Class Class Class, Tax Tax Tax

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“…but in this world nothing can be said to be certain, except death and taxes.” – Ben Franklin

The Internal Revenue Code (IRC) classifies real estate assets, for federal income tax purposes, based on the owner’s intended use of the property at the time of acquisition. There are currently 4 categories of classification, each with their own unique treatment (and benefits) under federal tax laws:

  1. Property held as a personal residence

    Personal residences are not eligible for cost recovery deductions or 1031 exchanges.

  2. Property held for sale to consumers (dealer property)

    Dealer properties are not eligible for cost recovery deductions, tax deferred (1031) exchanges, or installment sale tax treatment. Gains and losses on sales are considered ordinary business income. Dealer properties can be office, industrial, retail, or land with the common theme being that they real estate is being built or subdivided (land) for the purpose of being sold.

  3. Property held for use in trade or business (Section 1231)

    The real estate asset must be held for more than one year and is eligible for cost recovery deductions. Gains and losses resulting from the sale of such properties are treated separately from those on investments in other property types. The benefit of this particular class is that gains (above the property’s basis) are taxed at the lower capital gains rate while losses can offset the taxpayer’s ordinary income. Section 1231 properties can be exchanged (1031) for other qualifying Section 1231 or Section 1221 assets.

    *Extremely important to note is that one’s trade or business could be “real estate investor.” This means that such properties could be an office building owned and occupied by a company or a retail center being purchased with the intent of a long-term hold as a rental property.

  4. Property held as an investment (capital assets, Section 1221)

    Otherwise known as capital assets, these properties are not eligible for cost recovery deductions but can be exchanged (1031) for other qualifying Section 1221 or Section 1231 assets. An example of such an asset would be vacant land held for appreciation.

 

Vacant Space vs. Available Space vs… Vacant Available Space???

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A square is always a rectangle but a rectangle isn’t always a square. The same concept applies to vacant space and available space. It seems to reason that if a space is vacant is should be available, and one could also argue that available space would also have to be vacant. This is not necessarily true and when you throw vacant available space in the mix, now you have a recipe for confusion.

Every year each municipality’s department of tax administration assesses all the properties within their municipality, both residential and commercial. As of January 1, 2019, the Fairfax County Department of Tax Administration assessed 362,089 separate properties. The goal is to determine each property’s market value within the assessment to sales ratio for the purposes of levying taxes. Residential properties trade much more frequently than commercial properties and are thus easier to assess from a sale comparison standpoint. Furthermore, most residential properties are owner occupied and thus do not have other factors to consider such as market rental, vacancy, and absorption rates. Commercial properties, on the other hand, have a myriad of factors that contribute to a property’s market value and involve complex calculations.

Departments of tax administration consider a number of mitigating factors that can reduce a commercial property’s market value, particularly vacancy. Juxtaposed with residential real estate, commercial properties are mostly income producing and the revenue that a property generates or is cable of generating greatly impacts its market value. Multi-tenant properties can have varying levels of occupancy and, in addition to the lost revenue from space sitting empty, there are costs associated with leasing up the property, i.e. leasing commissions, tenant improvement allowances, etc. The DTA understands this and uses various metrics to arrive at a defensible and logical market value.

So, what metric provides the most accurate measure of the amount of unleased space in a (sub)market? Let’s start by defining the separate terms:

Vacant Space

Vacant space refers to all space not currently occupied by a tenant, regardless of any lease obligation that may be on the space. “Vacancy rate” is the most commonly used term to discuss the ratio of leased space versus unleased space; however, vacant space can be either available or unavailable. A good example would be a space that has been leased but is still undergoing construction and/or has not delivered yet. The space is still vacant but it is not available.

Available Space

The total amount of space that is currently being marketed as available for lease or sale in a given time period. Available space refers to any space that is available but does not specify if the space is vacant, occupied, available for sublease, or available in the future. A tenant could be actively marketing their space for sublease, but is still occupying the space (not vacant), or a property could be under construction or going through a renovation, in which case the landlord could actively market the space for lease; making it both available and vacant.

