Washington DC Metro Area 2020 Office Market Synopsis

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Rentable Building Area/Inventory

  • Market: 501,678,570 SF
  • 4 & 5 Star: 249,960,981 SF
  • 3 Star: 190,133,632 SF
  • 1 & 2 Star: 61,583,957 SF

Everyone knows that Washington, DC is home to the federal government. Of the 501,678,570 SF of office space in the metro area, the federal government occupies more than 100,000,000 SF (20%), and of the 157,863,785 SF in the District the federal government occupies approximately 55,000,000 SF (35%). This has made the DMV one of, if not the, most stable albeit slow growing markets in the country. Something less well known is that the DC metro area is, and has always been, a technology hub. AOL was started in Northern Virginia and the area has one the largest concentrations of software engineers in the nation, but while the west coast are innovators the east coast are integrators. Historically, the area’s IT industry was driven by the needs of the federal government and the resulting “unsexy” products and solutions were focused on interoperability, enterprise architecture, etc. rather than the apps that occupy the home screen on our smart phones. Federal dollars will still fuel a large part of the local economy, but Amazon’s decision to locate its HQ2 in Crystal City (National Landing) provided the spark that will fundamentally change the makeup of the entire region.

With regards to the DC metro area office market, there are several overarching themes, influenced by a number of factors; including but not limited to, a booming economy and increased government spending, changing demographics and preferences, rising construction and labor costs, and emerging submarkets. In a few words, the state of the DC metro office market can be characterized by a flight to (relatively) less expensive, quality space in metro-accessible, mixed-use/work-live-play environments. Increased funding for the Department of Defense and the resulting billions in federal contracts will benefit the area’s traditionally large tenants such as Northrop Grumman, General Dynamics, Booz Allen Hamilton, Leidos, and Accenture, which notably reduced their footprints from 2008-2016 due to sequestration. A large part of federal dollars are being allocated to cyber security and cloud computing. Federal contractors will need to compete with tech companies such as Amazon, Amazon Web Services, Google, and Microsoft for top talent. This will result in higher wages, an influx of new workers to the area, and companies leasing quality space to attract employees. With regards to demographics, more and more baby boomers are retiring every day and millennials are comprising a greater and greater share of the labor force. Companies and landlords are responding by locating in and creating work-live-play environments with access to public transportation (metro). Due to rising construction and labor costs, developers are forced/choosing to build in submarkets with rents high enough to offset their costs, which are invariably metro-accessible. Finally, emerging submarkets in Northern Virginia and DC are challenging the metro area’s (formerly) premier office markets. New construction and lower rents in submarkets like NoMA, Southwest (the Wharf), and Capitol Riverfront (Navy Yard) and Tysons Corner and Reston have caused a shift in demand away from areas like the downtown DC and the Rosslyn-Ballston corridor respectively. These “new” submarkets offer newer product and provide the same access to the region via metro.

Vacancy Rate

  • Market: 14.1%
  • 4 & 5 Star: 15.2%
  • 3 Star: 12.6%
  • 1 & 2 Star: 6.2%
  • Market Net Absorption Past 12 Months: 1,300,000 SF
  • Market Vacancy Change Past 12 Months: 0.2%

The GSA announced a 2020 initiative to reduce the federal government’s footprint nationwide by leasing less space but in nicer buildings. This will most negatively impact the District as other traditional, large tenants, notably law firms, are following suit; maintaining or lowering costs by leasing smaller spaces in more expensive buildings. New types of tenants are emerging to fill large blocks of space, particularly co-working companies like WeWork, Industrious, etc. but their long-term viability is still in question. Venture capital and job growth, specifically in the life sciences (bio-tech) industry, are driving demand in Maryland along the I-270 corridor, but the king of the DMV is (and has always been) Northern Virginia. Amazon has already leased over 500,000 SF in Crystal City with plans to occupy at least 6,000,000 SF by 2024, and while it may have chosen chosen National Landing as the site for its HQ2, but its subsidiary Amazon Web Services has quietly making Herndon its unofficial headquarters in the DC metro; purchasing and leasing over 1,000,000 SF this past year. Microsoft recently purchased over 300 acres in Loudoun County (data center demand has driven the price of land to over $1,000,000/acre). In addition, Microsoft was recently awarded the Department of Defense’s $10 billion, Joint Enterprise Defense Infrastructure (JEDI)contract and is looking for space in NoVA. Finally, Google leased 112,000 SF in Reston at the Wiehle Metro Station.

Average Asking Rent

  • Market: $37.74/SF
  • 4 & 5 Star: $45.02/SF
  • 3 Star: $31.49/SF
  • 1 & 2 Star: $26.01/SF
  • Market Rent Growth Past 12 Months: (0.1%)

Rent growth in the DC metro area has always been slow in relation to other markets in the country. A good year is typically defined by rent growth that keeps pace with inflation. Some analysts attribute this the federal government’s influence and associated market stability; however, I believe there are different factors at play that can better explain the negative 0.1% rent growth this past year. A closer look will reveal a fundamental change in demand and outlook for the future. The DC metro office market is a bifurcated one, with 4 & 5-Star properties on one end and 3-Star and lower properties on the other. In addition, there is a bifurcation between metro-accessible and non-metro-accessible properties. Most rent gains occurred in 4 & 5-Star, metro-accessible properties with those gains being offset by 3-Star, non-metro-accessible properties. When viewed in terms of rent growth, the numbers appear to present a troubling picture; however, the force at work here is competition. Premier submarkets are now having to compete with emerging submarkets which will result in rent losses in some places and gains in others; however, the overall effect will be an increase in 4 & 5-Star rents. Unfortunately, these gains will likely be offset by losses in 3-Star (and lower) properties and in what are currently considered 4 & 5-Star properties in non-metro-accessible submarkets which are increasingly becoming obsolete both from a functional and locational standpoint.

