HVAC stands for heating, ventilation and air conditioning (HVAC) and refers to the different systems, machines and technologies used to provide heating and cooling in and for commercial properties. The party responsible for a property’s HVAC system (tenant vs. landlord) is intrinsically linked to the tenant’s use, and the lease structure, full-service gross vs. triple net, which defines those responsibilities is a byproduct of that use. The vast majority of office leases, especially multi-floor office buildings with internal common areas/amenities, are structured as full-service gross leases where all costs of ownership (NNNs – real estate taxes, operating expenses/CAM, insurance) and occupancy (utilities and cleaning) are included in the base rent. Landlords are responsible for HVAC maintenance, repairs, and replacement along with maintaining a comfortable temperature levels. Landlords are willing to assume this responsibility because office tenants, regardless of their business, have little difference in their consumption of building resources/utilities. Therefore, landlords can estimate and include these costs in their proforma and accurately calculate their net revenue. In addition, landlords can “pass through” any increases in those costs over the initial year of tenancy to the tenant and most leases also contain provisions allowing the landlord to submeter a tenant’s space and charge them directly for utilities if it is determined that their use exceeds normal office use.

Retail, flex, and industrial properties, on the other hand, are structured as triple net leases. In addition to the base rent, tenants must pay their proportionate share of real estate taxes, operating expenses/CAM, and insurance along with utilities and cleaning for the leased premises. Particularly with respect to utilities, this is because of the uniqueness of each tenant’s use and their consumption needs to support their business operations. The same industrial project may have as tenants both a granite fabricator and a storage & distribution center. The granite fabricator will use significantly more water and power than the storage & distribution center; making an accurate allocation of utility charges an administrative nightmare. Of all commercial property types, retail projects contain the most diverse mix of tenants and uses, which presents the same challenge. Flex properties are a mix of office and warehouse; however, the proportion of office and warehouse can differ from project to project and even within spaces within the same project. Even for tenants within the same industry, the amount of office versus warehouse (conditioned vs. unconditioned space) will directly impact their consumption of utilities. For this reason, landlords treat each space/tenant as a self-contained unit and as such each will have their own HVAC unit(s)/system of which they are at least partially responsible.

In a typical (landlord-sided) lease, the tenant is responsible for maintenance, repair, AND replacement of the HVAC unit(s)/system. The HVAC system is and remains the property of the landlord even after the tenant’s occupancy/lease has ended. As a result, tenants may inherit an HVAC system along with any preexisting issues and/or deferred maintenance. Tenants should always inspect and/or request information on the existing HVAC unit(s) prior to signing the lease agreement. While HVAC responsibilities in triple net leases generally fall on the tenant, like most things in life and commercial real estate, they are subject to negotiation.

Maintenance

In nearly all cases, tenants are responsible for maintenance of the HVAC unit(s) servicing the leased premises. Lease agreements generally require tenants to contract with a licensed HVAC contractor to perform regular system maintenance (quarterly or biannually). The landlord may require the tenant to provide copies of the maintenance reports detailing the condition of unit. HVAC maintenance contracts include:

• Inspecting and Changing Filters
• Visual Inspection of the Entire System
• Cleaning and Removing Debris
• Checking the Condensate Drain
• Checking the Thermostat Settings
• Checking the Electrical Connections and Voltage
• Lubricating Moving Parts
• Inspecting Exhaust Outlets
• Checking Fuel Lines and Connections
• Checking the Refrigerant Levels

Repair

Despite regular maintenance, the HVAC unit(s) servicing the leased premises may require repairs over the term of the lease. Depending on the issue and/or age of the unit, repairs can be costly. As a result, tenants may request the landlord be responsible for repairs, especially if the unit is old and nearing the end of its useful life thus increasing the likelihood repairs will be needed. At the very least, tenants can negotiate a cap on repairs with the amount tied to the age/condition of the unit along with the tenant’s negotiating leverage. Tenants can also request that any existing warranties be transferred to tenant or request the landlord warranty the unit(s), themselves. Regardless, any damage caused by tenant or required repairs resulting from tenant’s negligence or actions will be the sole responsibility of the tenant.

Replacement

Due to the cost associated with replacing an HVAC unit/system, landlords want to place the responsibility on the tenant and vice versa with the age and condition of the existing unit(s) playing the primary role in the negotiations. The fact that the HVAC system is/remains the property of the landlord, the issue of replacement is a particularly contentious one for tenants. If a tenant is inheriting a unit at the end or nearing the end of its useful life, they should either request the landlord install new units prior to occupancy or require the landlord be responsible for replacements during the initial lease term. If the landlord is unwilling to agree to such terms and the tenant is responsible for replacement of the existing HVAC system, the tenant should request any warranties be transferred and that the landlord covenant that the system servicing the leased premises is in good, working order at the time of lease commencement. A case can be made that with regular maintenance and repairs as needed, a system in good, working order should not require replacement over the initial lease term or other agreed upon time period (for longer lease terms, i.e. 10 years). Landlords may be willing to warrant the unit for a reasonable period, i.e. 5 years, after which the tenant would be responsible for replacing the unit as required. Another solution to mitigate the tenant’s cost to replace the HVAC system (especially towards the end of the lease term) is to negotiate a proration of the cost of the new unit over its useful life. For example, if the cost of a new, $6,000 unit has a useful life of 15 years the tenant’s costs would be limited to $400/year of term remaining.