Now we come to the answer to our answer, which is also the metric used by departments of tax administration when assessing a commercial property in a particular (sub)market:

Vacant Available Space

Space which is currently vacant and is currently being marketed as available space. Because available space can be both vacant or occupied and because vacant space only refers to the occupancy of a space without regard to any lease obligation tied to the space (available or not), the amount of vacant available space is the best and most accurate measure of the amount of unleased space in a specific (sub)market. The more supply of [unleased] space the more competition. This puts downward pressure on rental rates (lowering a property’s potential gross income) and, more relevant to this discussion, it increases the amount of time in which a landlord can expect to lease their property to the submarket’s frictional vacancy, all of which lower a property’s market value (and associated tax bill).

Crystal & Pentagon City Submarkets Q3 2019

Crystal City

  • RBA: 12,100,053 SF
  • Vacancy Rate: 18.4%
  • 12 Month Net Absorption: (122,000 SF)
  • Average Asking Rent: $38.04
  • 12 Month Rent Growth: 2.1%

Crystal City may consider a name change to Amazon City. Amazon’s announcement to locate its HQ2 there did more than breathe new life into the submarket… it raised it from the dead. To provide some perspective vacancies peaked in Q4 2014 at over 25% and remained above 20% until recently. They are now 18.4% and dropping. Just last quarter, Amazon leased a staggering 585,000 SF JBG Smith. Along with companies moving into the submarket to be close to the tech giant, an increase in defense spending should also see more space being leased by the Crystal City’s traditional tenants, federal contractors. As a result, rents have seen consistent quarterly growth, averaging 2.1% in the past 12 months, with average market rate of $38.04/SF. Over 100,000 SF delivered in the past 12 months with another 115,000 SF in the pipeline. Interestingly, this new delivery is not Amazon-related, but rather is for the American Physical Therapy Association. The financial package offered to Amazon by Arlington County was based on Amazon occupying at least 6,000,000 SF of office space by 2024. Demand should continue to outpace supply leading to a continuing decrease in vacancy and increase in rents. The future for Crystal City is so bright is has to wear shades.

Pentagon City

  • RBA: 1,588,349 SF
  • Vacancy Rate: 0%
  • 12 Month Net Absorption: 0 SF
  • Average Asking Rent: $38.75
  • 12 Month Rent Growth: 3.4%

As the name suggests, Pentagon City’s small office market traditionally served defense contractors with most recent development being dominated by multi-family projects. Amazon’s presence will certainly transform the submarket, especially with its recent land purchases at Pen Place and Metropolitan Park, which combined have more than 4,000,000 SF of development potential; however, recent increases in defense spending should have a more immediate impact. Anemic demand has kept rents low in recent years despite low vacancy and while the 3.4% growth in the past 12 months may be seen as an outlier today, it is more likely an indication of things to come as the submarket benefits from the Amazon effect.

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Swing Space

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The term “swing space” refers to temporary office space, generally for the purposes of accommodating a tenant’s space needs while more permanent space is being constructed, renovated, acquired, etc. Situations arise in which companies may experience rapid growth; requiring them to add personnel quicker than their existing space can house them or the tenant can lease additional space. In other cases, a lease has been signed but due to lengthy build out timelines (up to 6 months now in Fairfax County) the tenant may require space before the construction is complete and ready for occupancy.

Most swing space options take the form of executive suite options, which have seen exponential growth in the past decade. Traditional options like Regus and newer, more modern options like WeWork provide tenants with flexible/short-term, turnkey office solutions with shared common areas and amenities. As a result, these companies charge a premium space, and while a godsend in the interim, these options do not make long-term economic sense particularly as space needs grow.

There is another, lesser known form of swing space… and surprise, it’s free! As stated earlier, situations can arise where a tenant’s build out cannot be completed quickly enough to accommodate their occupancy needs. In cases such as these where a lease has been signed, landlords may offer the tenant vacant space in the same building (or within another building in their portfolio in the same submarket) at no cost to the tenant. Leasing from landlords with a large square footage footprint within a particular submarket (either within the same building or portfolio) is a good strategy for tenants concerned with growth during the lease term. The terms and conditions of the lease would apply, particularly insurance requirements, but the tenant is not required to pay base rent until their leased premises are ready for occupancy. These options may come furnished but in many cases are not and in such cases tenants will need to pay moving costs to furnish the swing space and remove the furniture (and reinstall) when their permanent space is available.

