We are now 6 months into “15 days to slow the spread.” Many small businesses have closed for good and the survivors are either teleworking or downsizing; leaving many to speculate about the future of office space. The economic devastation caused by the lockdowns is clearly reflected in changes to market fundamentals across the board; however, the psychological impact of the virus will have greater, long-term effects. As demand plummets, tenants are constantly asking if this will be reflected in proportionate decreases in rents… “good deals.” As we enter the 4th quarter of 2020, where are we and what can we expect in the future?
Rentable Building Area
- Market: 507,641,251 SF
- 4 & 5 Star: 257,547,778 SF
- 3 Star: 188,690,068 SF
- 1 & 2 Star: 61,403,405 SF
- Deliveries Past 12 Months: 3,800,000 SF
The Washington DC metro area has traditionally been insulated from economic downturns due to the presence of the federal government and, with West Coast-based companies continuing to expand their footprint, the region has become a major East Coast tech hub as well. The Dulles Technology Corridor has been home to big tech firms for years. With its extensive fiber infrastructure, reasonable energy costs, and tax incentives, Ashburn, VA has evolved into the top data center market in the nation; hosting over 70% of the world’s internet traffic and earning the name: Data Center Alley. Historically, the area’s tech industry has centered around the needs of the federal government with a focus on integration versus innovation; however, with Amazon’s decision to locate its HQ2 in National Landing in 2018, big tech is now driving demand and has accounted for some of the largest leases in the past year.
The DMV has not been immune to the effects of the pandemic and government lockdowns. Approximately 230,000 jobs were lost since March 2020 and, while office users were able to adapt more easily by allowing their employees to work from home, many were still furloughed or laid off. Demand is down across the board, vacancies are up, and rent growth has flatlined. Small businesses are likely to delay leasing decisions at least until after the November election, the result of which could have a major impact on the national and local economy due to potential changes in tax rates and defense spending. Furthermore, Montgomery County, Prince George’s County, and Northern Virginia were slower to reopen than the rest of the country and, while this was in part due to the number of Covid-19 cases, the partisan nature and extent of the lockdowns cannot be ignored.
- Market: 13.8%
- 4 & 5 Star: 15.8%
- 3 Star: 13.4%
- 1 & 2 Star: 6.5%
- Market: 17.8%
- 4 & 5 Star: 20.8%
- 3 Star: 16.5%
- 1 & 2 Star: 9.3%
- Net Absorption Past 12 Months: (1,400,000 SF)
- Vacancy Change Past 12 Months: 0.7%
At 13.8%, the vacancy rate in the DC metro area is the highest its been in 4 years. Net absorption is at negative 1,400,000 SF over the past 12 months with the District being disproportionately impacted with over 1,000,000 SF being vacated since March. A more telling statistic is the availability rate, which reflects the actual amount of space on the market. At 17.8%, the market availability rate is 4% higher than the vacancy rate. This is the result of over 1,500,000 SF being added to the market since the beginning of the year, an increase of 25%. The gap is further pronounced (5%) in 4 & 5-Star properties with the area’s premier submarkets (East End, CBD, Tysons Corner, and Bethesda/Chevy Chase) accounting for nearly 50% of all available sublease space. As of this date, there is over 8,300,000 SF of sublease space on the market. Whether from struggling businesses seeking to reduce costs or healthy businesses reevaluating their space needs, this presents a troubling outlook for office market fundamentals.
The twin pillars of big tech and the federal government have accounted for some of the largest leases in the past year; however, many of the government-related deals were renewals rather than relocations or expansions. Large West Coast-based firms are driving demand as evidenced by Microsoft’s lease of nearly 400,000 SF at 11955 Freedom Dr in Reston Town Center in May, an expansion of its existing 150,000 SF footprint in the submarket at 12012 Sunset Hills Rd. The company plans to create a new software development hub, adding 1,500 new employees. Reston is also home to fellow tech giant, Google, which leased approximately 165,000 SF within the past year.
These leases reflect a tale of 2 economies. Large, multi-national companies are more easily able to weather the economic turmoil brought about by the pandemic while small businesses struggle to stay afloat. In fact, Google, Microsoft, and Facebook have all announced that employees may work from home indefinitely. Add to that the uncertainty surrounding the November elections and most firms will be delaying leasing decisions for the foreseeable future.