The Tax Cuts and Jobs Act of 2018 will likely have a huge impact on how both landlords and tenants approach the issue of HVAC replacement. Prior to its passage, HVAC replacement was viewed as a capital expense and thus subject to depreciation over a 39-year period. The new/current tax law treats replacement of an HVAC system (up to $2,500,000) as a business expense that may be deducted that same year (capped at $1,000,000/year). The value and timeliness of this change cannot be understated, as R22 (Freon), the industry standard refrigerant for many years, will be completely phased out by January 1, 2020.

On August 26, 1987, the United States signed the Montreal Protocol (on Substances that Deplete the Ozone Layer), an international treaty whose purpose was to protect the ozone layer by creating a timeline to “phaseout” the production of numerous substances responsible for ozone depletion. In response, the Clean Air Act of 1963 was amended in 1990; establishing new EPA regulations to phase out both the production and import of ozone-depleting substances (ODS) based on the schedule set forth by the Montreal Protocol. Ozone-depleting substances are divided into Class I and Class II categories with Class I substances, primarily comprised of chlorofluorocarbons (CFCs) which have higher ozone-depletion potential, already being 100% phased out in 2005. Class II substances, known as hydrochlorofluorocarbons (HCFCs) and originally used as transitional substitutes for Class I substances, are now being phased out.

Why it Matters

R22, otherwise known as Freon, is classified as a HCFC, HCFC-22 to be exact. For years this was the industry standard for air conditioning units; however, as of January 1, 2020 R22 will no longer be produced or imported in the United States. Therefore, starting in 2020 it will be increasingly difficult and expensive to obtain R22. Manufacturers have been switching over to the replacement coolant, R410a, for years; however, the older the unit the greater likelihood that it uses R22. Property owners and tenants responsible for HVAC maintenance, repair, and/or replacement as part of their lease should inspect their units to determine the type of coolant used. If it is determined that R22 is the coolant used, owners/tenants have 3 options:

Keep the Existing Unit/System

Depending on the age of the unit, owners/tenants may elect to keep the existing system. If well maintained it may continue to run for months or years. This does present a significant risk, as system failures during a heatwave coupled with the declining supply of R22 could result in extended downtime while units are being serviced or replaced. This is particularly relevant for commercial owners/tenants whose revenue is dependent on the habitability of their space and then again based on the property type, use, etc. Owners of multi-tenant office buildings must maintain comfortable temperature levels as part of their tenants’ right to quiet enjoyment. Failure to replace outdated HVAC units that results in untenantable conditions in the building could result in rent losses for the landlord. The impact of a system failure could be even more catastrophic for retailers, particularly restaurants, whose income is directly tied to being open for business and who have certain days/times in which the majority of their revenue is generated, i.e. weekends/evenings.

R22 can still be used to service existing HVAC units and technicians/contractors should recover and reclaim R22 from existing units to maintain adequate supply.

Retrofit the Existing Unit/System

Some units may be able to be converted to use approved refrigerants such as R410a; the operative word being “may.” Some units cannot be retrofitted, and in other cases, the process may be cost prohibitive. Additionally, depending on the condition of the unit, it may be difficult to find a technician that is willing and able to perform the work. Owners/tenants should confirm with their equipment supplier can be retrofitted to use an ozone-friendly, SNAP-approved (Significant New Alternatives Policy) refrigerant, that all system components are compatible with the new refrigerant, and that it will not void their warranty.

Replace the Existing Unit

While the cost of replacing an HVAC unit/system with a new one can be costly, there are tax credits for some residential HVAC systems and deductions for energy savings for commercial buildings. For principal residences and secondary homes, geothermal heat pumps are eligible for a 30% credit if placed in service by December 31, 2019 (26% if by December 31, 2020 and 22% by December 31, 2021). The Tax Cuts and Jobs Act of 2018 (26 U.S. Code § Section 179) provides a major tax break to commercial property owners/tenants that replace/invest in commercial HVAC equipment. Previously viewed as a capital improvement and therefore depreciable over 39 years, the new law allows owners/tenants to deduct up to $1,000,000 per year for purchases of new and used HVAC equipment. The Section 179 deduction is reduced, dollar for dollar, for investments exceeding $2,500,000. Owners/tenants should always consult a licensed tax accountant to ensure compliance with current tax laws.

On November 13, 2018, a date which will live in infamy, Amazon announced that it would locate its HQ2 in Crystal City. There are a number of analogies that one could use to describe Amazon’s announcement to locate its HQ2 in Crystal City: white knight, life preserver to a drowning man, etc. but on that date the submarket’s fundamentals did a complete 180; turning it into one of the hottest submarket in the DC metro area, if not the entire country. I always “knew” Amazon would choose somewhere in the DC metro area, specifically Loudoun County due to its reputation as Data Center Alley; however, the choice of National Landing (Crystal & Pentagon City) is not surprising for a number of reasons.

Arlington is the most educated county in the nation with neighboring Alexandria, Fairfax, Loudoun, and Montgomery Counties coming in at #2, 5, 7, and 8 respectively. In terms of wealth (median income), Arlington ranks 5^th [again] with neighboring Loudoun County, Fairfax County, City of Falls Church, and City of Fairfax coming in at #1, 2, 4, and 10 respectively. Reagan National Airport is located within the Crystal City submarket and both Crystal City and Pentagon City have metro stations; connecting National Landing to both the nation and region. Recent development at the Wharf and Navy Yard have shifted demand in DC to the Southwest and Capitol Riverfront submarkets, which are across the river from National Landing. Previously mentioned, neighboring Loudoun County, is home to the largest concentration of data centers in the world with over 70% of the world’s internet traffic flowing through its Data Center Alley. Amazon’s subsidiary Amazon Web Services currently leases hundreds of thousands of square feet of data center space with no end in sight to its expansion plans/needs.