Are Condos Good Investments?

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Are condos good investments? It’s a loaded question and responses will vary. Asset class certainly matters. Most people think residential when they hear “condo,” and residential condos are, by far, the most numerous; however, the term “condominium” refers to a type of real estate ownership. Every asset class of commercial real estate can have a condominium ownership structure: office, retail, flex, industrial, and even land.

One of the most widely known and criticized aspect of condo ownership is the existence of monthly condo fees/dues. Condo dues cover the maintenance costs of the common elements of the property which can vary based on asset type, property type, services covered, etc. While condo fees will only increase in time, whether by inflation or mismanagement by the association, they also remove the responsibility of managing and maintaining the property from the owner. That has a value, but that value needs to consistent with the services provided and market conditions for the property to appreciate (not depreciate) in value.

All condominiums have an elected association that administers and enforces the bylaws, which contain conditions, covenants, and restrictions that govern the common ownership of the overall property. One of its duties is to assess and manage the funds derived from the condominium dues. Effective association management is crucial for the success/value of a property and its condominium units. They are responsible for efficiently and cost effectively maintaining the common areas all while keeping adequate reserves for repairs and renovations.

There is a common saying in real estate investing, “You make your money when you buy, not when you sell.” This old adage applies to condo investment as well. Commercial condo sales are much less frequent than residential sales and, thus, values can be difficult to assess using the sales comparable method. A better way to determine value is to apply a market leasing rate for comparable properties to the rentable square footage and then subtract real estate taxes, operating expenses, insurance, and utilities to compute the net operating income for the property. Once you have the NOI, you apply a discount rate based on market and tenant risk factors to calculate the investment value. Condo fees are considered operating expenses and, thus have a direct impact on the property’s NOI and value.

The answer to the question, “are condos good investments,” is “they can be.” Because condominium ownership involves shared control and responsibility, the efficiency and competence of the condo association is of paramount importance. Effective property and asset management on the part of the association have a direct impact on the property’s value. “Buying right” governs all good real estate investments and if the difference between the cost of ownership and net operating income generates an investor’s minimum return, the condo is a good investment.  So, don’t hate on condos. Good investments are not relegated to a specific asset class or ownership structure, they’re based on good financial, market, and investment analysis and an understanding of the implications of the type of ownership structure.

Arlington’s Orange Line Submarkets Q3 2019

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Ballston

  • RBA: 8,037,415 SF
  • Vacancy Rate: 22.4%
  • 12 Month Net Absorption: 148,000 SF
  • Average Asking Rent: $41.40
  • 12 Month Rent Growth: (1.4%)

The big story in Ballston is the National Science Foundation’s move to Alexandria, which led to a 7.47% increase in the submarket’s vacancy rate. Only 10% of the 600,000 SF has been leased. With more than 2 million square feet available and competition from submarkets like Rosslyn and Tysons Corner and Reston, Ballston has seen a steady decline in rent growth over the past 2 years. Still, with a healthy economy, Amazon’s HQ2 announcement, and increased defense spending, Ballston should begin to see submarket fundamentals move in a positive direction.

Virginia Square

  • RBA: 1,651,602 SF
  • Vacancy Rate: 12.0%
  • 12 Month Net Absorption: 20,700 SF
  • Average Asking Rent: $37.79
  • 12 Month Rent Growth: (0.9%)

Clarendon/Courthouse

  • RBA: 6,293,752 SF
  • Vacancy Rate: 15.3%
  • 12 Month Net Absorption: (249,000 SF)
  • Average Asking Rent: $40.60
  • 12 Month Rent Growth: (0.5%)

The Clarendon/Courthouse submarket is more known for its restaurants/bar scene than for its office properties. The submarket not only has to compete with neighboring Ballston and Rosslyn but also with new deliveries in Reston and Tysons Corner. Net absorption over the past 12 months is a staggering (249,000 SF), but this was largely the result of the complete vacancy of 1650 Edgewood St for renovation. This led to a jump in the submarket’s vacancy rate of nearly 3% in just one quarter. Similar to Ballston and Rosslyn, Clarendon/Courthouse has seen negative rent growth over the past 12 months, but with a healthy economy, abundant amenities, and no new deliveries scheduled for the next 12 months, fundamentals should begin to rebound.