Average Asking Rent
- Market: $38.47/SF
- 4 & 5 Star: $45.68/SF
- 3 Star: $32.14/SF
- 1 & 2 Star: $26.67/SF
- Rent Growth Past 12 Months: 0.2%
High vacancy rates have been the main impediment to significant rent growth in the DC metro area in recent years, a trend that will be further exacerbated by the reduction in demand for office space and increased availability of sublease space as a result of the pandemic. Wholesale discounts are not widespread yet at least in the form of lower asking rents; however, large concession packages especially in high vacancy submarkets are revelatory of the true state of the market. One example is Dweck Properties’ lease of 12,162 SF at 1050 17th St NW in DC’s Central Business District submarket. The lease rate of $52.00/NNN reflected a 9% discount from the $57.00/NNN asking rate. When combined with the $135/SF tenant improvement allowance and 12 months free (assuming a 132-month term and 3% annual escalations) the resulting average effective rent over the entire lease term is only $43.55/SF/yr. Landlords will also have to compete with a glut of sublease space on the market which is, on average, about 13% lower than direct market rents.
Unfortunately, the pain has only just begun with forecasts predicting a 4.5% decrease in rents by mid-2021; however, rent growth and/or losses will likely vary by submarkets. National Landing is positioned for strong rent growth as home to Amazon’s HQ2 and due to its proximity to the Pentagon. The Dulles Technology Corridor should also perform well as big tech firms continue to expand in Reston and Herndon. The expansion of the Silver Line has leveled the playing field for these suburban submarkets which offer new, 4 & 5-Star product at a discount compared to closer-in urban submarkets. Reston and Herndon are also able to offer an often overlooked but economically poignant amenity: ample free parking. This may signal an emerging trend in office demand towards more affordable, suburban submarkets in general. With the increase in teleworking, companies may abandon or decrease their presence in urban areas and move to a “hub-and-spoke” model with multiple, smaller satellite offices in closer proximity to their employees’ homes.
- Market: 9,057,194 SF
- 4 & 5 Star: 8,972,317 SF
- 3 Star: 84,877 SF
- 1 & 2 Star: 0 SF
- Percent of Inventory: 1.8%
- Preleased: 74.4%
There is nearly 9.1M SF currently in the pipeline and while this may seem like a significant amount of space it is actually the lowest total since 2016 and represents only 1.8% of the existing market inventory. Due to strong pre-leasing this new supply will not be overly detrimental to the overall market vacancy rate but upon closer inspection a growing trend and demand shift away from the District is becoming evident. Despite accounting for over 1/3 of the new product under construction, the Reston and Chevy Chase/Bethesda submarkets are 80% preleased. This includes the 785,000 SF build-to-suit new Marriot headquarters at 7750 Wisconsin Ave, 7272 Wisconsin Ave (362,643 SF) which is 67.7% preleased to a diverse group of tenants, and the Reston Gateway Twin Buildings where Fannie Mae preleased 1,200,000 of the 1,400,000 SF. Government agencies contributed to strong preleasing activity further bolstering suburban submarket performance. The Transportation Security Administration recently moved into its new 623,000 SF headquarters at 6595 Springfield Center Dr in Springfield, VA, the Department of Homeland Security will relocate its headquarters to Camp Springs, MD where it will occupy 575,000 SF, and the Institute for Defense Analyses will lease 370,000 SF at 730 E Glebe Rd in Potomac Yard one block down from the future Virginia Tech Innovation Campus. Conversely, the District’s upcoming projects have an availability rate of 45% with the entire 226,000 SF at 1255 Union St NE in the Capitol Hill submarket and 165,000 SF at 699 14th St NW in the East End still available.
Sales Past 12 Months
- Sales Volume: $8,400,000,000
- Market Cap Rate: 7.2%
- Average Vacancy at Sale: 18.2%
The effects of the pandemic on the commercial real estate market can most easily be seen in its impact on investment sales. The $600,000,000 in sales in the 2nd quarter of 2020 marked a 75% decrease from Q1 (70% of the quarterly average for the past 2 years). Office prices have been decreasing since 2015 and, with the exception of some premier properties which can trade at over $1,000/SF, many deals involve repositioning strategies such as Dallas-based private equity firm Velocis’ purchase of 1530 Wilson Blvd or long-term bets like JBG’s investment in Crystal City (in retrospect). Perhaps the greatest and most startling example of the pandemic’s destructive impact was the sale of 8283 Greensboro Dr in Tysons Corner. Originally under contract for $63,400,000 in February, the property sold for over $6,000,000 less ($57,000,000). This was a particularly good deal for the Meridian Group, which purchased the building in addition to 2 others in the overarching Boro Project, and a bad one for Washington Real Estate Investment Trust which purchased the property in 2011 for $73,500,000. With the future of office demand in question, prices are likely to continue to fall as investors require a higher return/cap rate to justify their increased risk. Add to that the fact that many older office properties will require large capital investments to attract tenants in a competitive, high vacancy environment and office sales are likely to decline in overall volume in addition to price per square foot.