Another compelling, but relatively unknown, factor in Amazon’s decision was the fact that JBG Smith owns 5,9920,88 SF of the submarket’s 11,195,025 SF (53.5%). This allowed the company to negotiate with one lease with one landlord to fulfill its space needs. Consistent with Amazon’s service offering, this efficient approach lowered costs and streamlined the expansion process.

Finally, Jeff Bezos has a home in Washington, DC and owns the Washington Post. Amazon’s disruption of the retail market has been met significant backlash with talks of breaking up the company under anti-trust laws. As a result, Amazon and Bezos have a vested interest in establishing close ties with lawmakers and engaging in vigorous lobbying efforts to protect the company’s position, rights, and legal status.

Amazon’s announcement combined with increases in defense spending and the submarket cluster’s proximity to the Pentagon, has led to one of, if not, the greatest reversals in fundamentals in the history of the DC metro area. Vacancy in Crystal City has dropped by an astonishing 7.5% in the past 12 months driven by Amazon leasing 585,000 SF in 4 deals and, despite 100,000 SF delivering in the same time net absorption was approximately 700,000 SF. The plummeting vacancy rate has led to strong rent growth. Interestingly, the 4 & 5-Star properties that were responsible for rent losses from 2014-2017 are now leading the resurgence. This trend should continue as both Amazon and JBG deliver new supply of both office and multi-family properties to meet growing demand.

Fundamentals in Pentagon City are deceptively positive. Its 2.7% vacancy rate is more a factor of zero supply side pressure for over 10 years. The only sale in that time was when Boeing bought its 2 build-to-suit buildings constructed in 2013. There has been no leasing and no deliveries in the past 12 months and there are no projects planned in the next 12 months. The submarket was the definition of stagnant and despite extremely low vacancy rates landlords were unable to increase rents due to lack of demand. That has all changed and the future is bright for Pentagon City. Rents increased by 4.4% over the past 12 months and its proximity to both Amazon and the Pentagon coupled with an increase in defense spending should spark a flurry of new development in the years to come as demand continues to shift from the Rosslyn-Ballston corridor to National Landing.

Crystal City

• RBA: 11,686,539 SF
• Vacancy Rate: 15.7% (2.7% reduction in one quarter)
• 12 Month Net Absorption: 700,000 SF
• Average Asking Rent: $38.65 ($0.61/SF increase in one quarter)
• 12 Month Rent Growth: 1.9%

Pentagon City

• RBA: 1,588,349 SF
• Vacancy Rate: 2.7%
• 12 Month Net Absorption: (42,500 SF)
• Average Asking Rent: $39.43
• 12 Month Rent Growth: 4.4%

 

Clients/tenants are always asking “how negotiable” asking rents are. The answer is more nuanced than the question may suggest. In general, negotiations are based on leverage and the party with greater leverage controls the terms. There are both macroeconomic and microeconomic factors at play when establishing leverage. For the most part, landlords and tenants cannot control market cycles, fiscal/monetary policy, etc. that shape the state of the commercial space market and economy, as a whole, and they are instead forced to adapt and operate under existing market conditions. At the micro level though, there are factors that are within either party’s control that can improve or weaken their negotiating position. From the tenant’s position, leverage is directly related to their desirability (how bad the landlord wants them as a tenant). A landlord’s leverage is based on the status and performance of the subject property. In this article, I will discuss the macroeconomic and microeconomic factors that influence commercial real estate rental rate negotiations.

Macro

When it comes to factors that influence market conditions and thus, rent negotiations, it doesn’t get much more “macro” then the overall state of the economy. Generally speaking, a good economy will be characterized by decreased unemployment/increased hiring; resulting in the need for more commercial space. The increased demand and relatively static supply will lead to decreased vacancy rates with a corresponding increase in market rents. In a landlord’s market, where the demand for space exceeds the available supply, tenants must compete with one another just to satisfy their space needs. In such a market, there may be little to no room to negotiate a reduction in the rental rate. In a tenant’s market, landlords must compete for tenants; resulting in lower asking rates along with other concessions to attract tenants.

Property type and class also play a significant role in determining the negotiability of market rents. An interesting phenomenon in the DC metro office market over the past few years has been an increase in market rents despite historically high vacancy rates. While this may seem to violate the law of supply and demand, it can be understood and explained when analyzing absorption rates by asset class. In many DC office submarkets, new, 4 & 5-Star properties are driving demand and have vacancy rates below and rent growth above the submarket average. This flight to quality has led to stark differences between Class A, B, and C buildings within the same submarket; resulting in a demand vs. supply microcosm. Amazon’s influence has led to the strongest industrial market in years. In addition to it being a landlord’s market, even small incremental reductions in the asking rate, i.e. $0.25-$0.50/SF/yr, are amplified due to the relatively low base rates for industrial properties. For example, a $1.00/SF reduction in the asking rate for an office property whose asking rate is $30.00/SF equates to a 3.3% decrease while a $1.00/SF reduction for an industrial property with an asking rate of $10.00/SF is 10%. Retail is, by far, the most unique commercial property type. Rental rate negotiations and other economic concessions for retail spaces are more heavily influenced by the tenant’s profile (desirability) than in any other asset type. Finally, there is flex space, which is a combination of office and warehouse. The proportion of office to warehouse can vary from project to project and from space to space within each project; resulting in corresponding variations in asking rents. Flex rates are a blend of office and industrial rates as is their negotiability.

