Eisenhower Ave Corridor

• RBA: 4,896,873 SF
• Vacancy Rate: 10.0%
• 12 Month Net Absorption: (32,800 SF)
• Average Asking Rent: $36.45
• 12 Month Rent Growth: 3.1%

The Eisenhower Ave Corridor is an extremely dense submarket. Average rents may be higher than Tysons Corner or Reston at $36.45/SF, but this is due to the high concentration of 4 & 5-Star properties (84% of total inventory), which have an average rent of $38.54/SF. This puts them well below Tysons Corner ($40.60/SF) and only slightly below Reston ($38.82/SF), but these submarkets have more options and newer inventory with a focus on complementary residential and retail development. Relatively high rents may make it difficult to attract tenants but with vacancy rates hovering around 10% landlords should be able to continue pushing rents.

The lifeblood and main demand driver for the Eisenhower Ave Corridor is the United States Patent & Trademark Office, which occupies 2,000,000 SF in 4 buildings on Dulany St. These leases are not set to expire until 2024. Other notable tenants include ADT Alexandria, SENTEL Corporation, and the American Academy of PA’s, which combined lease approximately 132,000 SF with staggered lease expiration dates from 2023-2025. The co-working company, Industrious recently announced that it would be leasing 25,000 SF at 2461 Eisenhower Ave, a move that confirms the submarket’s current and future viability.

Two significant deals that did not have a direct, immediate impact on submarket fundamentals but which should have a huge impact on future demand are the National Science Foundation’s 700,000 SF lease at 2415 Eisenhower Ave in 2017 along with WMATA’s 297,000 SF lease at 2395 Mill Rd. Because these deals were build-to-suit they did not impact vacancy levels; however, the positive impact on the submarket’s reputation cannot be understated, nor can the economic impact of the thousands of employees they will bring with them. This leads into the biggest story and overarching theme of the Eisenhower Ave Corridor: savvy and forward-thinking repositioning and redevelopment of the submarket’s assets.

Development around the DC metro area is hyper-focused on metro-accessible submarkets with rents high enough to justify rising construction and labor costs. Mixed-use projects are the result of changing demand trends and increased preference for work-live-play environments. Investors in the Eisenhower Ave Corridor are paying attention and responding by increasing the submarket’s livability by developing more multi-family properties with ground-level retail. After the Department of Defense vacated 600,000 SF at 200 Stovall St in 2017, the property was purchased by Perseus for $73.06/SF and demolished in 2018 to make way for a 520-unit apartment building; lowering the submarket’s vacancy rate by an incredible 10.2%. The aforementioned, National Science Foundation build-to-suit project also included plans for retail, restaurants, and a movie theater. Right next door is the Parc Meridian at Eisenhower Station, a 505-unit apartment building that stabilized in less than a year a half. All of this is positive news, albeit still somewhat speculative, as evidenced by the fact that approximately 40% of the submarket’s inventory traded this cycle, but at rates akin to smaller, suburban Virginia submarkets rather than closer-in, urban submarkets like Crystal City and Rosslyn. Still, there is much to be excited about in the Eisenhower Ave Corridor and submarket fundamentals should continue as much.

I-395 Corridor

• RBA: 11,116,960 SF
• Vacancy Rate: 24.5%
• 12 Month Net Absorption: (108,000 SF)
• Average Asking Rent: $30.75
• 12 Month Rent Growth: 1.1%

The I-395 Corridor no longer has the highest vacancy rate in the DC metro area; Oakton now claims that title at 25.1%. The submarket’s issues are symptomatic of a larger shift towards metro-accessible, newer 4 & 5-Star properties. While a relatively large from both a geographic and square footage standpoint, the I-395 Corridor does not have a metro station and, to make matters worse, it is surrounded by submarkets that do. Crystal City, while slightly more expensive, is home to Amazon’s HQ2; Falls Church is more affordable; and Eisenhower Ave has newer product. The submarket is heavily reliant on federal agencies to drive demand and is thus highly vulnerable to large move-outs. Indeed, it is still reeling from the Defense Intelligence Agency’s relocation to Fort Meade, MD at the end of 2011, which contributed to a total negative net absorption in 2012 of 711,000 SF; causing a staggering 6.3% increase in the vacancy rate.

The submarket issued an audible sigh of relief late last year when the U.S. Patent & Trademark office renewed its lease at 2800 Randolph St for an additional 15 years. Adding another 191,000 SF to the more than 2,700,000 SF already vacant, would have been more than the submarket could bear as most leasing activity is from smaller, local businesses. There were 48 lease deals signed in the past 12 months for a total of just over 188,000 SF. The composition and size of these deals offers additional insight into both the status of the submarket, itself, and greater DC metro; being indicative of the overall flight-to-quality. Over 63% of the leasing activity took place in five 4-Star buildings with an average deal size of 9,216 SF. The remaining 35 deals took place across fifteen 3-Star properties with an average deal size of 1,975 SF.