In an unprecedented move in late March 2020, federal, state, and local governments across the country forcibly shut down the U.S. economy; requiring “nonessential” businesses to close their doors. As is the case with many government policies, externalities were not considered, and the resulting chaos led to the greatest economic disaster since the Great Depression. Retail businesses, still reeling from the disruption caused by e-commerce, were especially hard hit because the real estate they occupied was inextricably tied to their ability to generate revenue. Office users were less impacted as many companies found that their employees could work from home, at least in the interim, with a relatively negligible loss in productivity, but it caused many employers to reevaluate their office space needs. It is difficult to predict the long-term impact of the lockdown on commercial real estate but, in the short-term it has resulted in the closure tens of thousands of businesses which, through no fault of their own, were denied use of their space but still required to pay rent.
It is easy to forget that landlords are also business owners whose business is to lease real property to tenants and collect rent. Landlords were forced by the government to deny tenants the use of their space and, like their tenants, landlords were still required to pay their own “rent” in the form of mortgage payments. Landlords also have employees (property managers, janitorial staff, etc.) and a portion of rents go towards their compensation. The point is: landlords are not the bad guys.
After the government drove a proverbial pick-up truck through the living room, tenants and landlords were left to sort through the rubble and resolve the Catch-22 of paying and collecting rent; leading to a renewed interest in and importance of an often overlooked clause in many commercial leases: force majeure.
“Force majeure” is French for “greater force” and, in contract law, refers to an event outside the reasonable control of a party which prevents a party from performing its obligations under a contract. Because force majeure is not generally an implied term (like quiet enjoyment), the ability of a party to claim relief depends on the terms expressed in the contract. As a result, most, if not all, commercial leases contain a section on force majeure with common language/examples such as “fire, act of God, governmental act or failure to act, strike, labor dispute, inability to procure materials” as well as “catch-all” language like, “outside the reasonable control of the affected party.”
Force majeure events are generally separated into two categories: political and non-political, otherwise referred to as natural, force majeure; often providing different remedies. Political force majeure deals with risks in the political environment like embargoes, riots, strikes, war, etc. as well as in the legal environment such as changes in the law, zoning, permits, etc. In cases of political force majeure, the affected party is typically afforded an extension of time to perform and/or compensation for its losses/expenses. Non-political/natural force majeure events include physical risks to the property, business, etc. such as earthquakes, floods, etc. with relief in such cases affording an extension of time to perform and relief from termination.
Whether political or non-political, an event or circumstance must satisfy three distinct criteria to pass the “force majeure test” and relieve the affected party from its contractual obligation:
the event must be beyond the reasonable control of the affected party;
the affected party’s ability to perform its contractual obligation must have been prevented, impeded, or hindered by the event; and
the affected party must have taken all reasonable steps to mitigate or avoid the event or its consequences.
The issue of the day is whether the Covid-19 pandemic or, more accurately the government lockdowns, qualifies as a force majeure event thereby relieving commercial tenants from their obligation to pay rent. Because force majeure provisions are express terms (not implied), the language in each lease or contract and its specific context will be of primary importance. As a result, if a lease or contract contains specific references to a pandemic, it will make it much easier for a party to successfully bring a force majeure claim. If it does not, a party may contend that such an event is covered by other language such as “act of God” or “governmental action,” the latter more likely. What is relevant in each case is that the event is “beyond the reasonable control” of the party and consequentially impacts the affected party’s ability to fulfil its contractual obligations. For example, if a salon is required to close due to lockdown orders, a case could/should be made that the tenant is relieved of their obligation to pay rent because their means of generating revenue has been interrupted through no fault of their own.
The degree to which the Covid-19 pandemic and government lockdowns have impacted tenants’ ability to pay rent is another factor that must be considered. Again, the express terms of the lease/contract will determine the likelihood of successfully making a force majeure claim, and language like “hindered” or “impeded” are more tenant-friendly than “prevented;” however, in either case, the affected party must show a causal link between the event and their inability to pay their rent. This makes the case more difficult for office tenants because of their ability to have their employees telework. Unless specifically stated in the lease, events that merely disrupt or negatively impact a tenant’s profitability are unlikely to qualify as a force majeure event. As a result, even though economic downturns and Presidential Elections do have real, adverse impacts on businesses, they are generally insufficient to bring a successful force majeure claim.
Finally, tenants must show that they have taken reasonable steps to mitigate or avoid the event and its consequences. Covid-19 and the related government lockdowns are impossible to avoid but, as has been discussed previously, office users are able to mitigate the impact of the event through teleworking. Retail tenants have a better claim, particularly service-based businesses, who have no alternate means of generating revenue and thus performing their contractual obligations. When assessing the validity of a force majeure claim, the reasonableness of mitigation efforts is measured within the context of the additional costs that would be incurred by the affected party.