Micro

Within the space market paradigm, there are microeconomic factors that can either increase or decrease a tenant or landlord’s negotiating leverage. For tenants, the goal is to maximize their appeal to prospective landlords. For landlords, it is successful property and asset management.

Tenants

As stated previously, a business’/company’s desirability as a tenant plays the strong role in being able to negotiate the maximum amount of concessions from the landlord. Of the many factors that contribute to a tenant’s desirability and thus their leverage, square footage, financial strength, and lease term play the most significant roles. The larger a tenant’s square footage requirement the greater their leverage. While not a direct (proportional) relationship, landlords are generally willing to accept less rent on a per square foot basis the larger the space being leased. This is particularly true for retail space.

Landlords must analyze a tenant’s risk of default when determining the amount of any economic concessions. The more economically viable the tenant, the more desirable. Tenants’ financial strength is extremely important in landlord markets because they can be the deciding factor in which tenant the landlord chooses to lease to. Even in tenant markets, a tenant’s financial strength provides substantial leverage by reducing the likelihood of default and the associated costs, i.e. vacancy, commissions, improvement allowances, etc.; allowing the landlord the opportunity to share those savings with the tenant in the form of a reduced rental rate.

Lease term can also play a role in lease rate negotiations. In most cases, the longer the lease term the greater the tenant’s leverage. This is particularly relevant when coupled with a tenant’s financial strength because landlords’ main goal is to have their property leased for as long as possible (at or above the prevailing market rent). Landlords may be willing to reduce the base rental rate for a long-term lease with the expectation that annual escalations will bring the rate up to market over the term. Also, the longer the lease term the longer the period in which the landlord does not incur lease up costs. In rare cases, landlords may be willing to reduce their rental rate for short-term leases, i.e. 3 years, in order to secure a tenant in a competitive market. In this situation, the landlord can provide the tenant with a renewal option at the expiration of the term at the then market rate.

Finally, rental rate negotiations are influenced by the amount of any other economic concessions/considerations related to the deal, i.e. free rent, improvement allowances, etc. Free rent is foregone income while tenant improvement allowances are cash out-of-pocket. Landlords recoup these losses through rental payments. The more months of rental abatement and the larger the improvement allowance the longer the time required for the landlord to recover their costs and thus the less room for negotiation off the asking rate.

Landlords

Landlords are able to maximize the strength of the negotiating position through effective and efficient property and asset management. This begins from the point of acquisition and the price at and assumptions under which the subject property was purchased. When determining whether to purchase an investment property (and at what price), investors must make projections based on their analysis of current and future market conditions. They create proformas that guide deal structuring based on asking rates, lease terms, square footage, etc. Landlords that purchases assets based on conservative assumptions or at below market prices, i.e. bankruptcy/foreclosure sales, have room to negotiate on their rental rate while still maintaining an acceptable internal rate of return. During the holding period, landlords can position their property to be competitive within its asset type/class and submarket by investing in capital improvements to reduce operating costs and/or, in the case of amenities or renovations, increase asking rents. By making wise acquisition and management decisions, landlords strengthen their financial position, thereby increasing their leverage. They are able to negotiate on their asking rate, but not required to do so, and the lower the subject property’s vacancy the less inclined a landlord is to come off their asking rent.

On the flip side, landlords that overpay or do not effectively manage their property may have little to no control over their leasing rate. Landlords with high vacancy properties have little leverage and may be forced to agree to significant rate reductions simply to cover the costs of ownership and/or “stop the bleeding.” Landlords that do not maintain their property relative to their competitors risk functional obsolescence and the potential situation in which they cannot reduce their asking rate enough to attract tenants while generating an acceptable rate of return or, in dire circumstances, a positive net operating income.

Every year, municipalities assess the market value of all real property within their jurisdiction for the purpose of collecting real estate taxes. Due to the vast number of properties, assessors conduct mass appraisals. Real property is divided into classes based on property type and further stratified based on its unique characteristics. Assessors then use the most appropriate valuation model and apply collected market value indicators to calculate value. Most commercial properties are income-producing and, therefore, the income capitalization approach is primarily used because it provides the most accurate and pertinent approximation of market value.

Because the purpose of the assessment process is to determine value for the purposes of taxation, assessors are left with a Catch-22 dilemma. The direct capitalization approach calculates value by dividing a property’s net operating income by the market cap rate. Net operating income is calculated by subtracting all costs of ownership from the property’s gross revenue; including real estate taxes. Real estate taxes are ad valorem taxes; meaning their amount is based on the value of a transaction or, for the purposes of this article, a property. This means that if assessors were to use the traditional direct capitalization approach they would have to subtract real estate taxes from the gross revenue to establish the net operating income in order to calculate the value which would determine the real estate taxes that would need to be subtracted from the gross revenue to calculate the net operating income to calculate value which would determine the real estate taxes… You get the point.

So, how do assessors escape this circular logic? Simple, by loading the cap rate used to establish value.

Loading the cap rate involves adding the municipality’s ad valorem tax rate to the market cap rate for a particular property (class, type, etc.). Assessors then remove real estate taxes from the property’s net operating income and divide that amount by the loaded cap rate to calculate the property’s market value. I’ve provided examples below (with actual real estate tax rates) to show how calculations using loaded cap rates arrive at the same valuation as when real estate taxes are included in a property’s net operating income and the “unloaded,” market cap rate is used.