When breaking the DMV down into its parts, we see Maryland particularly hard hit by this flight to quality. Maryland suffers from a lack of quality buildings and, as a result, most submarkets saw rent losses in 2019. Perhaps most disturbing is the fact that its premier office market, Bethesda/Chevy Chase, experienced rent losses across the board, in 3-Star and 4 & 5-Star properties alike. Supply-side pressure in DC is driving down rates in the District. Emerging submarkets like NoMA, Southwest, and Capitol Riverfront are offering newer product at lower rates while simultaneously providing the same metro accessibility and more residential options. While a similar trend is happening in Northern Virginia, it remains the strongest area of the metro area. Average rent growth was 1.2% over the past year but was 3.1% for 4 & 5-Star properties. The Silver Line immediately connected (former) suburban submarkets like Reston and Tysons Corner to the entire region and spurred a flurry of development both office and multi-family. When compared to Northern Virginia’s premier submarkets along the Rosslyn-Ballston corridor, these areas offered newer, nicer product at a lower cost. With the delivery of the 2nd phase of the Silver Line set for the end of the year, NoVA should continue to see strong demand and rent growth along with the emergence of Herndon as a major office submarket.

Under Construction

  • Market: 12,657,030
  • 4 & 5 Star: 12,424,463 SF
  • 3 Star: 232,567 SF
  • 1 & 2 Star: 0 SF

In terms of office square footage under construction, the DC metro ranks 2nd nationwide. Approximately 5,000,000 SF delivered last year; bringing quality office space to submarkets that desperately needed it, notably Crystal City and Bethesda. Another 5,000,000 SF is expected to deliver in 2020, but a strong economy should continue to fuel demand and mitigate supply-side pressure. The is particularly true because most, if not all, development is occurring in metro-accessible submarkets with rental rates that can compensate for rising construction and labor costs. Many new projects are mixed-use; providing a combination of office and multi-family in order to cater to the preferences of the growing millennial labor force. In fact, the DC metro area ranks 3rd in multi-family development in the nation. Developers understand that creating work-live-play environments is the recipe for long-term growth and stability.

Sales Past 12 Months

  • Sales Volume: $8,400,000,000
  • Market Cap Rate: 6.7%

At $8.4 billion in sales in 2019, the DC metro area was behind only New York City in terms of sales volume. While more than $2.7 billion traded in Q3 2019, the largest quarterly sales volume in 3 years, this was in response to the District’s Fiscal Year 2020 Budget Support Act, which increased transfer and recordation fees from 2.9% to 5% starting on October 1, 2019. While the impact on capital investment of this short-sighted and punitive change to the tax law is yet to be seen, it will likely contribute to the overall trend towards and growing preference for Northern Virginia. The Amazon effect on National Landing and surrounding submarkets coupled with the delivery of the 2nd phase of the Silver Line and corresponding increase in metro-accessible submarkets will provide more than enough viable and profitable options for investors.

At an average market cap rate of 6.7% the DC metro area is in the middle of the pack when compared to other markets. This puts it alongside fast-growth markets like Charlotte, Dallas-Fort Worth, and Denver. When considering the risk associated with such markets, the DMV becomes even more attractive from an investment standpoint. Fast growth creates prime conditions for a bubble and, while increased demand and trading drive cap rates down and values up, the last person holding the hot potato will likely get burned. What the Great Recession taught us is that the DC metro area is somewhat recession proof, a byproduct of the sizable segment of the local economy related to the federal government. The stability inherent in this market makes a 6.7% (all cash) return significantly more valuable than comparable yields in riskier markets. Despite speculation of an impending economic slowdown, forecasts are calling for continued vacancy compression in the DC metro area over the next 2 years. This is unsurprising when considering the fact that the private sector now employs more people than the region’s automatic stabilizer, the federal government. The DMV is now in an unprecedented position, in which it will likely continue to enjoy its historical stability due to the federal government while achieving growth and gains associated with riskier markets driven by a booming tech industry.

Alexandria Minus Old Town: A Tale of Two Submarkets

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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.

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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.

Paging Dr. McDreamy: How Desirable are Medical Tenants?

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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.

Merrifield Office Submarket Q4 2019

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  • 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 2nd 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 2nd 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 2nd 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.

Happy Thanksgiving for Good Clients

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This is the time of year when we reflect on all the things in our life for which we are grateful. Over my nearly 12 years as a commercial real estate broker, I’ve had the opportunity to work with many different clients in various industries and across every property type and asset class; from first-timers to established companies to seasoned investors. For the most part, I’ve been fortunate to work with good clients and even better people. Some have become dear friends. I’ve attended clients’ weddings and been adopted as a member of their company “family.” It’s a blessing to work with/for people you like. To those clients, I want to extend my sincere thanks for placing your trust in me and allowing me to represent you. It is a pleasure and an honor.

On the flip side, bad clients are the worst. Instead of enjoying working with/for them, you tolerate them. Simple interactions have the ability to cast a shadow over your entire day and leave you feeling exhausted. At this point in my career, I’m able to choose who I want to work with/for and have the experience to identify (potential) bad clients. The most important take-away from my experience with bad clients is that they remind me how blessed I am to work with good clients and makes me appreciate them even more.

The difference between a “good” client and a “bad” client can best be understood by their juxtaposition, and it’s not about money. It’s about the relationship. Here are some important distinctions that separate good clients from bad clients.

Ask questions vs. question you

Some of the best clients are the most inquisitive. Their questions stem from a desire to understand and learn so that they can take a more active and engaged role in the process. Bad clients question you. Their questions stem from both a lack of trust and lack of knowledge and their purpose is more to test their broker’s knowledge rather than understand the logic/factors behind the issue(s).