Recommendations for Clients
What was once a relatively ignored lease provision has been brought to the forefront by recent unforeseen events. Moving forward, tenants should ensure that force majeure provisions are included in their commercial leases and that the terms cover specific events, i.e. pandemics, government lockdowns, etc. or that there is “catch-all” language that is sufficient to successfully bring a claim for relief. Many leases that do contain force majeure provisions also include clauses that do not excuse the timely payment of rent despite a force majeure event. If landlords are unwilling to omit this language, tenants should consider specific events that would prevent, hinder, and/or impede their ability to pay rent and address those with objective measures, timeframes, and remedies. When making concessions, the more specific the verbiage the greater the likelihood the landlord will agree to it. Landlords do not like “catch-all” language when it is not to their benefit.
Many force majeure events like a natural disaster, i.e. hurricane, are limited in terms of location and time; allowing for finite notice timeframes. Due to the widespread nature and developing impact of the pandemic and associated lockdowns, conventional notice timeframes are insufficient. Therefore, tenants should include protective or rolling notices in their leases that allow them to claim relief as the situation changes, i.e. state or local government reinstitute lockdowns due to increases in Covid-19 cases. Tenants should also identify and specify the evidence and supporting documentation necessary to make a force majeure claim along with the remedies for a successful claim; generally, an extension of the time to perform and/or a deferment of the obligation for the duration of the force majeure event. While business interruption insurance is advisable and protective, in cases of a prolonged force majeure event, tenants may want to include a termination option.
Reviewing commercial leases can be a tedious and painstaking exercise because every provision and clause must be analyzed through the lens of the worst-case and, sometimes, outlandish scenario. Force majeure provisions are no exception. More concerning than Covid-19 is the government’s shutdown of the economy. The lockdowns will have long-lasting, adverse effects on the economy and life, in general. The government showed the full extent of its destructive power by forcibly shutting down the best economy in a generation and, through its actions, putting 40 million Americans out of work. The genie cannot be put back in the bottle and, with little consistency or objective measures justifying the institution, duration, and/or conditions of the lockdowns along with their partisan nature, there is little to prevent future, authoritarian measures from being implemented with equally disastrous results. Commercial real estate landlords will adapt to the post-Covid-19 world by instituting feel-good safety measures but, once the hysteria subsides (likely on November 4, 2020), one of the long-lasting impacts will be a renewed and greater focus on force majeure provisions in commercial leases and contracts, in general.
Competition describes and covers a variety of factors impacting the risk associated with a property. The governing principle is the law of supply and demand, which states that the greater the demand for a product/asset relative to its supply, the more valuable it is. Alternately, the greater the inventory/supply of a particular product/asset relative to its demand, the less valuable it is. In real estate investment, the space market and capital market combine to determine the market value of particular property types and asset classes.
The space market represents the relationship between the demand and supply for commercial space with the intersection of the supply and demand curves establishing the market rental rate. Because of the time required to construct and deliver commercial properties, supply remains relatively constant. Therefore, demand for space is the main driver of increases or decreases in the market rent for a particular property type and asset class. Cap rates are similarly influenced by supply and demand; however, it is the point of equilibrium in the capital market which determines the market cap rate. The capital market represents the supply and demand for resources (money) to invest in real estate or other assets, i.e. stocks and bonds. The higher an asset’s return relative to its risk the more desirable that asset becomes in relation to other investment alternatives and the more capital allocated to that particular asset class. As demand increases, investors are willing to pay more for the same net income; leading to an increase in the asset’s value.
Amazon’s disruption of the retail industry and the rise of e-commerce coupled with the exponential growth of data and the need to store it, has led to an unprecedented increase in demand for industrial space. In terms of the space market, this has led to rent growth, year-over-year, that has outpaced all other asset classes. In the DC metro area, industrial rents have increased by an average 3.6% over the past 5 years and by 22% total since the subject property began leasing up in 2013. Most, if not all, industrial leases are triple net; meaning the net operating income is calculated by the rental rate multiplied by the square footage. This means, that on average and relative to market cap rates, industrial properties in the DMV have increased in value by an average 3.6% per year since 2015. The increase in market rents in the Route 28 South industrial submarket is only slightly less than the DC metro average; totaling 19.3% since the first/existing leases were signed at the subject property. With e-commerce expected to grow by 10% in 2020, demand for last-mile delivery space should remain strong and contribute to sustained rent growth.
All forecasts decrease in reliability as they increase in length of time. The subject property’s below-market leases are scheduled to expire in 2021 and 2022. The relatively short timeframe reduces the risk of any adverse changes in economic conditions that might impact demand and market rents for industrial space. This allows prospective purchasers to predict with greater certainty the potential increase in net operating income as a result of simply bringing contract rents up to market. Market analysts predict industrial rents to grow by 3.1% in 2020; insulating purchasers against overstating potential NOI growth in their acquisition assumptions and likely leading to an underestimation of the actual increase in future value.