Amazon’s HQ2 announcement is the likely cause of the submarket’s unjustifiable rent growth over the past 12 months, with 3-Star properties topping out at 6.6% in Q3 2018 and 4 & 5-Star properties hitting 7.4% last quarter. Gains resulting from the initial optimism have been completely negated for 3-Star properties (currently at 0.3%) and 4 & 5-Star rent growth is expected to plunge in early 2020. The is understandable considering the vacancy rate for the submarket’s 4 & 5-Star properties sits at an unbelievable 43.7% with the availability rate even higher at 47.9%. Indeed, if not for the low proportion of 4 & 5-Star inventory (48.2% vs. 70-80% in neighboring Crystal City, Eisenhower Ave, and RB Corridor submarkets) the submarket’s vacancy rate would be even higher. Unfortunately, the comparatively low average 4 & 5-Star rents ($33.16/SF) lack sufficient appeal to attract tenants away from surrounding metro-accessible submarkets.

The lack of supply side pressure has been a saving grace for the I-395 Corridor but is also revelatory of the submarket’s viability from an investor standpoint. The majority of new development across the metro area is focused on high-rent, metro-assessible submarkets with an emphasis on mixed-use projects. For investors to take a chance on a submarket like the I-395 Corridor a significant risk premium must be applied to the acquisition price; a fact evidenced by Stonebridge and Rockwood Capital’s purchase of Victory Center (5001 Eisenhower Ave). The 625,000 SF property sold for $71/SF in May of this year. Prior to the purchase, the building had been vacant since 2003 when the Army Material Command relocated to Fort Belvoir. The site has been entitled for new uses and rezoned with plans to create a high-density, commercial and residential mixed-use development and only time will tell if this may be a much-needed catalyst to renew interest from both tenants and investors, alike.

 

In commercial real estate, there are generally considered to be four asset types: office, retail, industrial, and land; however, there are subtypes or specializations within each that have their own unique characteristics. One example is flex space. Flex properties are unique because they are a combination of office and warehouse; not to be confused with one-story office or industrial with a small office component. Another example, and the subject of this article is medical space. While traditionally falling under the office category, the desire for visibility and “walk-ins” have led to an increase in the number of doctors and dentists locating their practices in retail spaces. There are specific features of medical space that differentiate it from typical office use and impact its appeal from a landlord/investor perspective.

There are many different medical specialties, but the most important characteristic of medical space that distinguishes it from general office space, from a commercial real estate perspective, is how the space is used. Normal office space is for the use of the tenant and its employees with the occasional visitor or guest. Medical space, on the other hand, is used by the tenant, its employees, and patients. This is significant because of the increased traffic and resulting wear and tear on the building’s common areas. Furthermore, tenants (and their employees) of a building have an interest in taking reasonable care of the common spaces (particularly bathrooms) because they work there and use the facilities every day. Patients and visitors do not*. They may visit the building once or twice per year and, therefore, care little with how they leave it (testing centers are particularly notorious in this regard). Depending on the size of the practice, number of practices within a particularly building, and the number of daily patients, landlords may incur significant costs by having to renovate the common areas to maintain the building’s quality and with greater frequency than its nonmedical counterparts. This causes many landlords, particularly of Class A buildings, to institute a policy of no medical tenants in their building.

*Many medical offices have bathrooms within their space for the use of their employees and patients, and while this may be their decision based on the nature of their practice it may also be a requirement of the landlord to minimize wear and tear and disturbance of other tenants.

A distinction does need to be made between both single-tenant (individual condo) and multi-tenant properties and then again between office and retail space. As mentioned, the wear and tear on building common areas is the main reason that medical use is seen as undesirable. This issue is magnified in multi-tenant office buildings where common areas are shared, and particularly in multi-story buildings in which the medical tenant occupies space on any floor above the first. For single-tenant office properties (usually smaller) where a medical tenant occupies the entire building, this issue is mitigated to the point of elimination. In these situations, the tenant’s use is factored into the deal, mostly likely through a triple net rental structure where the tenant is responsible for paying for maintenance, repairs, and replacements of common areas and building systems. This leads to the subject of medical use in retail space. Most retail spaces are self-contained units with their own entrance and building systems. The common areas are relegated to the parking lot, sidewalks, etc. and retail landlords account for and want as much traffic as possible. Like single-tenant office properties, they mitigate their exposure to the externalities of medical space through a triple net rent structure.