Rosslyn

  • RBA: 10,161,789 SF
  • Vacancy Rate: 21.1%
  • 12 Month Net Absorption: 704,000 SF
  • Average Asking Rent: $44.04
  • 12 Month Rent Growth: (0.5%)

Rosslyn has seen a steady improvement in submarket fundamentals since BRAC and sequestration pushed vacancies to a record high of 28% in 2014. At 21.1% vacancy the submarket still has a ways to go, and despite Nestle moving its HQ to 1812 N Moore St along with Deloitte’s expansion plans to lease about 115,000 SF at Waterview Tower, rents have still declined in recent quarters. In fact, other than the I-395 Corridor submarket and Ballston, Rosslyn has the highest vacancy rate in Northern Virginia. Fundamentals have the opportunity to recover as no projects are currently under construction; however, landlords are on the clock to fill the submarket’s approximately 2.5 million square feet with large GSA leases expiring in late 2020 and 2021.

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What are Condos?

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When you think of condos you probably picture a 1-2 bedroom apartment-type property with monthly dues. That is not incorrect, but like every square is a rectangle not every rectangle is a square. Condominium refers to the ownership structure of the real estate.

Condominium (“condo) ownership involves fee simple ownership of individual units of an overall property where common areas are owned in common and paid for through monthly dues. Many definitions focus on residential condo ownership; using operative words such as “dwelling” units. While there are vastly more residential condominiums, each asset class of real estate can be owned in condominium form, even land.

Typically, square footage (percentage of ownership of the overall project) dictates voting rights. For example, if one owner of an industrial condo project owned 51,000 SF of a 100,000 SF project they would have 51% voting rights, which could overrule the other owners combined. Condo fees are also based on percentage ownership and can be expressed in per square foot terms. Because common areas are shared, depending on the asset type, condo units may have a core factor which contributes to discrepancies with County records.

Upon creation, condominiums create bylaws, which contain conditions, covenants, and restrictions that govern the common ownership of the overall property. These bylaws are enforced and administered by an association of elected directors and can include covenants which restrict certain otherwise legal uses. For example, many industrial condos prohibit automotive uses regardless of whether the use is permitted by right under the property’s zoning.

The importance of a competent, effective condominium association cannot be understated. Its stewardship of the funds appropriated from association dues is critical. Condo areas must be upkept while maintaining adequate reserves for repairs or renovations. In addition, it is in the interests of all the owners for condo dues to remain as low as possible.

Reston Submarket Q3 2019

  • RBA: 20,439,919 SF

  • Vacancy Rate: 12.5%

  • 12 Month Net Absorption: (81,500 SF)

  • Average Asking Rent: $33.05

  • 12 Month Rent Growth: 0.3%

Reston is just behind Tysons Corner when it comes to office submarkets in Northern Virginia. The last stop of Phase-1 of the Silver Line is Wiehle Ave; the gateway to Reston. With the 2nd phase delivering in 2020 and the next stop being at Reston Town Center we can expect stable fundamentals despite new supply. As is the case in many submarket in the DC metro area, 3-Star and 1 & 2 Star properties underperform; adversely impacting submarket metrics.

The average asking rate is $33.05/SF, but 4 & 5-Star properties’ average rent is $36.93/SF. While vacancy rates for 3-Star properties is slightly lower, it does not tell the whole story. The higher vacancy in 4 & 5-Star properties is the result of new deliveries and increases in supply. The past quarter saw a 17,883 SF to (11,312 SF) difference in net absorption between the two, and 1,682,457 SF of 4 & 5-Star space is currently under construction to satisfy demand.

Reston is an attractive submarket for many reasons. The Silver Line is number one. Reston Town Center is number two. Proximity to Dulles International Airport is number three. The fourth reason is an extension of the first 3: the number of major tenants such as Oracle, Fannie Mae, Sallie Mae, the Defense Intelligence Agency, etc. which attract other/smaller tenants that benefit from proximity to these economic engines. Reston Hospital may be number six. The healthcare industry is stable and primed for continued growth.