Much like Washington DC’s downtown submarket cluster, the Rosslyn-Ballston Corridor is suffering from competition from emerging submarkets that offer newer, 4 & 5-Star properties with access to public transit and lower market rents. What was once home to Northern Virginia’s premier submarkets is now being assaulted on two fronts. The Silver Line provided suburban submarkets like Tysons Corner and Reston with access to public transit and increased densities, and Amazon’s announcement to locate its HQ2 just next door in Crystal City has left many tenants searching for reasons to be in the R-B Corridor.

Ballston

• RBA: 8,037,415 SF
• Vacancy Rate: 21.7%
• 12 Month Net Absorption: 172,000 SF
• Average Asking Rent: $41.92
• 12 Month Rent Growth: 0.6%

At 21.7%, Ballston has the 2^nd highest vacancy rate of all Northern Virginia submarkets behind only the I-395 Corridor. From an absorption standpoint, this can be attributed to the National Science Foundation relocating to Alexandria and vacating approximately 600,000 SF (almost 7.5% of the submarket’s total inventory); however, this is only part of the story. The true cause of Ballston’s woes is competition from emerging submarkets like Tysons Corner and Reston, which have lower market rents, access to public transit, and new 4 & 5-Star properties. Ballston is in trouble. With the 2^nd highest rents (and vacancy) in Northern Virginia, Ballston has seen a steady decline in market rents over the past 2 years with its 4 & 5-Star properties particularly hard hit (3.7% decline last quarter). The problem is that there is simply no reason to be in Ballston anymore. The delivery of the Silver Line changed the game and Ballston may not be able to recover in the foreseeable future. After the National Science Foundation’s relocation, the building owner performed a $140,000,000 renovation. The property is currently is only 14% leased.

Virginia Square

• RBA: 1,651,601 SF
• Vacancy Rate: 14.2%
• 12 Month Net Absorption: (35,500 SF)
• Average Asking Rent: $38.25
• 12 Month Rent Growth: 1.3%

Blink and you may miss it. The Virginia Square submarket lies between Ballston and Clarendon and has only 1,651,601 SF of total inventory. Even more than Ballston, there is simply no reason to be there, and this is reflected in the submarket’s fundamentals. The vacancy rate is slightly above the metro average at 14.2%; however, this is deceptive. The vacancy rate for 4 & 5-Star properties, which comprise over 71% of the submarket’s office space, is at 18.1%. Despite being one of the smallest submarkets in Northern Virginia, Virginia Square is one of the most expensive with market rents for 4 & 5-Star properties at $41.05/SF. With no projects under construction or even proposed, Virginia Square should continue to suffer from a lack of demand. Coupled with the oversized impact of any negative net absorption due to its diminutive inventory, Virginia Square should see continued downward pressure on rents and rising vacancy rates.

Clarendon/Courthouse

• RBA: 6,295,624 SF
• Vacancy Rate: 14.7%
• 12 Month Net Absorption: (228,000 SF)
• Average Asking Rent: $40.90
• 12 Month Rent Growth: 0.6%

Clarendon/Courthouse is more a multi-family submarket than an office submarket. The only building built in the past 2 years, 2311 Wilson Blvd, is more than 90% leased but is also only 175,000 SF. Clarendon/Courthouse’s vacancy rate has jumped by 3.6% over the past 12 months and while this is in large part due to the renovation of (3-Star) 1650 Edgewood St, it represents only 139,000 SF of the total 228,000 SF of negative net absorption over that period. The 3-Star vacancy rate in Clarendon/Courthouse is only 10.5%; meaning its 4 & 5-Star inventory (17.9% vacancy) is largely responsible for the submarket’s elevated vacancy rate. At $40.90/SF ($43.44/SF for 4 & 5-Star properties), market rents in Clarendon/Courthouse are among the most expensive in the DC metro area and, with no new projects under construction to drive demand, the submarket should continue to see fundamentals suffer. In addition to its nearly 1,000,000 SF of vacant and available space, Clarendon/Courthouse must compete for demand with neighbors, Ballston and Rosslyn, and their nearly 4,000,000 SF of space along with emerging submarkets like Reston and Tysons, which offer the same access to public transit with lower market rents.

Rosslyn

• RBA: 10,144,610 SF
• Vacancy Rate: 18.5%
• 12 Month Net Absorption: 928,000 SF
• Average Asking Rent: $44.97
• 12 Month Rent Growth: 0.7%

As strange as it may sound, Rosslyn is celebrating a vacancy rate below 20% for the first time since Q4 2013. The submarket delivered 504,000 SF of new inventory in the past 12 months but saw positive net absorption of 928,000 SF over the same period. This is encouraging news but may not be a true indicator of Rosslyn’s viability. Despite having the 3^rd highest vacancy rate in Northern Virginia, Rosslyn has the highest market rents at $44.97/SF; $47.83/SF for 4 & 5-Star properties which comprise over 76% of the submarket’s inventory. This has led to negative rent growth in eight of the past 10 quarters. Rosslyn is in need of a makeover. Roughly 80% of its office inventory was built before 2000 (45% between 1960 and 1979). The most recent delivery was 1201 Wilson Blvd which completed in Q4 2019 and added 565,000 SF. Due to strong preleasing the property is currently over 92% leased. While this provides evidence of the demand for new product in Rosslyn, there are no projects under construction or proposed in the next 12 months. Arlington County created the Rosslyn Sector Plan to “set out policies on public spaces building height and form, access, affordable housing, bicycle and pedestrian amenities, and viewshed preservation” to transform the submarket. Unfortunately this will take many years and, with large GSA leases expiring in 2020 and 2021, the submarket may not respond in time to shifts in demand and competition from less expensive but equally accessible submarkets.