Example:

  • Good client: “What is the current market escalation rate and what factors influence it?”
  • Bad client: “I read somewhere that 2% escalations are market now. You proposed 2.5%, why?”
Treat broker as an advisor vs. an order taker

Good clients appreciate the important role that commercial real estate plays in the health and wealth of their company and thus regard their broker as trusted advisor and partner. There are many decisions and factors that have serious impacts on how a company operates, grows, etc.; including but not limited to: whether to lease or purchase, how much space to take, how long of a lease term to sign, etc. Commercial real estate brokers help their clients develop a strategic plan and have the knowledge and expertise to negotiate and structure deals based on their client’s short-term and long-term goals. Bad clients treat their brokers as order takers. Bad clients do not respect their broker’s experience or market knowledge and want to do things their way regardless of the potential consequences.

Example 1

Due to the fact that the space is in shell condition, estimates for the turnkey build out came in north of $70/SF. The landlord requires a 7-year term over which to amortize the costs. The client is only comfortable signing a 6-year lease agreement.

  • Good client: “What can we do? We’d prefer not to have to come out-of-pocket for the build out”
  • Bad client: “We’re not signing a 7-year lease. Tell the landlord we’ll do a 6-year or we’re walking.”

With bad clients it’s their way or the highway. Their arrogance and self-centeredness blinds them to the possibility that there may be alternative ways to accomplish their goals. This example was taken from a real transaction with a good client. We structured the deal so that they had the right to terminate the lease after 6 years by paying the unamortized transaction costs. The terms protected the landlord’s capital investment and got my clients what they needed based on their risk tolerance.

Example 2

Broker is representing a tenant and receives a letter of intent (proposal) from the landlord, which they review, edit via track changes, and presents the proposed counter to the client. The broker explains that, based on their experience, the terms they recommend countering with are consistent with current market conditions in that particular submarket for that particular asset class/property type and similar tenants based on their financial strength, length of lease term, etc.

  • Good client: “Thank you. Would you please explain x, y, and z? Would it be possible to ask for 1 more month of rental abatement or should we ask for another $0.50/SF off of the rental rate?”
  • Bad client: “I know another company that leased space in this submarket and got “x” more months of free rent and were at $”y”/SF. Counter with those terms and see what they say.”

Bad clients don’t realize or care about the potential negative impacts of “lowballing” or presenting unrealistic/one-side terms. It denotes either a lack of respect or lack of knowledge (oftentimes both) and can result in the other party terminating negotiations and refusing to deal with the offending party. It is also a waste of time; another indication of a fundamental lack of respect.

Working with/through broker vs. looking for ways to cut them out

This is an issue of loyalty and basic respect. In theory, one works with an experienced, commercial real estate broker because their market knowledge and expertise along with their understanding of the client’s needs will result in the best deal possible; one that extracts maximum concessions both monetary and non-monetary and protects the client’s interests. Bad clients (erroneously) believe the savings from not having to pay the broker’s commission (even if the other party is responsible for paying commissions) will result in a better deal for them and thus will look for ways to cut their broker out of the deal. Bad clients do not understand or appreciate the value an experienced broker provides or that commissions are factored into landlord proformas. Economic concessions in leasing are market-driven not commission driven.

Example 1

A broker has an active agency agreement with a client that is looking to lease or purchase an office property. The client identifies a potential option not presented by their broker.

  • Good client: “I was doing some of my own research and came across a property that I think could work well for us. I’ll send you the address. Please reach out to them and get some more information.”
  • Bad client: Calls landlord or seller directly “Can I get a better deal if you don’t have to pay my broker a commission?”

Example 2

Broker negotiated a renewal right in their client’s lease agreement. The landlord reaches out to the tenant with a proposal to renew the lease.

  • Good client: Sends proposal to their broker and notifies the landlord to negotiate through their broker.
  • Bad client: Tells the landlord that they will not be using a broker if they agree to lower the rental rate.

Bad clients are short-sighted and ignorant. They do not know how to gain leverage in renewal negotiations nor what concessions are available to them based on market conditions, which are different from initial leasing concessions. Brokers protect their clients’ interests by staying up-to-date on market conditions; thereby ensuring they are able to negotiate from a position of strength and extract the maximum amount of concessions.

Realistic expectations vs. unrealistic expectations

Realistic expectations denote an underlying respect for the broker as a professional and person. Good clients are respectful of a broker’s time; understanding that sufficient notice and time must be given to compile data, schedule tours, review contracts, etc. Good brokers strive to provide the highest level of service possible. Good clients appreciate that “possible” falls within the context of agreed upon timeframes and the fact that the broker has other clients and responsibilities. Bad clients, like bad people, are selfish and only care about themselves. It’s their world and everyone else is living in it. In their eyes, brokers exist to do their bidding and should be at the beck and call. These very people are, themselves, often unresponsive.

Example

  • Good client: “I’ll send you a list of dates/times that we’re available next week for a tour. Please confirm which work for you.”
  • Bad client: “I’m only available tomorrow at 2pm tomorrow to see the properties. Let me know where to meet you.”

Fairfax Center Submarket Q4 2019

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Fairfax Center

  • RBA: 7,796,6925 SF
  • Vacancy Rate: 22.2%
  • 12 Month Net Absorption: 13,200 SF
  • Average Asking Rent: $30.29
  • 12 Month Rent Growth: 3.3%

The Fairfax Center submarket is mainly comprised of the areas known as Fair Oaks and Fair Lakes (and coincidently is where I was raised and currently live). The area is centrally located with convenient access to Route 50, I-66, Route 29, and the Fairfax County Parkway; making nearly every destination within Northern Virginia less than a 30-minute drive. Fair Oaks Mall, Fair Lakes Shopping Center, Fairfax Corner, and Fairfax Towne Center offer over 3,000,000 SF of retail amenities and the submarket is also home to Fair Oaks Hospital and medical campus. Despite these positive features, Fairfax Center has suffered over the past decade due to BRAC, sequestration, and move-outs by large, government contractors. Emerging trends in office leasing are likely to contribute to these woes due to the submarket’s lack of access to public transit.