The Silver Line may be numero uno, but Reston Town Center has always been the shining jewel of Reston and commands rents over 20% higher than the rest of the submarket. Boston Properties is the majority owner and made the regrettable and short-sighted decision to begin charging for parking. After law suits from tenants and a decline in overall, retail revenue due to patrons boycotting the center, they changed the policy to allow for 2 free hours of parking, but you have to download their app, which is an obvious data mining ploy. I digress, Reston Town Center is still pretty awesome and with the delivery of the 2nd phase of the Silver Line, it’s going to get even better.

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Business Plan? We Don’t Need No Stinkin’ Business Plan!

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Attention, new businesses! If you want to lease commercial space, you need a business plan. At this point in my career, I don’t even know anymore if I’m more surprised when a new business actually has a business plan or when they don’t. Needless to say, it’s frustrating and alarming how many do not; frustrating because a business plan is table stakes for leasing commercial space and alarming because leases have very real legal and financial ramifications in the case of default. I require a business plan before I represent any new business for 2 seemingly contradictory reasons: self-interest and altruism.

Self-interest

If a new business doesn’t have a business plan a landlord will not consider leasing to them, period. No lease means no commission. When you work on a contingency basis, time is money. Brokers must thus allocate time accordingly to the deals that have the greatest possibility of closing. No business plan equals no deal equals no money equals no time.

If a new business hasn’t invested the time/taken the first step, why should anyone else?

Altruism

As a broker and particularly a CCIM, I hold myself to the highest ethical standards when it comes to representing my clients. I could not in good conscience allow a client to lease space if they are not prepared to do so. As I stated, most landlords will not even consider leasing to a new business if they do not have a business plan; however, even in the case that one would, I could not allow a client to be taken advantage of like that, because that’s what it would be. The only case in which a landlord might consider such a deal would be one in which the tenant had sufficient funds to pay for the tenant improvements, in cash, and personally guarantee the lease. As rare as it would be, this would be a situation where the landlord would not care if the tenant defaulted because they could go after their personal assets.

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The purpose of a business plan is NOT to “check off the box.” Its purpose is to provide a framework for how a business will make money. Its purpose is to protect the business owner from the potential pitfalls associated with the capital expenditure and personal liability inherent in any entrepreneurial venture. Its purpose is to provide a roadmap to success. A business plan is the navigation app to help get you to where you want to go as quickly as possible, all while avoiding traffic, cops, and road hazards.

Half the Rent, Double the Fun

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In my article, Rent Free or Die, I explained how rental abatement in commercial leases typically works and showed the powerful impact it can have on the net effective rent over the lease term. At the end of the day, rental abatement has an economic value and, as a result, can be structured differently based on the tenant or landlord’s situation.

Half rent doubles the length of the reduced rent period. If a tenant is able to negotiate 6 months of rental abatement (on a 6 to 7-year lease, total 78 to 90-month lease), they might consider requesting the abatement be spread out over a year. This provides the tenant with a longer “ramp up” period, which can be particularly useful for retail tenants and/or new businesses. The concept behind leasing commercial space is that it contributes to the business’ ability to generate revenue. By increasing the time in which the tenant enjoys beneficial occupancy of the property, they are increasing the time in which they are able to grow their business and revenue.

Landlords may prefer half rent to full rental abatement because they begin collecting rent day one. Depending on the deal, asset class, etc. landlords may be required to provide sizable tenant improvement allowances to attract tenants. There is always the risk that a tenant will default before the landlord is able to recover their initial investment. Half rent allows landlords to provide the same economic incentives to lease their space while incurring less risk. The time value of money states that a dollar today is worth more than a dollar tomorrow. As a result, the income received during the (half) rental abatement period is more valuable than the income that would be received months later. This money can be reinvested or used to pay down the landlord’s out-of-pocket leasing costs.

Not every deal fits into a neat, little box. Oftentimes the difference between getting a deal done or not is the expertise and creativity of the broker negotiating it. Understanding one’s client’s needs as well as those of the opposite party is crucial in reaching a mutual agreement. If one can identify and address each party’s concerns, constraints, etc., they can effectively mitigate such issues through creative deal structuring and extract the maximum concessions from the other party.