Most people have a least heard of a 1031 Exchange, but if you ask them about a 1033 Exchange you’ll probably get a puzzled look follow by: “you mean a 1031 Exchange?” While less well known, 1033 Exchanges are another powerful tool included in the Internal Revenue Code (Section 1033 to be exact) that allows for the deferral of tax liabilities resulting from capital gains. The fundamental difference between Sections 1031 and 1033 of the IRC is the cause precipitating the exchange. In the case of a 1031 Exchange, an owner voluntarily sells a piece of real property and then chooses to reinvest the realized capital gains into another “like-kind” property, the operative word being “voluntarily.” A 1033 Exchange, therefore, provides an owner the ability to defer and reinvest any capital gains resulting from an “involuntary conversion,” such as theft, casualty (complete or partial destruction), or eminent domain. Capital gains, in this case, derive from condemnation or insurance proceeds.

1033 Exchanges have rules that are similar to those governing 1031 Exchanges. Like in a 1031 Exchange gains must be reinvested in another real property of equal or greater value within a specified period of time; however, because the conversation is compulsory or involuntary time frames are extended. The minimum time for owners to complete a 1033 Exchange is two years from the end of the tax year in which the gain is realized; however, special rules and/or appeals to the IRS can extend the time to three to four years. The type of conversion impacts the commencement of the replacement period as well. In cases of taking by eminent domain the clock starts on the earlier of: 1) the date the property was condemned/seized, 2) the date the property was subjected to “threat or imminence of condemnation or seizure,” or 3) the date of disposition under “threat or imminence of condemnation or seizure” (IRC Section 1033(a)). With regards to theft or destruction the time period begins on the date the incident occurred. Therefore, if gains are realized at any time in 2018 a 1033 Exchange must be completed by December 31, 2020.

IRC rules take into account the nature and impact of the involuntary conversion and make allowances accordingly. Because the government is placing the burden on the taxpayer in cases where property is taken by eminent domain, the replacement period is extended to three years for property held for productive use in a trade or business or for investment. Another consideration is made for personal residences that are destroyed in a federally declared disaster. In such cases, owners have four years to complete a 1033 Exchange.

Another important distinction is the replacement property standard. For 1031 Exchanges, the property must be “like-kind” as “defined” by the IRS. Defined is in quotations because there is formal definition. Properties are considered of “like-kind” is they are “of the same nature or character, even if they differ in grade or quality.” (IRS.gov). Again, because of the involuntary nature of the conversion, the IRC requires a different standard for 1033 Exchanges, which is both subtle and significant. Properties under a 1033 Exchange must be “similar or related in service or use” with the goal being to return the taxpayer to a substantially similar position prior to the involuntary conversion. The IRS applies a functional test to determine if the standard is met, which distinguishes between owner-users and investors. Replacement properties for owner-users must have similar physical characteristics and end uses while investors benefit from a more lenient standard, which is similar to the “like-kind” standard in 1031 Exchanges. This is because investment properties are income-generating and, therefore, “related in the service or use” refers to the collection of (passive) rental income.

Much like 1031 Exchanges, 1033 Exchanges provide taxpayers with a powerful tool to defer taxes associated with capital gains resulting from insurance or condemnation proceeds due to the theft, destruction, or taking (by eminent domain) of real property. Due to the voluntary versus involuntary nature of the conversions, there are significant differences in the rules governing each, notably the time periods for the exchange and standards for the replacement properties. There are other important distinctions that I will discuss in subsequent articles; including the use of funds, role of qualified intermediaries, replacement of equity with debt, etc. In the meantime, it is always recommended to consult a tax advisor/CPA when contemplating a 1033 Exchange.

Tysons Corner

• RBA: 30,259,633 SF
• Vacancy Rate: 15.1%
• 12 Month Net Absorption: 560,000 SF
• Average Asking Rent: $35.88
• 12 Month Rent Growth: 4.2%

Tysons Corner is behind only the East End and CBD in terms of asset value and total inventory and despite vacancy levels that are above the metro average, the submarket continues to post rent growth that far surpasses the 10-year average and which even rivals the submarkets surrounding Amazon’s HQ2. It has been nearly a decade since the Fairfax County Board of Supervisors adopted a new comprehensive plan for the area that led to a combination public infrastructure projects and private development that shows no signs of slowing down. The delivery of the Silver Line in 2014 transformed the suburban, commuter submarket; connecting it to the rest of the region and spurring a flurry of transit-oriented, mixed-use development that should continue to drive demand.

Tysons Corner’s vacancy rate and rent growth metrics seem contradictory but upon closer examination provide evidence of the real story going on in the submarket. The market rent in Tysons Corner is nearly $36.00/SF; however, this again only tells part of the story.  The submarket’s aging inventory is largely to blame. 3-Star properties, which comprise 1/3 of total inventory, have a vacancy rate of 16.7% and an average rent of $27.31/SF (1.6% higher and $8.57/SF lower than the submarket averages). On the other hand, 4 & 5-Star properties have an average rent of $40.52/SF with new projects commanding even higher rates. In fact, properties built since 2015 have average rents just shy of $50.00/SF. Development, both commercial and residential, will continue to focus around the submarket’s four metro stations as will demand; resulting in a type of “locational” obsolescence for a significant number of properties.