At 22.2%, Fairfax Center’s vacancy rate is 9.4% higher than the DC metro average, but it is actually down from its peak of 24.3% in 2017. The downturn started in 2007 when, over the next 4 years, the submarket experienced 849,200 SF of negative net absorption (approximately 11% of total inventory) the result of sequestration and a shift towards small business in federal contracting, which caused anchor tenants like Northrop Grumman and ManTech to vacate large blocks of space. Just as the submarket was starting to recover in 2011, posting 4-straight years of positive absorption, SRA International vacated 290,000 SF at the end of 2015 due to its merger with CSC.

Fairfax Center’s availability rate paints an even bleaker picture of the current state of the submarket and its possible future. 4 & 5-Star properties comprise 57% of the submarket’s inventory and while the vacancy rate is 18.8% the availability rate is 25.2%. Similarly, 3-Star properties, which comprise over 40% of total inventory, have a vacancy rate of 28% with a whopping 32.7% availability rate (nearly 1/3). Combined the submarket has over 2,100,000 SF available (28% of total inventory).

The submarket’s “recovery” is being driven by smaller tenants with the average lease being less than 10,000 SF; however, it is unlikely that small-tenant leasing will be able to make a significant impact on submarket fundamentals in the near future. Furthermore, the submarket is still vulnerable to large-scale move-outs. CGI occupies over 200,000 SF at 12601 Fair Lakes Cir and their lease is set to expire in February 2021. General Dynamics signed a short-term renewal of the entire 185,581 SF at 12450 Fair Lakes Cir in 2018; indicating that it is likely to reduce its footprint over the coming years.

Despite this all, rent growth over the past 12 months was 3.3%. This can mostly be attributed to the submarket’s 4 & 5-Star properties, which was over 4.5%. This can be attributed to a number of factors, one of which is rising construction costs. Many spec suites and build-to-suits today can cost more than $70/SF. This has caused many landlords to increase their minimum lease terms and/or increase rental rates to either increase the amortization period or reimbursement timeframe. In addition, some owners are repositioning older assets; updating common areas and adding building amenities such as fitness facilities, tenant lounges, etc. so that they might compete with similar assets in Reston and Tysons Corner. This can involve huge capital outlays, which are reflected in the property’s asking rate.

Another factor contributing to the oxymoronic rent growth figures, is likely competition amongst tenants for small blocks of space. Fairfax Center has 12 buildings that have at least 25,000 SF of contiguous space available. Landlords are likely still holding out hope that they will be able to lease these blocks to full-floor tenants so that they do not have to incur the costs of multi-tenanting the floors. To “multi-tenant” a floor, landlords must create a common area corridor that provides ingress and egress to all tenants on the floor (per code) as well as access to bathrooms. Landlords with underperforming assets may be unwilling or unable to incur the significant, up-front expense to demise their spaces to adapt to the submarket’s changing tenant profile.

The “good” news for Fairfax Center is that there has been little to no supply-side pressure to exacerbate the submarket’s vacancy issues. Only 2 buildings have been built since 2008: Inova’s medical office building on Fair Oaks Hospital’s campus and the Apple Federal Credit Union building at Fairfax Corner. The only proposed project is the Peterson Companies’ 2nd phase of Fairfax Corner; however, this is indefinitely on-hold due to weak preleasing activity.

Fairfax Corner is a perfect example of the impact of public transit amidst changing workforce demographics and demand trends. As baby boomers continue to require and millennials make up an increasing percentage of the employment base, access to metro is becoming a requirement. Some millennials in Arlington and DC do not own cars, limiting them to metro-accessible employment centers. Employers that do not locate their business in such submarkets risk greatly reducing the talent pool from which they’re able to draw. Even though Fairfax Center is more affordable than submarkets like Reston and Tysons Corner, asking rents will likely need to decrease further to compete for tenant demand to compensate for its lack of access to public transit. Unfortunately, this drop in asking rates is more likely to be the result of (continued) elevated and/or increased vacancy rather than a proactive strategy by submarket owners.

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Call a Tenant’s Bluff

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In this article, I will explain and apply commercial real estate concepts; using a real-world situation. Through this example, I will demonstrate the critical importance of working with an experienced, commercial real estate broker (especially) when negotiating the terms of a lease agreement. There are many considerations beyond basic economics that impact and govern the tenant/landlord relationship. If your lease is less than 20 pages, you’re doing it wrong (unless you like paying attorneys’ fees). There’s a saying that goes something like, “if it were not for attorneys, the world would not need attorneys.” A simple lease is a weak lease. An agreement that dictates the relationship between two unrelated parties for a period of multiple years benefits neither party if the terms are left ambiguous and open to interpretation. Ambiguity only benefits attorneys because they charge by the hour. By working with a commercial real estate broker (not agent) and particularly a CCIM, you will have access to market data and deal-structuring expertise that will allow you to negotiate effectively and “Call a Tenant’s Bluff.”

In this scenario, my client is the owner of a commercial property that is currently leased to a tenant with less than 6 months left on a 3-year lease. The tenant has a 5-year renewal option at the then market rate; however, it is capped at 106% of the rent in the final year of the lease term. The owner would like to sell the property and will likely realize a higher sales price if it were sold as an investment property (leased) versus vacant. My client sent me the following (paraphrased) message relating a conversation with the existing tenant:

I spoke with the tenant and they are on the fence and are weighing the decision to 1) stay in place and purchase the building, themselves; 2) renew the lease, but for 3 years not 5 years; or 3) move to another building in the same submarket at a far lower rate with 6 months of free rent and a moving & tenant improvement allowance. The tenant suggested I meet with their broker to discuss terms.

My response:

I would like to address the points we discussed over the phone and included in your email and will send a separate email with my recommendation moving forward.

