent; resulting in a 10% increase in their rental obligation. That’s a big jump from a percentage standpoint and a potentially huge jump in actual rent depending on the tenant’s square footage.

Gross up provisions account for such increases in variable expenses, which are the result of increased occupancy. Landlords will still need to be competitive in terms of market rates, so tenants are still paying $20/SF/yr while eliminating the risk of absorbing the additional costs associated with leasing activity. In fact, tenants have an incentive for the expenses in their base year to be as high as possible because in most commercial leases landlords will not provide rental credits for any decreases in expenses in subsequent lease years.

What are “Gross Up” Provisions?


Whether it’s a full service (gross) or triple net lease, the costs of occupancy are always “passed through” to the tenant. The costs of occupancy include operating expenses, real estate taxes, and insurance (in full service leases operating expenses include janitorial, trash removal, utilities, etc.). These expenses are divided amongst tenants based on their proportionate share, which is the ratio of their rentable square feet to the total rentable square footage of the building.

A tenant that occupies 2,500 SF in a 100,000 SF building therefore has a proportionate (pro rata) share of 2.5%. If the costs of occupancy are $200,000 per year, that tenant will be responsible for paying $5,000 of that amount either directly in a triple net lease or as part of their overall rent in a full service lease. As covered in my previous article, What are Pass-Throughs?, tenants with full service leases are only charged for increases in the costs of occupancy over their base year.

Example: If rent in the first year of a full service lease is $20/SF/yr with costs of ownership of $8/SF/yr, the tenant is paying $20/SF/yr with the landlord netting $12/SF/yr in profit. If those costs of ownership increase to $8.50/SF/yr in year 2, the tenant will be charged an additional $0.50/SF/yr as additional rent.

These expenses can increase or decrease from year to year due to various factors such as adding building amenities, increasing/decreasing building square footage, increasing efficiency of building systems or contracts, etc. The factor with the greatest impact on such expenses though is vacancy. In theory, a building that is 50% leased will have half the expenses as a fully leased building.

Gross up provisions are terms in commercial leases that call for the overstatement (or “grossing up”) of building operating expenses to a level that would be incurred if the building were fully leased. Only variable building expenses are subject to “gross up.” Building insurance is not affected by occupancy levels and while real estate taxes are not generally included, they can be impacted by a property’s occupancy (when assessed using the income approach). Interestingly, gross up provisions do not typically call for an overstatement based on 100% occupancy (90-95% is common).

Gross up provisions serve to mitigate the adverse impact of fluctuations in operating costs to the benefit of both landlords and tenants.

Alexandria’s Submarkets Q2 2019

Old Town Alexandria

  • RBA: 10,275,321 SF
  • Vacancy Rate: 11.7%
  • 12 Month Net Absorption: (60,500 SF)
  • Average Asking Rent: $33.36
  • 12 Month Rent Growth: 2.5%

As its name denote, Old Town Alexandria is old. Over 77% of its inventory comprised of 1, 2, and 3-Star properties. The effects of the Great Recession coupled with a lack of space has resulted in no new deliveries since 2010. Due to the historic nature of the submarket’s core most new construction has taken place farther west near the King Street Metro station. The good news for the submarket is that this lack of new supply has helped vacancy rates decline since a peak in 2011 and remain well below the metro average.

Old Town has historically suffered from weak demand; resulting in negative net absorption for the past 4 years and anemic rent growth. Rents are now only slightly above prerecession levels and are the lowest of any Virginia submarket with both metro access and proximity to DC. The submarket may be one of the many “boats” lifted by the rising tide of Amazon’s HQ2; however, due to its lack of 4 & 5-Star properties that appeal to the types of companies that would benefit from close proximity to the tech giant, Old Town will most likely continue to lose tenants to surrounding submarkets despite its affordability.

I-395 Corridor

  • RBA: 11,148,336 SF
  • Vacancy Rate: 24.5%
  • 12 Month Net Absorption: 22,700 SF
  • Average Asking Rent: $30.33
  • 12 Month Rent Growth: 3.3%

Eisenhower Ave Corridor

  • RBA: 4,881,426 SF
  • Vacancy Rate: 8.8%
  • 12 Month Net Absorption: 43,000 SF
  • Average Asking Rent: $35.60
  • 12 Month Rent Growth: 3.4%

What is Percentage Rent?


Percentage rent is a simple enough concept. It is additional rent paid (over the base rent) based on a percentage of gross sales.

Percentage rent is a common lease term for shopping centers and other multi-tenant retail properties. Tenants benefit from the overall draw of the shopping center and their various neighboring tenants. Retail landlords, moreso than any other real estate asset class, must pay special attention to their tenant mix. They do not want a Subway next to a Potbelly next to a Firehouse Subs. Through efficient and effective management of a center, landlords reduce competition amongst tenants thus increasing their likelihood of success and profitability. Percentage rent allows landlords to share in the profits they helped generate.

Percentage rent is generally charged on an annual basis and only applies after gross sales reach a certain amount. This amount is called the “breakpoint” and can be either artificial or natural. If the breakpoint is not met the tenant does not have to pay any percentage rent. An artificial breakpoint is simply a dollar amount (gross sales) agreed upon by the landlord and tenant after which percentage rent kicks in. The natural breakpoint is determined by dividing the annual base rent by the percentage rent. For example:

  • Base Annual Rent: $100,000
  • Percentage Rent: 5%
  • Natural Breakpoint: $2,000,000 ($100,000 / 5%)

If the tenant has sales under $2,000,000 they pay no percentage rent; however, if they have gross sales of $2,200,000 the tenant would be required to pay $10,000 of additional/percentage rent ($2,200,000 – $2,000,000 = $200,000 x 5% = $10,000).

As stated previously, percentage rent is simply enough to understand; however, when negotiating specific terms governing the amount, breakpoint, etc. things can get complicated and require an in depth analysis and understanding of a particular tenant’s business.

I will cover percentage rent in greater depth in subsequent articles, but in the meantime, if you have any questions please contact me, Ryan Rauner, CCIM at Ryan@RealMarkets.com or 703.943.7079.