The capital market is not totally independent and is heavily influenced by activity in the space market. Increased demand for industrial space, driven in no small part by Amazon, led to an increase in market rents, both generally and in relation to other commercial asset classes. As discussed previously, the more demand for something relative to its supply the more individuals are willing to pay more for it. What’s striking about the DC metro industrial market is the strong and sustained rent growth over the past 5 years despite millions of square feet delivering during that time. Due to the relationship between rental rates, net operating income, and value, industrial real estate has become more and more desirable from an investment standpoint. This has led investors to accept increasingly lower returns for each dollar of net operating income; represented by a decrease in the market cap rate and rise in property values.
Industry experts are calling for a 10% increase in e-commerce and further cap rate compression in 2020. Each would contribute to an increase in market value, independent of one another; however, when combined they act as a one-two punch byboth increasing the net operating income that is being capitalized and lowering the capitalization rate (required return). With its proximity to Dulles Airport and major transportation nodes, the subject property is ideally positioned as a last-mile delivery facility and should benefit from increased demand in both the space and capital markets.
Competitive Advantage (Space Market)
As mentioned previously, the subject property is comprised of 12 approximately 2,600 SF units. While seemingly innocuous, this data point reflects a competitive advantage that can actually be calculated. Currently, the smallest block of industrial space available in the Route 28 South industrial market is 3,162 SF. This is relatively low in terms of minimum blocks of space for industrial properties, but is still 562 SF larger than the subject property’s individual units. At the subject market’s estimated market rent of $9.50/NNN the annual rent is $30,039.00. Using this example, a tenant would be paying an additional $5,339/year or $444.92/month for space they may not need. Another way to look at it is that the subject property could, theoretically, charge an additional $2.00/NNN and still have a lower occupancy cost than the next alternative.
Spaces can always be doubled up to accommodate larger tenants but it is difficult, if not impossible based on the building’s layout, to demise bays into smaller spaces. The subject property is thus uniquely positioned in the market to be able to appeal to a broader tenant base on both square footage and price. The landlord has the option to price the space slightly above market due to the net difference in occupancy cost attributed to its competitors larger blocks of space or price the space(s) at market and reduce any potential vacancy losses by being the best deal in town.
Competitive Advantage (Capital Market)
Until recently, small retail strip centers have been one of the most desirable commercial real estate investment types. While still desirable, the Amazon effect has shifted capital to the industrial sector of the real estate market. This trend, alone, increases to the subject property’s present and future value; however, one of the reasons that small retail strip centers continue to be desirable also applies to the subject property.
As mentioned previously, value is measure of demand for an asset relative to its supply. All things being equal, the more desirable an asset the greater its value. The enduring demand for small retail strip centers comes from their size and thus their affordability. Market rents are subject to change; a property’s rentable building area not so much. A property’s value is determined by dividing the net operating income by the market cap rate, and because net operating income is limited by the current market/contract rents and cap rates are influenced by interest rates, in addition to other factors, there is an upper limit to its value simply based on square footage. Smaller buildings will always be affordable to a larger group of potential buyers. When you increase the number of buyers relative to the supply of available properties, the value goes up simply due to competition. This is true at the macro level as more capital is being allocated to industrial real estate; however, the effect is multiplied for the subject property, which at 32,000 SF and $4.16M is affordable to most commercial real estate investors. Size (rentable building area), therefore, acts as a type of value protection; maintaining and maximizing value through competition by being affordable to the largest group of prospective purchasers.
For more information on the subject property or to discuss listing your own property, please contact me at Ryan@RealMarkets.com or 703-943-7079.
The world is a dangerous place, fraught with risk. Life is all about assessing, analyzing, and mitigating those risks. Decisions are weighed and made based on an individual’s/company’s risk tolerance and expected return. The risk-return tradeoff states that the potential return rises with an increase in risk. In other words, investors are willing to accept a lower return for less risk. Prime examples are Treasury bonds in the capital markets and long-term, triple net leases with a credit-tenant, i.e. CVS, in commercial real estate. There are many risk factors to consider when making an investment decision, and these vary in applicability and importance based on the market, asset class (office, retail, flex, industrial, and land), etc. Before discussing various types of risk it’s important to understand the valuation method for income-producing properties, particularly cap rates, and the difference between market value and investment value.