Tenant weighing decision to stay in place and purchase the building

Most renewal options include a timeframe, expressed in months from the lease termination date, by which the tenant must notify the landlord of its intention to renew. Unfortunately, your lease with the existing tenant does not, which allows them to weigh their decision and keep you in limbo. If they are weighing their decision to stay, I would not put much “weight” in their claim that they are considering purchasing the building. If they truly wanted to stay then buying the building would make sense; however, it should be at the market price for the property as the cost of ownership would significantly decrease their costs of occupancy.

Renew for 3 years (not 5 years)

I would not recommend agreeing to anything less than a 5-year lease. When discounting cash flows, investors must apply a cap rate plus a risk premium to the income stream to ascertain its value. Sales data can be used to determine the market rate for a particular asset type, class, etc. but, at the end of the day, the cap rate is a reflection of what each individual investor is willing to pay for each dollar of net operating income. Because there are multiple years of income the investor must also apply a risk premium to the cap rate to account for the potential loss of that income. Discount rates consider a number of risk factors, including but not limited to: length of lease term, single tenant vs. multi-tenant, size of space, cost of reletting space, difficulty in reletting the space, etc. Based on the fact that our property is a 10,000 SF (actual square footage redacted for confidentiality), single-tenant space, most investors would place a significant risk premium on a 3-year lease from an existing tenant because it strongly indicates that they do not intend to stay long-term. Below is a (relatively) hypothetical example of how the risk associated with a 3-year lease could impact the sales price.

5-Year Lease

  • 10,000 SF x $12.00/NNN = $120,000/year net operating income
  • $120,000/year ÷ 6.5% (hypothetical market cap rate) = $1,846,153.85 Sales Price

3-Year Lease (with added risk premium)

  • 10,000 SF x $12.00/NNN = $120,000/year net operating income
  • $120,000/year ÷ 7% (discount rate) = $1,714,285.71 Sales Price

As you can see, a 3-year lease has the potential to lower the investment value of your property by over $131,868.14.

Tenant moving to another building in the same submarket at a far lower rate with 6 months of free rent and a moving & tenant improvement allowance

I would recommend asking for the address of this supposed location. There are so many contradictions within this assertion that I almost don’t know where to start.

Far lower rate

I ran a search for flex spaces in our submarket from 7,500-12,500 SF and have attached a report showing the available options. In addition, I’ve attached an analytics report on all flex properties within our submarket; showing the average market rent to be $13.46/SF ($12.74/SF for available space). The maximum rent we can charge the existing tenant based on our current lease is $12.50/NNN. If they are looking at another submarket then it’s not “nearby” and is not comparable. If they’re looking at straight warehouse/industrial space they can expect to pay a lower rent but not “far lower.” In addition, if the rent is “far lower” that would be because the space is not built out; meaning there is no (significant) showroom/office portion of the space. If there was the landlord would adjust their rental rate accordingly. I originally used a square footage range of 7,500-12,500 SF but after expanding it to 15,000 SF, identified one property to which they may be referring. The space is 14,419 SF (over 30% larger than our space) and they are asking $9.32/NNN. The space is 60% office and has 3 docks. I spoke with the listing broker and they have not seen demand for that much office and are thus pricing it closer to a straight industrial property. For a tenant with good credit that is willing to sign a 5 to 7-year deal they would be in the $7-$10/SF range in terms of a tenant improvement allowance. At their asking rate the annual rent would be $134,385.08 ($14,385.08 more per year than our property at $12.00/NNN).

6 months free

This amount of rental abatement is not market for industrial spaces. Because flex space is a combination of office and warehouse a tenant may expect a slight increase in the number of months of rental abatement but that would be based on the length of the lease term, proportion of office to warehouse, rental rate, etc. A landlord may be willing to provide 6 months free for a 10-year term but not likely for a 5-year and certainly not for a 3-year.

Moving & tenant improvement allowance

How much? Allowances are based on a number of factors; including but not limited to, length of lease term, rental rate, landlord’s pro forma, etc. If they’re paying a “far lower rate” there’s a high likelihood that there will be “far lower” money the landlord is willing to provide for either a moving or improvement allowance. As mentioned previously, if they are truly being offered a “far lower rate” this would likely be because the property is more warehouse than flex and would require a significant build out to make it comparable to your property.


In summation, based on these points along with the list of current, available options I do not believe this to be an accurate claim. They may be able to find a space that has two of the three, if they are willing to sign a longer-term lease, but not all three and not in this submarket.

Not explicitly addressed in my response but a telling an important point is that the tenant suggested that my client speak with their commercial broker; clearly so that they could receive unbiased advice. After all, this is the impartial party whose appraisal of the leasing market is founded on objective data and not on the fact that they only get paid a commission if the tenant moves or if they’re able to convince my client to pay them if they can convince their own client, the tenant, to renew. Just like landlords (can) take advantage of unrepresented tenants’ lack of experience, expertise, and market knowledge the reverse is also true. My client was unrepresented when they originally negotiated the lease with their tenant; resulting in a renewal option without a notice period and in which the rental rate was capped. They also agreed to a 3-year lease term, which is not long enough for it to be a viable investment sale and is too long for the property to be considered by an owner-user. Commercial real estate decisions should not be made in isolation, but rather should be part of a greater strategy based on the client’s goals and plans. Good commercial real estate brokers, particularly CCIMs, have the analytical tools to help clients formulate said plan and the expertise to structure deals in accordance with it.

Herndon Submarket Q4 2019

Herndon

  • RBA: 12,815,207 SF
  • Vacancy Rate: 15.7%
  • 12 Month Net Absorption: 307,000 SF
  • Average Asking Rent: $31.83
  • 12 Month Rent Growth: 2.8%

Herndon is one of the most exciting submarkets in the DC metro, quietly nestled in the shadow of neighboring juggernaut Reston; however, with the delivery of the 2nd phase of the Silver Line in 2020, Herndon is poised for explosive growth. Historically, Herndon has suffered from an “address stigma,” which is more relative (compared to Reston) than objective. Herndon has over 7,600,000 SF of 4 & 5-Star properties many with prominent visibility along the Dulles Toll Rd and Route-28. Rates for these properties increased by a whopping $1.00/SF (2.86%) from last quarter ($35.02/SF to $36.02/SF) and average rents increased by $0.63/SF (2.02%). Even 3-Star properties saw a $0.20/SF increased from last quarter ($25.73/SF to $25.93/SF). On top of that, Herndon’s metro accessible properties command rates higher than the average market rate for both Reston and Tysons Corner. That’s not all.

