What’s an Accredited Investor?

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In response to the abuses that led to the Great Depression and its devastating impact on individual investors, Congress passed the Securities Act of 1933, also known as the “Truth in Securities Act,” which regulated interstate sales of securities, along with the Securities Exchange Act of 1934 which regulated sales of securities in the secondary market and created the Securities & Exchange Commission (SEC). A security is a certificate or other financial instrument that has monetary value and can be traded, i.e. stocks, bonds, derivatives, etc. Basically, the SEC was created to protect people from being scammed. They accomplish this goal by regulating the securities industry and specifically by determining the criteria for being an accredited investor.

As the term implies, “accredited” investors are “officially recognized or authorized” as sophisticated and/or capable of investing in higher-risk, unregistered investment vehicles. The SEC under Regulation D establishes the requirements for such individuals based on income, net worth, asset size, governance status, or professional experience. In order for an individual to be considered an accredited investor they must meet one of the following requirements:

  1. Annual income of $200,000 (or $300,000 joint income if married) for the past 2 years with the expectation that one will earn the same or more in the current year.
  2. Minimum net worth of $1,000,000 either individually or jointly if married. One’s personal residence is not included in their net worth, but neither is their mortgage counted as a liability. Net worth is defined as assets minus liabilities or what you own minus what you owe.
  3. In 2016, Congress included registered brokers and investment advisors as accredited investors along with individuals that can prove sufficient education and/or job experience in unregistered securities.

If membership has its privileges, what’s so great about being an accredited investor? First, as the status denotes, accredited investors are financially stable, experienced, and knowledgeable. They understand the risks involved in an investment and/or have the resources to absorb reasonable losses. Second, whenever dealing with the government there is a cost associated with “red tape.” Regulatory filings and compliance can be costly. As a result, investments that can be offered directly to accredited investors are able to produce a higher return (by lowering costs). The final point is a combination of the previous two. The exclusivity of investments available only to accredited investors makes them valuable. Furthermore, the sophistication of the investors provides validation for the investment vehicle, itself. If such investments weren’t solid, safe, etc. they wouldn’t exist because no accredited investor would risk investing in them.

You can fool all the people sometimes and some of the people all the time, but you’d be hard-pressed to fool a bunch of high net worth individuals with investment experience.

Alexandria Submarkets Q3 2019

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I-395 Corridor

  • RBA: 11,121,602 SF
  • Vacancy Rate: 24.7%
  • 12 Month Net Absorption: (27,200 SF)
  • Average Asking Rent: $30.47
  • 12 Month Rent Growth: 2.7%

Landlords in the I-395 Corridor are praying that the “Amazon effect” extends to their submarket, which has one of the highest vacancy rates in the metro at 24.7%. Rent growth was the highest in the area behind only the Capitol Riverfront, which may indicate an increase in demand to its proximity to Amazon’s HQ2. Still the submarket suffers from a lack of metro access and competition from neighboring submarkets like Falls Church, Crystal City, and particularly the Eisenhower Ave Corridor, which has only slightly higher rents, metro access, and an abundance of 4 & 5-Star properties. In fact, the I-395 Corridor has only slightly more 4 & 5-Star inventory at 5,362,225 SF vs. Eisenhower Ave’s 4,109,627 SF despite its total inventory over twice that of its neighbor. Time will tell if the submarket can recover from the damage done by BRAC. Apart from renewals from the U.S. Patent and Trademark Office and the GSA, leasing has been dominated by local businesses downsizing.

Eisenhower Ave Corridor

  • RBA: 4,891,844 SF
  • Vacancy Rate: 9.1%
  • 12 Month Net Absorption: 29,500 SF
  • Average Asking Rent: $36.24
  • 12 Month Rent Growth: 3.9%

At only 4,891,844 SF, the Eisenhower Ave Corridor is a relatively small submarket; however, it is absolutely dominated by 4 & 5-Star properties which comprise 84% of the total office inventory. The submarket’s vacancy rate is comfortably below the metro average of 13.1%. The Department of Defense vacated 600,000 SF in 2017 but the building was demolished, which reduced the office inventory and vacancy levels. This large-scale move out was also offset by the National Science Foundation leasing 700,000 SF when 2415 Eisenhower Ave delivered in the same year. Two indicators that the “Amazon effect” may continue to improve fundamentals are the nearly 4% growth in submarket rents over the past 12 months along with the co-working company, Industrious, recently leasing 25,000 SF at Carlyle Tower. This may signal diversification in tenant mix in a submarket dominated by federal tenants. The submarket’s resiliency and attractiveness will be put to the test in a few years (2023, 2024, and 2025) when over 2.1 million square feet of space come up for renewal from government tenants. The USPTO, alone, occupies 2,000,000 SF.