Apart from this adverse aspect, medical tenants are some of the most desirable from both a landlord and investor perspective for two main reasons: 1) they sign long-term leases and 2) they are considered to be among the most stable/least risky businesses from a financial standpoint. Due to the significant capital investment required to build out medical space, doctors and dentists prefer 10-year (plus) leases with renewal options, typically two 5-year terms for a total of twenty years. This gives them a longer period over which to amortize their costs. Medical practices also benefit from the sense of familiarity and permanence that remaining in the same location instills and which also allows them to add to their patient base over the years. In addition to the capital cost of moving and constructing a new office, medical tenants also risk lost revenue from attrition.

Healthcare spending now accounts for nearly 1/5 of our gross domestic product and, as more states implement Medicaid expansion and baby boomers continue to retire, we can expect that number to rise (healthcare spending on average nearly doubles after the age of 64). Medical practices have always been seen as stable businesses though. Doctors and dentists have specialized skills that are always in demand. Just like you can’t fix your own car (anymore), you don’t want to perform surgery on yourself and, unlike automotive problems, serious health issues are not something you want to put off addressing. Even in 2008 and 2009, when the economy and lending ground to a halt, banks were still lending to doctors and dentists and, today the rates offered to medical practices/practitioners are among the most aggressive out there (even to the point of 0% down and rates around 4% or lower). This provides a vital insight into how medical practices/tenants are viewed from an investment standpoint. The process by which landlords evaluate tenants is similar to the underwriting process for financial institutions. Instead of lending money, the landlord is lending the tenant use of their space and, thereby, foregoing income from other potential tenants. The more stable the tenant, the greater the likelihood the landlord will receive the agreed upon income stream over the lease term, and the less risky an investment the more an investor is willing to pay for it. Landlords are investing in their tenants and thus are willing to make greater economic concessions to secure them as a tenant because they are confident that they will make that money back over the term of the lease and/or based on a sale of the property.

Another element of medical space that contributes to its security from an investor/landlord perspective is the large capital investment made to construct the premises and the resulting infrastructure value. Medical build outs have never been inexpensive but with rising labor and construction costs they can reach $150+/SF. Depending on the rental rate and tenant’s financials, landlords may be willing to contribute a sizable tenant improvement allowance, but one that is still unlikely to account for even half of the required capital. Tenants that invest their own money in a space have an interest in that space; increasing the likelihood of remaining/renewing in place and decreasing the likelihood of default. In the off chance a medical tenant defaults, vacates, or relocates, the landlord is left with an extremely marketable space with valuable infrastructure (and potentially equipment). Most medical practices have similar layouts (waiting room and check-in/check-out area, exam rooms with sinks, etc.) that can easily be reused by other specialties (doctors and dentists). Medical tenants can save hundreds of thousands on build out; allowing them to deploy capital elsewhere. As a result, landlords may also be able to charge a premium for medical space thus increasing the property’s net operating income and market value.

As discussed in previous articles, cap rates provide an estimate of property’s value based on its net operating income. They are expressed as a percent because they reflect the rate of return (based on an all cash purchase) that an investor is willing to accept for the year-one income stream. Market cap rates are calculated by analyzing sales comps based on property type, class, size, etc., but acquisitions are truly made based on the discount rate an investor places on the property’s future cash flows. Discount rates include a risk premium which can either increase or decrease the acquisition cap rate thereby lowering or raising the price, respectively. Secure investments require a much lower return (think Treasury bonds). While there are many factors involved in a risk assessment, the probability of tenant default and length of lease term are among the most important. If a tenant defaults the landlord must incur legal fees, lease-up costs (brokerage commissions, improvement allowances, etc.), and vacancy losses. Similarly, assuming the tenant does not default, the remaining lease term, better expressed as the remaining future cash flows, is the only income stream that the purchaser can rely on with relative certainty; being unable to predict future market conditions (vacancy rates, rental rates, etc.). The tenant may renew but it may also be the case that the owner is required to find another tenant, thereby incurring the aforementioned transaction costs and vacancy losses. Medical tenants minimize these risks through all the reasons mentioned and ask a result, landlords/owners are able to sell their leasehold interests at a premium; increasing the sales price relative to an equal but considerably riskier rental income stream.

• RBA: 10,196,000 SF
• Vacancy Rate: 15.6%
• 12 Month Net Absorption: (96,900 SF)
• Average Asking Rent: $32.71
• 12 Month Rent Growth: 3.2%

Merrifield, along with Herndon and Fairfax Center, have historically been considered 2^nd tier office submarkets in Fairfax County; however, changing demand trends have resulted in a growing disparity not only between premier and secondary submarkets but also within this 2^nd tier. Employers and developers are increasingly catering to the millennial generation, which constitute a greater percentage of the employment base every day and value convenience and experiences; leading to the emergence and dominance of the mixed-use development. A combination of preference and lack of affordability in the DC metro housing market has given rise to a more urban generation, many of which do not own automobiles. In order to be able to recruit and retain top talent, employers are moving to metro accessible submarkets. Within these submarkets, 4 & 5-Star properties are absorbing the lion’s share of demand, particularly newly built assets. As a result, developers are focused on metro assessible submarkets due to the increased density levels and higher rents, which can offset rising construction and labor costs.