Herndon has been plagued by high vacancy since Q1 2016 when the submarket saw a 3.7% jump in the rate in one quarter from 12.5% to 16.2%. Vacancy peaked at 18.7% in Q2 2017 and then fell to 14.5% just 3 quarters later (Q1 2018). Just when things were looking up, vacancy again skyrocketed by 3.7% in 2018; ending the year at 18.2%. The submarket’s rollercoaster ride is the result of large-scale move-outs, the most recent being Time Warner Cable vacating 13820 Sunrise Valley Dr in 2018 when it was acquired by Charter Communications. Herndon has endured stormy weather for nearly 4 years; however, recent and significant leasing activity (including at 13820 Sunrise Valley Dr) has brought vacancy back down to 15.7% and should indicate an end to Herndon’s vacancy woes. Projections have rates dropping to 12.1% in the next 12 months likely due to the delivery of the 2nd phase of the Silver Line.

13820 Sunrise Valley Dr Video (1)

Amazon may have chosen National Landing as the site for its HQ2, but its subsidiary Amazon Web Services (also known as Vadata) is quietly making Herndon its unofficial headquarters in the DC metro. On October 4, 2019, AWS purchased 13600 EDS Dr for $54,000,000. The 400,000 SF office building sits on 57.05 acres along Route 28 (the property was assessed at $80,676,490). The company established One Dulles Tower (13200 Woodland Park Rd) as its east coast hub in 2017 when it leased the entire building (403,622 SF). Remember 13820 Sunrise Valley Dr that contributed to the spike in the submarket’s vacancy rate? AWS leased the entire building (268,240 SF) in May of this year.

The reason for all this is Herndon’s strategic location. The submarket provides access to two major north-south and east-west transportation nodes: Route 28 and the Dulles Toll Rd, respectively. Herndon is situated between two of the largest industrial submarkets in the area: Route 28 North and South. Tech giants like AWS are continually building and leasing more data center space and neighboring Loudoun County and the area known as Data Center Alley is home to the largest concentration of data centers in the world. In addition, Amazon’s disruption of the retail industry has directly benefited the industrial market by increasing the need for storage and distribution space as well as last-mile delivery. Herndon’s proximity to over 47,200,000 SF of industrial inventory and Dulles International Airport along with its inventory of 4 & 5-Star properties make it an ideal choice for Amazon and others.

One Dulles Tower Video1 (1)

With the opening of Herndon’s two metro stations (Herndon Station and Innovation Station) next year, the submarket will be immediately connected to Dulles International Airport and the greater DC region by public transit. Reston and Tysons Corner have already begun syphoning demand from closer-in submarkets (Rosslyn-Ballston Corridor) since phase-1 of the Silver Line delivered because of their relative affordability and new supply of trophy, 4 & 5-Star properties. Herndon has similar quality product and is even more affordable.

Considering these recent developments, it should come as no surprise that Herndon led all Virginia submarkets in sales over the last year with almost $1,000,000,000 deployed over the past 3 years. Despite this, Herndon’s average market cap rate (6.3%) is still above the metro and its average sales price per square foot is below that of Reston and Tysons Corner. As a result, Herndon presents a rare opportunity for investors to “buy low” in a submarket in the early stages of a complete transformation. There are more than two dozen projects proposed and in April 2019 the Town of Herndon approved Penzance Properties’ first mixed-use redevelopment at 555 Herndon Pkwy. This project, located right at the new Herndon Metro Station, will include a high-rise office building and two high-rise residential towers. This is just the beginning for Herndon. The combined forces of the Amazon effect, AWS’ growing office and data center needs, and a regional shift in employment growth into the cyber-security, IT, and high-tech fields could see Herndon join the ranks of Reston and Tysons Corner as one of Northern Virginia’s premier office submarkets.

13600 EDS Dr Video (1) (1) (1) (1)

Using the Income Approach to Value Non-Income-Producing Properties

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No one wants to pay more for something than it’s worth; however, determining what something is worth isn’t always straightforward. The difference between market value and investment value can sometimes blur the lines when appraising or assessing real estate, especially for owner-occupied properties. Market value is defined as a property’s likely sales price in an arm’s length transaction (in a competitive and open market) between a buyer and seller, both acting knowledgeably, prudently, and without compulsion. Investment value is unique to each buyer and, as a matter of perspective, it can include tangible and intangible considerations. As a result, when a buyer is purchasing real property for their own use a subjective element is introduced into an otherwise objective (valuation) process.

There are three main valuation methods used to appraise/assess a property’s value: 1) cost approach, 2) direct capitalization approach, and 3) sales comparison approach. The cost approach is primarily used for insurance purposes because only the value of the improvements are insurable. This method calculates the cost to build an equivalent property (minus depreciation) and then adds the value of the land. The direct capitalization approach is used for income-producing properties and calculates value by “capitalizing” (dividing) a property’s net operating income by the appropriate (cap) rate. Cap rates, expressed as a percent, reflect the return an investor is willing to accept for each dollar of NOI based on an all-cash purchase. For example, an investor that is willing to accept a 10% return would be willing to pay $1,000,000 for a property with a net operating income of $100,000 ($100,000 ÷ 10% = $1,000,000). Market cap rates vary based on property type, age, etc. and are calculated through analyses of recent market sales of income producing properties.