As covered in my article, What’s a Cap Rate?, cap rates are a measure of value, expressed as a percent, that represent the all-cash return an investor is willing to accept based on a property’s net operating income. Cap rates are a simple, albeit incomplete, valuation method that provide a useful starting point from which to analyze an investment (for more information, check out my article, “4 Things Cap Rates Aren’t Telling You”). Market cap rates are determined by and based on recent sales comps for a particular asset class. For example, the current average/market cap rate for industrial properties in the Route 28 South submarket is 6.1%. This metric was derived from the sale of 35 properties in the submarket over the past 12 months. While related, the average sale price ($143/SF) is a less important indicator of value because it applies more to owner-user acquisitions. The average vacancy at the time of sale (11.6%), on the other hand, is a relevant data point because it relates directly to the risk that investors in that submarket/asset class are willing to incur for each dollar of net income. This means, that on average, investors in the Route 28 South industrial submarket are willing to accept a 6.1% return on an all-cash purchase despite an asset being 11.6% vacant with the associated lease-up costs.
The market cap rate and associated vacancy at the time of sale reflect the market value of a particular property type within that (sub)market; market value being the probable sales price in a competitive and open market under fair sale conditions. It is from this baseline that an income-producing property is analyzed and assessed based on its specific characteristics in relation to its competitors and market sales comps. For example, if the average property age in a particular submarket is 15 years and the subject property is 25 years old an investor may require a slightly higher return to compensate for the associated risks, i.e. deferred maintenance, repairs/replacements, etc. Alternately, if a property is fully leased and the average vacancy at the time of sale is 11.6%, as in the Route 28 South submarket, investors might be willing to accept a slightly lower return. This all contributes to a property’s investment value, which is a subjective measure, unique to each investor and heavily influenced by their risk profile.
As mentioned previously, there are a variety of macroeconomic and microeconomic factors to consider when analyzing an investment. To illustrate the practical application of these concepts, I will perform an analysis a real-life income-producing, triple net investment property in Chantilly, VA. The subject property is a 32,000 SF industrial building, built in 1986. The property is fully leased to 8 tenants with staggered lease expiration dates over the next 5 years. All leases are triple net with 3% annual base rent escalations and several have contract rents that are significantly below market. None of the building’s tenants have renewal rights and many have improved their spaces at their own cost and expense. With a net operating income of just over $255,000 per year and an asking price of $4,160,000, the property is being sold at a 6.13% cap rate. Below, I will identify and explain various, pertinent factors that have the power to increase or decrease a property’s value based on the risk premium, expressed as a percent, that is applied to the market cap rate.
Building Age/Year Built
A property’s age can impact its risk premium for a variety of reasons. As logic would imply, the older the building the higher the risk due to natural deterioration, deferred maintenance, repairs, and replacements, etc. That being said, they also built things to last “back then.” The subject property is 34 years old and the average age of industrial buildings that sold in the Route 28 South submarket in the past 12 months is 32 year old. As a result, there is little to no case for an increase in the cap rate (reduction in value) based on its age.
What’s important to know is whether there are any big-ticket items that must be addressed in the near future that are the responsibility of the landlord. In triple net leases, tenants are generally responsible for maintenance, repairs, and replacements of systems servicing their space. Also, landlords are able to “pass through” the costs of any capital improvements in the triple net charges; however, they must be amortized over their useful life. If the property is only partially leased, landlords must cover the proportionate share of the costs for the vacant space. The subject property is fully leased and the roof was replaced in 2017, further justifying no adjustment to the market cap rate.
Don’t put all your eggs in one basket. Diversification refers to the risk management strategy of investing in a variety of assets to reduce exposure to one particular asset and the conditions/circumstances that might adversely impact it or its value. The concept also applies to individual properties, which can be “single-tenant” or “multi-tenant.” As the name suggests, a single-tenant building has a higher risk profile because if the tenant defaults and/or vacates, the entire income stream is lost. Multi-tenant buildings are less risky, in general, but within this category there is a risk spectrum based on the size and proportion of the individual tenants’ spaces. For example (in theory), a multi-tenant building with 2 tenants is riskier (4x more) than a building with 8 tenants. Assuming the tenants’ proportionate share and base rent were the same for all of the tenants, if one of the two tenants in the 1st building were to default/vacate, it would result in a 50% reduction in the property’s net operating income; however, in the case of the 2nd building, the loss of one tenant would only result in a 12.5% decrease in NOI.
The subject property has 8 tenants, which occupy either 2,600 SF or 5,200 SF. Therefore, the loss of one tenant would only result in an 8.125% reduction in NOI, on the low end, and 16.25%, worst-case scenario. Risk is compartmentalized and minimized by the number of tenants, thereby creating built-in diversification. This validates the subject property’s cap rate as it relates to the average market cap rate and might even justify a slight reduction.