Old Town Alexandria

  • RBA: 10,398,384 SF
  • Vacancy Rate: 10.9%
  • 12 Month Net Absorption: (3,600 SF)
  • Average Asking Rent: $33.45
  • 12 Month Rent Growth: 1.3%

Conventional wisdom would suggest that Old Town Alexandria will benefit from Amazon’s HQ2 based on its location, alone; however, I do not believe this will be the case. The major issue with Old Town is that it’s old. Rent growth, while positive, is more likely the result of a strong economy rather than increased demand. The submarket is comprised mostly of 3 and 1 & 2-Star properties (over 77%), and the type of companies that will want to be in close proximity to Amazon will prefer neighboring submarkets with an abundance of 4 & 5-Star properties. Old Town is still Old Town and due to its walkability, retail amenities, and metro access it will still be attractive to certain, most likely smaller, tenants. Evidence of this is ALX Community and Spaces leasing approximately 59,000 SF in the past year. The two co-working companies clearly saw a demand from small businesses and entrepreneurs who want to work, live, and play in Old Town without having to sign “larger,” long-term leases.

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Uniformity

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Article X of the Constitution of Virginia mandates that all property shall be taxed. Furthermore, it requires such taxation be uniform upon the same class of subjects within the territorial limits of the taxing authority. Because revenue derived from real estate assessments makes up a significant portion of local government budgets, the importance of the process for determining a property’s fair market value cannot be understated. Tax rates vary from municipality to municipality and are subject to change. Therefore, in order to ensure that assessments are fair and equitable the Code of Virginia mandates the process be uniformly applied and in accordance with state statues and local ordinances.

Fairfax County, alone, has 362,089 individual properties to assess every year. As a result, the Department of Tax Administration uses accepted mass appraisal standards and techniques recognized by the International Association of Assessing Officers (IAAO) and other nationally recognized professional appraisal organizations. As the term implies, “mass appraisals” are different from appraisals of individual properties. When estimating the value of a group of properties, appraisers use different techniques based on the statistical analysis of large amounts of data. Properties are classified and stratified based on their characteristics with property type at the top of the hierarchy. Under the Code of Virginia, the Department of Taxation has established the following 7 classes:

  1. Single-Family Urban
  2. Single-Family Suburban
  3. Multi-Family Residential
  4. Commercial and Industrial
  5. Agricultural or Undeveloped – 20-100 acres
  6. Agricultural or Undeveloped – over 100 acres
  7. Tax Exempt

Once classified and stratified, Assessing Officers will collect and analyze data that provide market value indicators. This data includes local economic conditions, planning and zoning regulations, neighborhood boundaries, current construction cost data, income and expense data for rental properties, recent qualified real estate sales, etc. and comes from public records, real estate and construction professionals, property owners, and physical inspections. This data provides the groundwork for the appraisal process.

There are 3 traditional approaches to property valuation: Cost Approach, Sales Comparison Approach, and Income Capitalization Approach. Without going into detail for each, it is enough to note that one approach may be more applicable than another based on property class/type. Assessing Officers consider this in addition to their statistical analysis of market value indicators to create Valuation Models.  It is these Valuation Models that provide the basis for uniformity.

The authority to levy taxes is one of, if not, the greatest power accorded to government. When you’re taking people’s money you need to be able to defend and justify the amount you’re taking. In order to do that there must be objective measures to ensure that the process is applied equally to everyone/all properties. Assessing Officers use accepted mass appraisal standards and techniques recognized by national professional appraisal organizations because they provide a third-party standard that in turn creates a uniform framework under which properties can be assessed. Perhaps the most important takeaway is that uniformity refers to the process not the outcome.