The sales comparison approach compares recently sold properties with similar characteristics to the property being valued, including location (within the same building, project, neighborhood, submarket, market, etc.). Price adjustments are made for differences between the sales comps and subject property to determine a value that is consistent with recent market activity (typically within 6 months). This method is most commonly used to value residential properties, both because of the large number of sales (sample size) and due to the fact that owners enjoy beneficial occupancy of the property (not income-producing). Because owner-occupied commercial real estate also provides beneficial occupancy rather than rental income, the sales comparison approach is also commonly used valuation analyses for such acquisitions.

The biggest problem in using the sales comparison approach to value commercial real estate is the issue of sample size. The number of residential properties exceeds that of all commercial properties (office, retail, flex, and industrial combined) by many orders of magnitude. Leasing makes up the overwhelming majority of commercial transactions and, as a result, there may be few, if any, sales to use as a basis of comparison. This is evident in assessed values that remain the same year after year. Assessors use the direct capitalization (income) approach to assess income-producing real estate, but generally use the sales comparison approach when valuing owner-occupied commercial properties. When there are no comparable sales in the year of assessment or other data to support an increase or decrease in a property’s assessed value remains the same. Because assessors often value properties at an assessment-to-sales ratio (ASR) below 100%, many (brokers and laymen, alike) believe that a property’s assessed value reflects the lowest end of the spectrum in terms of market value. As alluded to earlier, this is not necessarily the case and as certain properties, property types, etc. age and become functionally obsolete, the reverse may be true. A lack of comparable sales may indicate that there is no market for a particular property (type) and is likely evidence of a decline in value and in a property (type) being over-assessed.

As the title of this article suggests, there is a way to use the direct capitalization approach to value for owner-occupied properties. As mentioned previously, most residential transactions involve the purchase and sale of real estate, while leasing dominates commercial real estate. As a result, leasing comps are nearly as numerous, on a proportionate basis, in commercial real estate as sales comps are in residential. In order to use the direct capitalization method to calculate the market value of an owner-occupied commercial property, one must perform a hypothetical investment analysis of the subject property using actual market data, rates, etc.; treating it as if it were being purchased as an income-producing property.

Market Analysis

Prospective buyers and/or brokers must first conduct a search for comparable properties that are available for lease. Search parameters such as square footage (range), building age (range), location, etc. should be as narrow as possible. The resulting (short) list of properties should produce an accurate market rent (range) for the property. Rents quoted in triple net terms allow for a quick and easy calculation of net operating income (rental rate x square footage = NOI). Full-service gross leases present more of a challenge and require all costs of ownership (real estate taxes, operating expenses, utilities, cleaning, & insurance) be added together and subtracted from the rental rate on a per square foot basis. The resulting number is the triple net equivalent rent which can then be multiplied by the square footage to calculate the property’s net operating income.

After calculating the subject property’s potential net operating income, more market research and analysis is required to determine the appropriate market cap rate to apply to the income stream. There are a number of sources which provide cap rate information based on submarket, property type, etc.; however, as before, the narrower the focus the more accurate the resulting valuation. Assessors will add basis points to cap rates based on age, vacancy, etc. thereby lowering the value relative to NOI. For example, if the market cap rate for industrial properties in a particular submarket is 7% with average vacancy rate at the time of sale of 50%, a property that is 0% vacant may justify a 0.5% reduction in the cap rate while a property that is 100% vacant may require a 0.5% increase to account for risk. For a property with an NOI of $100,000 the resulting difference in value would be $205,128.21 = ($100,000 ÷ 6.5%) – ($100,000 ÷ 7.5%). Relevant/current data coupled with market knowledge and experience will produce the best, most accurate estimates of value.

Case Study

Ryan Rauner is interested in purchasing 123 Industrial Ave and plans to occupy and use the 25,000 SF property for his storage and distribution business. Due to a lack of comparable sales in the surrounding area, Ryan is having trouble determining how much he should pay for the property. After researching leasing rates for comparable properties within the same submarket, he determines that the market rent is about $10.00-$11.00/NNN; resulting in a potential net operating income of $250,000-$275,000. The current market cap rate for industrial properties in the subject submarket is 7%; however, the submarket’s vacancy rate is slightly about the market average. Ryan knows that investors would likely require a higher rate of return to account for the risk associated with the property’s vacancy and thus adds 1 basis point to the cap rate as a risk premium. He then capitalizes the potential NOI by 8% for a resulting valuation of $3,125,000-$3,437,500.

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Fairfax County Town & City Submarkets Q4 2019

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Fairfax City

  • RBA: 5,054,602 SF
  • Vacancy Rate: 10.9%
  • 12 Month Net Absorption: 24,000 SF
  • Average Asking Rent: $24.72
  • 12 Month Rent Growth: (0.2%)

At slightly over 5,000,000 SF, Fairfax City is 1.78, 2.55, and 2.96 times larger than the McLean, Vienna, and Falls Church submarkets respectively. The vast majority of the submarket is comprised of 3-Star and 1 & 2-Star properties (98%) and the average market rate of $24.72/SF reflects as much. The submarket’s vacancy rate of 10.9% is well below the metro average but this is the result of zero supply side pressure. There have been no significant deliveries since 2007, before the Great Recession, and there are no projects under construction and none proposed in the next 12 months. Low demand is the biggest threat to Fairfax City’s fundamentals. The office inventory is old with an average and median age of 1978 and 1982 respectively and small with an average and median size of 22,872 SF and 13,096 SF respectively). Combined with a lack of metro access the submarket will continue to struggle to attract large tenants. This risk is reflected in the recent sales of WillowWood Plaza I & II (10300 & 10306 Eaton Pl) and WillowWood Plaza III & IV (10302-10304 Eaton Pl), arguably the submarket’s nicest and best located buildings. Buildings I & II sold in June 2018 for $22,300,000 ($91/SF) and were about 50% vacant at the time of sale. Buildings III & IV sold in December 2018 for $32,000,000 ($115/SF) and were 0% and 50.1% vacant at the time of sale respectively. The submarket’s largest tenant, Zeta Associates, occupies the entire building at 10302 Eaton Pl (Building III). Despite having an occupancy level approximately 25% higher, this portfolio sale was only able to achieve a $24/SF higher sales price.