Length & Strength of Leases
When purchasing an investment property, one is essentially buying the leases and associated income streams, and the longer and stronger the leases, the better. Length and strength are interconnected. A lease that is “long” but not “strong,” meaning the lease language is vague, tenant-sided, etc. or the tenant is financially weak, is less valuable because the income stream is less reliable. Leases that are “strong” but not “long” are also less valuable because investors must factor in the possibility of vacancy losses when the lease terms expire along with the costs associated with securing another tenant, i.e. brokerage commissions, tenant improvement allowances, etc.
One exception to this rule is a situation in which the contract rents in the existing leases are below current market rents. The same concept applies, in that long-term leases with financially sound tenants maximize value from a risk mitigation standpoint; however, cap rates are applied to a property’s current net operating income, which is the sum of the various contract rents at that moment in time. In this case, a shorter lease term would be preferable because it would sooner provide the landlord with the opportunity to increase the base rent to the then market rate either by renewing the existing tenant or finding a new tenant. Application of the same cap rate to the larger net operating income would lead to a significant increase in value; however, a case could also be made to apply a lower cap rate depending on the length and strength of the new lease, resulting in an even greater increase in value.
I will use the subject property to demonstrate this principle. The property is currently valued at $4,160,000 based on a net operating income of ~$255,000 and a cap rate of 6.13%. At present, approximately 13,000 SF is leased at well-below market rents. After applying current market rates, the net operating income would increase by over $33,000 per year. Using the same cap rate would result in an increase in value of nearly $540,000 ($33,000 ÷ 6.13%). If the new leases are “long and strong,” a reduction in the cap rate might be justified; leading to even greater appreciation. For example, if 6% were used instead of 6.13% (a relatively minor change), the value would increase by an additional $10,000. For the subject property, the risk associated with some of the shorter lease terms is mitigated by the opportunity to increase the property’s NOI, and the potential losses/costs are offset by the resulting appreciation in value.
To be continued…
For more information on the subject property discussed in this article, please contact me at 703-943-7079 or Ryan@RealMarkets.com.
Rentable Building Area/Inventory
- Logistics: 153,321,228 SF
- Specialized Industrial: 28,657,987 SF
- Flex: 77,401,676 SF
- Market: 259,380,891 SF
The big story and overarching theme in the industrial market both nationwide and in the DC metro area is Amazon. The tech giant has disrupted both the retail and industrial real estate sectors unlike anything before. E-commerce, which is expected to grow by 10% in 2020, has forever changed retail, specifically in the way product companies manage their real estate needs. Businesses are reducing their retail footprint and storing product off-site in industrial facilities with rental rates and triple net expenses many times lower than their retail counterparts. Products can now shipped or delivered at minimal cost. Retail landlords are struggling to adapt to this new environment but, in short, retail’s loss is industrial’s gain. “Last-mile delivery” is driving the DC metro logistics market, which comprises nearly 60% of total inventory. While national distributors prefer metro areas with cheaper land and less traffic congestion, the region’s buying power, population density, and access to both national and international airports (DCA and IAD respectively) more than compensate and, as a result, the demand and value for industrial space will continue to increase.
The Amazon effect is not limited to logistics. Along with other tech behemoths, Google and Microsoft, the need for data storage is fueling another sector of the industrial market: data centers. Amazon may have chosen National Landing as the site for its HQ2, but its subsidiary Amazon Web Services has quietly made Herndon, VA its unofficial east coast headquarters; occupying over 1,000,000 SF in the submarket. This is due to its proximity to Loudoun County, home to Data Center Alley and over 70% of the world’s internet traffic. Microsoft recently purchased 332 acres in Leesburg and Google purchased two sites for a combined 148 acres for data center development. In addition, just last week, Amazon purchased 100 acres in Chantilly for $73,000,000 with sources indicating the site will be used for data centers. With data increasing exponentially and more companies and individuals moving to the cloud, the need for data storage will continue to increase for the foreseeable future; resulting in rising values for both existing product and industrial-zoned land.
*Due to diminishing supply, land in Loudoun County can exceed $1,000,000 per acre.
- Logistics: 5.3%
- Specialized Industrial: 6.7%
- Flex: 7.6%
- Market: 6.2%
- Net Absorption Past 12 Months: 1,900,000 SF
- Vacancy Change Past 12 Months: 0.1%
There was a slight increase in the metro vacancy rate over the past 12 months and while a 0.1% increase is hardly noteworthy by objective measures, it does provide insight into the overall strength of the industrial sector. Large tenant move-outs due to bankruptcy filings were a major contributor to the vacancy increase with HH Gregg and Toys R Us vacating nearly 400,000 SF at 14301 Mattawoman Dr in Brandywine, MD and 670,000 SF at 7106 Geoffrey Way in Frederick, MD respectively. This combined 1,070,000 SF accounts for approximately 0.4% of the market’s total inventory. The real story is in the 1,900,000 SF of net absorption over the past year due to a booming logistics industry and demand for data center space. The overwhelming majority of demand is focused in Northern Virginia with its 5 largest industrial submarkets accounting for 99.8% of total absorption (1,897,000 SF) over the past 12 months despite comprising only 32% of the DMV’s total inventory. Route 28 North, alone, contributed 1,100,000 SF to that number; evidence of the strong and growing demand for data center space.