This flight-to-quality trend has mitigated supply-side pressure on submarket fundamentals. New developments like the Boro have experienced strong pre-leasing and despite 582,000 SF delivering in the past 12 months, vacancy levels decreased by 0.4%. There are no projects currently under construction, but Tysons’ proposed development pipeline is staggering. Of the more than two dozen projects, Clemente Development’s View at Tysons is of particular interest. The proposed 40-story, 600-foot tall, 3,000,000 SF office building will be located near the Spring Hill Metro station; an area that has not seen the same level of interest as its counterparts. Another sign of things to come is the assemblage of more than seven acres on Tyco Rd by the Georgelas Group, which is in addition to the 7,500,000 of developable square footage already assembled.

One final, notable piece of news is the Hanover Company’s purchase of 1500 Westbranch Dr with plans to develop up to 420 residential units with ground-level retail. This may be a sign of things to come as developers repurpose or redeveloper older, high-vacancy office properties into residential uses, and could be the solution to the submarket’s vacancy issues.

Reston

• RBA: 20,669,006 SF
• Vacancy Rate: 13.2%
• 12 Month Net Absorption: (229,000 SF)
• Average Asking Rent: $33.66
• 12 Month Rent Growth: 0.3%

Like Tysons Corner, Reston’s future has been forever changed by the delivery of the Silver Line metro and similar trends are shaping submarket fundamentals. Demand, driven by proximity to public transit, and measured development have caused vacancy levels to fall below the submarket’s historical average. The most recent, notable delivery was Comstock Company’s 5-Star, 368,000 SF office building at Reston Metro station. Google signed a 164,000 SF lease there in the 2^nd quarter of this year; prompting Comstock to break ground on phases two and three early this year. The two buildings will add an additional 446,000 SF to the site and are expected to deliver in mid-2020.

Boston Properties, the largest landlord in the submarket, continues to prosper with Fannie Mae taking 850,000 SF at Reston Gateway (under construction) and Leidos relocating its headquarters by consolidating into 287,000 SF at 17Fifty (delivering in 2020).

Rent growth in Reston since 2016 has been nearly 8%, but like Tysons Corner, this belies the true state of the submarket. The average rate for 4 & 5-Star properties is $38.00/SF; however, Reston Town Center commands rents more than 20% higher and Comstock’s Reston Station has rents in the $51.00-$52.00/SF range. New development, centering around existing and future metro stations, should continue to dominate demand. As a result, the submarket should continue to see a flight-to-quality and widening gap in fundamentals between 4 & 5-Star properties and 3 and 1 & 2-Star properties.

When valuing a multi-tenant, income-producing property, a discounted cash flow analysis is the most appropriate valuation method because it accounts for an investor’s perceived risk associated with each income stream and calculates a value based on the required return to compensate for that risk. Risk factors range from macroeconomic to microeconomic issues; some of which can be mitigated or insured against while others are unpredictable and uncontrollable. By analyzing income streams independently, investors can focus on the factors most likely to affect that particular tenant/business and account for them by increasing their required return, thus lowering the present value of that income stream (reducing the amount they are willing to pay for it).

Discounted cash flow analyses are especially important when valuing multi-tenant retail properties. This is because of the importance of tenant mix within this asset class, which results in a variety of businesses/services, square footages, etc. In no other asset class will one find such a range in the terms and concessions in different tenants’ leases within the same project. To some extent, the terms offered to various tenants reflect the landlord’s risk assessment at the time of lease; however, investors purchasing these income streams must reassess the value based on current market conditions and risk factors.

For this article, I will discuss and analyze risk factors that are particularly relevant for 3 broad classifications of retail tenants: anchors, franchises, and mom-and-pops.

Anchors

Anchor tenants are typically major department/chain stores in a retail center whose presence draws customers thus providing smaller tenants with increased exposure/business. Anchor tenants generally occupy large blocks of space, but due to their importance (leverage) they are able to negotiate lower rental rates than other, smaller tenants. Still, because many retail leases contain percentage rent clauses, anchor tenants contribute to the landlord’s bottom line by increasing overall gross sales in the center. Much like their footprint and role in the vitality and viability of the center, anchor tenants’ income streams deserve an oversized risk analysis.

Investors must consider the likelihood and overall impact of the anchor tenant defaulting on their lease and/or vacating the center. This would not only include lost revenue from the anchor, itself, but also the lost revenue from percentage rent due to the reduction in gross sales. The cost and time required to replace the former anchor must also be calculated. If landlords do not replace the anchor quickly other tenants may default or choose to leave; creating a positive feedback loop that is anything but “positive.”

Franchises

Many of the “brand name” tenants that occupy retail centers are franchises that are locally owned and operated. Franchises make good tenants because they have proven business models and quality standards that are imposed and enforced at the corporate level. Franchises’ recognizability can contribute to a more positive perception of the center; resulting in increased patronage, gross sales, and leasing demand, which in turn can lead to higher rents. As a result, franchises are generally seen as less risky than independent businesses.

When analyzing franchise income streams investors should focus on the age, history, and current public perception of the individual franchise. There are relatively young/new franchises that are considered to be some of the most desirable tenants, i.e. Orange Theory; however, newer franchises may also be considered riskier because they do not have a track record over multiple market cycles. While the past is not necessarily an indication of the future, investors can and should look at a franchise’s performance over its history and during different economic cycles; paying special attention to the current relevance and perception of the product or service (think Blockbuster).