falls church city

City of Falls Church

  • RBA: 2,831,871 SF
  • Vacancy Rate: 12.4%
  • 12 Month Net Absorption: (25,400 SF)
  • Average Asking Rent: $25.46
  • 12 Month Rent Growth: 1.4%

Negative net absorption of 25,400 SF led to a 0.9% increase in the submarket’s vacancy rate over the past 12 months. Oddly, this was accompanied by a 1.4% increase in market rents. Even more strange was that this increase came largely from 4 & 5-Star properties ($30.10/SF average rent), which have a vacancy rate of 21.5%. Despite only comprising 17.5% of total office inventory, 4 & 5-Star metrics are heavily influencing the submarket’s fundamentals. Combined, 3-Star and 1 & 2-Star properties have an average market rent of $24.48/SF and vacancy rate of 10.5% versus the submarket’s $25.46/SF and 12.4%. Vacancy rates should remain low due to zero supply side pressure. There are no properties under construction or proposed in the next 12 months. The average & median age of the office inventory is 1962 & 1965 and the average & median size is 14,749 SF & 5,560 SF respectively. As a result of demand trends, Falls Church would benefit from new product, particularly in proximity to the submarket’s lone metro station (East Falls Church). The most significant recent sale was of 6400 & 6402 Arlington Blvd in February 2019. The 410,197 SF project was 26.76% vacant at the time of sale and sold for $38,119,000 ($92.93/SF); reflecting the value-add nature of the sale.

mclean

McLean

  • RBA: 1,708,579 SF
  • Vacancy Rate: 11.2%
  • 12 Month Net Absorption: (40,800 SF)
  • Average Asking Rent: $31.18
  • 12 Month Rent Growth: (0.5%)

McLean was once the central business district of Fairfax County; however, this title was usurped by neighboring Tysons Corner. The submarket’s fundamentals provide a telling picture of the state of office demand in McLean and the greater DC metro, as a whole. Negative net absorption of 40,800 SF led to a 2.4% increase in the submarket’s vacancy rate and a 0.5% drop in market rents, which despite having no 4 & 5-Star properties average $31.18/SF. At $32.82/SF and $28.93/SF, McLean has the highest 3-Star and 1 & 2-Star rents in Fairfax County. With an aging inventory (average/median age of 1977/1980) and no access to metro, McLean’s fundamentals should continue to suffer. The submarket’s one saving grace, zero supply-side pressure, is also the main contributing factor to its lack of demand.  There are no properties under construction or proposed in the next 12 months and with high rents relative to asset quality and demand trends favoring newer product with proximity to metro, tenants will likely look to Tysons Corner for their office needs. Despite this Fairfax County’s Department of Tax Administration considers McLean to be one of the County’s premier submarkets, along with Tysons Corner and Reston. As a result, commercial properties received a 0.5% reduction in their market cap rate; leading to an increase in assessed values even if a property’s net operating income remained the same. The recent sale of 1420 Beverly Rd may cause assessors to reevaluate the submarket’s status. The 46,000 SF building, built in 1985, sold in November 2018 for $12,700,000 ($276/SF) at a 7% cap rate and was fully leased at the time of sale. Another significant sale occurred in December of 2018 when 1313 Dolley Madison Blvd (53,051 SF) sold for $13,000,000 ($245/SF). The property was 13.8% vacant at the time of sale with the most recent lease signed in September 2018 at $32.00/SF full-service.

town of vienna

Town of Vienna

  • RBA: 1,984,657 SF
  • Vacancy Rate: 7.3%
  • 12 Month Net Absorption: (8,200 SF)
  • Average Asking Rent: $28.86
  • 12 Month Rent Growth: 2.0%

Vienna’s total office inventory is fairly, evenly divided between 4 & 5-Star, 3-Star, and 1 & 2-Star properties (634,390 SF, 595,033 SF, and 755,234 SF respectively) as are the rents for each property class with an average of $4.46/SF between them. Despite a 7.3% vacancy rate which decreased by 0.5% over the past 12 months and is nearly half the metro average along with 2% rent growth over the same period, Vienna’s fundamentals are misleading. The true Vienna submarket is located within 2 blocks of Maple Ave (Rt-123) and is comprised solely of 3-Star and 1 & 2-Star properties with an average rent and vacancy rate of $26.64/SF and 10.4% versus the submarket’s $28.86/SF and 7.3%. Vienna’s inventory is old and small, with an average and median age of 43 years (built in 1976) and average and median size of 18,901 SF and 7,200 SF respectively. A total of 3 buildings comprise the submarket’s 634,390 SF of 4 & 5-Star office inventory. One of the three is 1007 Electric Ave, a build-to-suit, headquarters expansion for Navy Federal Credit Union that delivered in 2017 and increased the submarket’s 4 & 5-Star inventory by 37%. This property borders Tysons Corner. The other two, 9300 & 9302 Lee Hwy, are located by the Dunn Loring Metro and I-66’s Nutley St exit and border the Fairfax City submarket. Full building leases for both properties expire in 2022, which could have a tremendous impact on the submarket’s vacancy rate if they remain unleased. That being said, the properties’ proximity to metro coupled with the submarket’s most significant, recent sale may alleviate such concerns. In December 2018, the 41,224 SF 2-Star office building located at 9401 Lee Hwy sold for $9,300,000 ($226/SF) despite its age (built in 1973). This property is even closer to the Fairfax City submarket, notably the new mixed-use development, Scout on the Circle, which will have 83,200 SF of retail space and 400 apartments and was likely purchased as a redevelopment play.