*Loudoun County offers incentives for data centers including sales tax exemptions for equipment such as servers, generators, and chillers.
Average Asking Rent
- Logistics: $10.62/SF
- Specialized Industrial: $10.63/SF
- Flex: $14.68/SF
- Market: $11.83/SF
- Rent Growth Past 12 Months: 3.3%
Industrial rents in the DC metro area began to recover from the effects of the Great Recession in 2012 and, since then, have outpaced all other asset classes in terms of rent growth. This can be attributed to the rise of e-commerce, due largely in part to Amazon’s disruption of the retail industry, and cloud computing and the need for data storage. As the law of supply and demand would indicate, the increase in demand led to significant vacancy compression over that time; 44.14% to be exact. This number is even more astounding when considering that over 17,250,000 SF delivered over the same period. New product cannot be built quickly enough and the discrepancy between supply and demand will continue to push rents up. This is further exacerbated by the price of industrial land, particularly in Loudoun County, along with rising labor and construction costs.
- Logistics: 777,030 SF
- Specialized Industrial: 1,375,177 SF
- Flex: 445,170 SF
- Market: 2,597,377 SF
- Deliveries Past 12 Months: 3,100,000 SF
In stark contrast to the DC metro office market, demand for industrial space exceeds the existing supply. This is amazing when considering that 3,100,000 SF delivered in the past 12 months and nearly 2,600,000 SF is under construction and scheduled to deliver in 2020. Again, Northern Virginia led the way; delivering 8 of the largest properties in the metro area in 2019. Development is largely driven by tech companies’ insatiable appetite for data and the need to store it. From sensitive information like health and/or financial records to iPhone photos, more and more data is being created and stored in the cloud, and while “the cloud” may sound ethereal it’s actually a collection of brick and mortar buildings: data centers. Companies like Google, Amazon Web Services, and Microsoft have been competing to secure land/assets to support their data warehousing needs and, in doing so, have driven up prices (predominantly in Loudoun County). Affordability will thus be a growing impediment to future development; however, it’s likely that demand will continue to outpace supply leading to further rent growth which should justify the investment. The remainder of development was primarily in Prince George’s County along the east side of I-95 and, while only 104,973 SF delivered in 2019, there is currently over 400,000 SF under construction with an additional 650,000 SF proposed. Due to its proximity to Amazon’s HQ2 in National Landing, Prince George’s County is strategically positioned to become the Data Center Alley of Southern Maryland.
The exact opposite is happening in the District. The majority of DC’s industrial product is in Northeast and Southeast/Southwest, historically depressed and high-crime areas; however, as evidenced by high-profile developments like the Wharf and Navy Yard, these areas are undergoing gentrification and slated for redevelopment. As a result, the highest and best use for existing industrial properties is multi-family (mixed-use) projects; a trend that should continue to benefit Prince George’s County.
Sales Past 12 Months
- Sales Volume: $2,700,000,000
- Market Cap Rate: 7.0%
- Average Price/SF: $224
- Average Vacancy at Sale: 8.1%
Nearly all capital investment in 2019 was in Northern Virginia and to a lesser extent, Prince George’s County. In addition to Google’s, Amazon’s, and Microsoft’s recent acquisitions, Digital Realty purchased more than 400 acres in Loudoun County for $236,500,000 with the potential to develop over 2,000,000 SF of data center space. Other notable sales include Amazon’s acquisition of 13600 EDS Dr in Herndon for $54,000,000, which includes a 434,000 SF data center; DWS Group’s purchase of the 350,000 SF Chantilly Distribution Center located 3900 Stonecroft Blvd for $56,100,000; Blackstone’s purchase of a 7-property portfolio of shell industrial buildings that it converted into data centers; NGP Management’s $142,000,000, 9-property portfolio purchase in Lorton, VA; and Buchanan Partner’s acquisition of 39 properties across the DC metro area totaling nearly $200,000,000. At $2.7 billion, 2019 sales set a record and surpassed the previous year’s total by nearly 60%. With Amazon’s growing influence on both the logistics and data center industries, not to mention the impact it will have on employment and population growth in the DMV, the industrial sector should continue to thrive and remain the most desirable and valuable asset class in commercial real estate for the foreseeable future.
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.
- 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.
- 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.
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.
- 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 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.