Merrifield, while technically metro accessible, has less than 10% of its office inventory within walking distance (0.5 miles) of its one metro station, Dunn Loring. On top of that, only 16.5% of its 4 & 5-Star properties (4 of 26) are metro accessible; even less considering the fact that 2675 Prosperity Ave is 100% occupied by U.S. Citizenship and Immigration Services. Most development in the submarket over the past decade, particularly around the Dunn Loring metro, has been multi-family, mixed-use. While considered the submarket’s crown jewel, the Mosaic District is not metro accessible and has only one office property totaling a meager 97,191 SF and which is 100% leased by CustomInk. Over half of the submarket’s 4 & 5-Star inventory (51.6%) is located within the Fairview Park office campus and, of that, nearly a quarter (2,426,213 SF) is available for lease. Of the remaining 4 & 5-Star properties, 8115 Gatehouse Rd (209,423 SF) is owned and occupied by Fairfax County Public Schools; 8110 Gatehouse Rd (214,075 SF) is owned and occupied by Inova Health Systems; and 3023 Hamaker Ct, 8501 Arlington Blvd, & 8505 Arlington Blvd (288,423 SF total) are medical buildings. That leaves only 8260, 8270, & 8280 Willow Oaks Corporate Dr (596,802 SF total) which, like the Fairview Park Dr properties are not metro accessible. *Costar has 2751 Prosperity Ave (93,893 SF) erroneously listed as a 4-Star property.

The submarket’s vacancy rate has been improving since it nearly doubled (12.1% to 23.1%) in Q2 2015 when Exxon Mobil vacated its 117-acre campus and approximately 1,200,000 SF. Positive net absorption from 2016-2018 brought vacancy levels back down. Inova Health Systems is mostly responsible for the rebound in the submarket’s fundamentals. It purchased the former Exxon Mobil site in 2015 across from its flagship hospital. The Fairfax County Board of Supervisors approved updates to Inova’s plans in September 2019 to allow more academic and research space along with complementary housing, retail, and hotels. Initial plans were scaled back from 15,000,000 SF to 5,000,000, and while this seems like a dramatic reduction it is still on par with Amazon’s HQ2 plans in National Landing. The University of Virginia and Inova will each occupy approximately 2,000,000 SF; leaving an additional 1,000,000 SF for commercial use. Officials expect the center to establish Fairfax County as a health sciences innovation hub, thereby helping to grow and diversity the economy.

General Dynamics added to the 1,000,000 SF of positive net absorption in 2017 when it leased the entire building at 3170 Fairview Park Dr (143,000 SF) and BAE Systems just relocated its headquarters from Rossyln to 2941 Fairview Park (133,000 SF). Most leasing is from smaller tenants though and owners and investors are hoping that Inova will have its own “Amazon effect;” acting as the submarket’s main demand driver.

Despite this, rent growth has been strong; averaging 3.2% over the past 12 months. This is exclusively attributable to the submarket’s 4 & 5-Star properties which saw a 5.62% increase in rents versus a 0.17% drop in 3-Star rents. This is consistent with the “flight-to-quality” trend across the DC metro area. At $36.64/SF, Merrifield’s 4 & 5-Star rents may be lower than Tysons Corner and Reston but they are higher than Herndon ($36.02/SF). Two of the metro stations in the 2^nd phase of the Silver Line will be located in the Herndon submarket, immediately connecting it with the entire DC metro region via public transportation. With twice the number of metro stations and millions more square feet in existing and proposed inventory, Herndon will emerge as the next premier submarkets in Northern Virginia; leaving Merrifield in the dust.

Due to no supply-side pressure, landlords may be able to maintain rents in the short-term, but with an aging inventory and competition from more urban, metro accessible submarkets the long-term outlook isn’t promising. Net absorption for 2019 is currently at negative 96,900 SF and the submarket’s vacancy rate jumped by a staggering 2.3% from last quarter. Submarket sales also provide evidence of Merrifield’s decline, which averaged around $60,000,000 over the past 5 years but are just over half that for the year ($36,500,000). This may all be temporary, but it is more likely that Merrifield’s failure to evolve as an office submarket prior to the delivery of the Silver Line in 2014 will likely doom it to an existence as a secondary submarket for the foreseeable future.