Another important factor to consider is the number of franchise locations, both nationally and locally (owned by the franchisee). The number of locations across the nation can provide insights into the viability, popularity, and strength of the franchise, in which case the more the better. When viewed from a local perspective, the number of locations requires a more skeptical analysis. Multiple locations owned by the same franchisee may indicate financial strength and success; however, it may also be a sign that the franchisee has spread themselves too thin and/or oversaturated the market thus making an otherwise attractive tenant a risk of default.

Perhaps the most important factor for an investor to consider is whether or not there is a corporate guaranty securing the lease. Personal guarantees are only as strong as the individual signing the guaranty and, if the business is in dire financial straits, one can expect this to extend to the guarantor. Corporate guarantees, on the other hand, are secured by the corporate franchise, which takes responsibility for the financial obligations of the lease in the case the franchisee defaults.

Mom-and-Pop

“Mom-and-pop” retail tenants are small, family-owned or independent businesses that present the greatest risk to investors due to competition from large retailers, e-commerce sites, and franchises which have the advantage of economies of scale, greater buying power, larger advertising budgets, etc. This is not to say that such businesses cannot be good tenants; however, they require the greatest scrutiny with particularly attention being paid to the number of years in business (in general and/or at their current location), financial strength (gross sales/net profits), and amount of local competition from similar businesses. If the tenant has been in business and profitable for many years (at the present location) with a history of on-time payments and provides a product or service that insulates them from corporate/franchise competition, they may be a relatively low risk. The upside for investors is that “mom-and-pop” tenants generally do not lease large blocks of space and thus re-leasing the premises is relatively easy and inexpensive.

Is subleasing a good idea? The answer, like most others in commercial real estate, is “it depends.” This question is not from the point of view of the existing tenant who is seeking to transfer their lease rights/interests and possession of the premises to a 3rd party, known as the sublandlord/sublessor or assignor. Rather, it comes from the perspective of the 3rd party, known as a subtenant/sublessee or assignee. For tenants, sublease/assignment rights are one of the most important afforded to them in a commercial lease because they provide a means of “getting out of their lease” when it makes economic, strategic, or practical sense to do so. Tenants are not usually, truly released from their leasehold obligations but rather are able to rent the entire premises or a portion thereof to mitigate their monetary obligations. Therefore, subleasing is always a “good idea” for the tenant even if the situation necessitating it is not.

For the potential subtenant or assignee the situation is not as clear cut and a number of factors must be considered. Subleases can be a great option for some companies but can also be fraught with danger. Before deciding if subleasing makes sense it’s important to understand the pros and cons associated with this type of leasehold interest and the associated opportunities and liabilities.

Cons

No Tenant Improvement Allowance

Because many sublandlords are trying to lower their leasehold costs they are typically unwilling or unable to provide tenant improvement allowances (market or otherwise). As a result, subtenants must take the space “as-is” or pay for the cost of any improvements or changes to the premises. Depending on the remaining term and/or the subtenant’s own financial situation this may be undesirable or untenable.

Non-Market Deals

Subleases provide the opportunity for non-market deal terms that benefit subtenants such as below market rents and/or shorter (sub)lease terms; however, they can also exclude positive market terms such as rental abatement and tenant improvement allowances. There can be instances in which the economic value of typical, market terms for prime leases can exceed the savings offered by sublease options.

Landlord Approval Required

All subleases/assignments must be approved by the landlord. In most cases, the landlord’s approval “shall not be unreasonably withheld, conditioned, or delayed;” however, in other cases it may be withheld in the landlord’s sole discretion or conditioned so that finding a suitable subtenant or assignee is difficult. Furthermore, the timeframe within which the landlord must respond to a tenant’s request to sublease or assign their space can vary and for subtenants looking/needing to occupy quickly, delays could be costly and/or dire.

Landlord AND Sublandlord Approval Required

After the sublease or assignment has been agreed to by the landlord, all future requests on behalf of the subtenant are subject to the approval of both the landlord and sublandlord. This additional level of bureaucracy can result in minor inconveniences to real damages in cases of service interruptions, issues impacting the subtenant’s use of/access to the premises, etc.

Subject to Terms and Conditions of the Prime Lease

Sublease agreements are typically shorter/simpler than prime/commercial leases. This is because they are subordinate to the lease between the tenant/sublandlord and landlord; making many important terms and conditions non-negotiable. Subtenants are subject to the timeframes, remedies, etc. set forth in the prime lease and must rely on the sublandlord to advocate and make requests on their behalf.

Non-Transference of Rights

Many rights afforded to the sublandlord/tenant under the terms of the original lease do not transfer to the subtenant. It could be argued that rights such as renewal options or rights of first offer/refusal should not transfer to another party; however, the right to sub-sublet or assign the sublease is an important protection for subtenants or assignees especially depending on the length of the sublease term.

Sublandlord Default

The financial strength/situation of the sublandlord/assignor is an extremely important factor that subtenants must consider when determining whether to enter into a sublease agreement. Many requests to sublet/assign the lease result from financial hardships and/or mismanagement on behalf of the existing tenant. If the tenant/sublandlord defaults on their lease the subtenant is at risk of losing possession of the premises either by the landlord recapturing the space or requiring the subtenant pay the prevailing market rate for the property. Prospective subtenants should always request to see the sublandlord’s financials.