Source: Virginia Department of Taxation, Board of Equalization Manual

Hazardous Materials

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Successful lease negotiations are based in a comprehensive understanding of the terms and provisions, what’s important about each, and how they impact a particular client (tenant). While every commercial lease is different, there are some provisions that are in every commercial lease. The Hazardous Materials section is a prime example. Language may vary, but there are common points/themes that are important to consider and negotiate:

Definition/Exceptions

Whenever a lease term is capitalized it’s because it has a specific description or definition within the lease. For example, “default” and “Default (or Event of Default)” do not mean the same thing because lower case “default” includes notice and cure periods while capital “Default” defines a violation that is beyond such notice and cure periods. Hazardous Materials is similar in that it is defined by specific federal laws that are the same in nearly every lease. “Hazardous Materials” are defined as a “hazardous substance”, “hazardous material”, hazardous waste”, “regulated substance” or “toxic substance” under:

  • Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, 42 U.S.C. §9601, et seq.
  • Hazardous Materials Transportation Act, 49 U.S.C. §1801, et seq.
  • Resource Conservation and Recovery Act of 1976, 42 U.S.C. §6901 et seq.
  • Clean Water Act, 33 U.S.C. §1251, et seq.
  • Safe Drinking Water Act, 14 U.S.C. §300f, et seq.
  • Toxic Substances Control Act, 15 U.S.C. §2601, et seq.
  • Federal Insecticide, Fungicide and Rodenticide Act, 7 U.S.C. §136 et seq.
  • Atomic Energy Act of 1954, 42 U.S.C. §2014 et seq.
  • and any similar federal, state or local Laws, and all regulations, guidelines, directives and other requirements

Examples of exceptions are for cleaning and/or office products or limitations on quantity, but this is not really necessary as the materials that would trigger a default under this section are clearly defined and legal/proper use and disposal is always a requirement.

 Property Type/Use

The relevance/importance of the Hazardous Materials sections is directly impacted by the property type and use of the space. Tenants leasing industrial space are more likely to be impacted by the section based on their own use, that of neighboring tenants, and/or previous tenants. Office users generally have the least to worry about based on the nature of their use: “general office.” Tenants must understand if their business requires the use of any Hazardous Materials. If so, this should be disclosed to the landlord prior to leasing, but most importantly the tenant must use, store, and dispose of such Hazardous Materials according to applicable laws.

Inspections

Landlords may require the right to inspect the tenant’s space to check for the presence of any Hazardous Materials violations. Such rights should be based on a reasonable standard/just cause and, while landlords would not typically expend the resources to frivolously inspect the premises, the cost should be born by the landlord unless any violations are discovered. Tenants will always be responsible for remediating any contamination (that is the fault of the tenant).

Preexisting Conditions

Depending on the property type, tenants may want to inspect the property for the existence of Hazardous Materials. This is particularly and primarily important with land (office not so much). It’s good to have the landlord indemnify the tenant against the existence of any Hazardous Materials present prior to the tenant’s occupancy, but better to have them covenant that there are no Hazardous Materials prior to the tenant’s occupancy. The first requires the tenant to prove that the Hazardous Materials were there before they occupied and not the result of their occupancy while the latter puts the burden of proof on the landlord.


Hazardous Materials wouldn’t exist if they weren’t used in one capacity or another. This universal lease provision is mostly a “cover your butt” for the landlord. In most cases they’re never used; making it a relatively irrelevant section in most leases. When it does apply the tenant simply needs to use, store, and dispose of the Hazardous Materials according to applicable law and pay to remediate any violations, spills, etc.

Fairfax County’s Silver Medal Submarkets Q3 2019

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Second best isn’t that bad when considering your competition. Tysons Corner and Reston are two of the largest office submarkets in the country with a combined 50,536,733 SF, 29,519,533 SF of which is comprised of 4 & 5-Star properties (58.4%). That’s only slightly less than Herndon, Fairfax Center, and Merrifield’s entire inventory combined (30,903,488 SF). Whether a matter of perception (Herndon), lack of direct access to Metro stations (Fairfax Center), or delayed development (Merrifield), these submarkets are often an afterthought for tenants when considering where to locate their business; however, with more than 16.5 million square feet of 4 & 5-Star properties between them, these submarkets offer both quality and value with average rents well below the both the metro average (45.19/SF) and Reston ($36.93/SF) and Tysons ($39.97/SF).

Q3 2019 saw an improvement in nearly every metric in each submarket with only Herndon’s 12-month rent growth seeing a slight decline from 2.1% to 1.4% (still positive). Each submarket has its own reason to be optimistic, but the common theme seems to be that the secret is out!

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Herndon

  • RBA: 12,769,326 SF
  • Vacancy Rate: 16.1%
  • 12 Month Net Absorption: 95,800 SF
  • Average Asking Rent: $31.20
  • 12 Month Rent Growth: 1.4%

In 2017, Amazon Web Services moved to Herndon; constituting the largest deal in over 5 years. This was in no small part to Herndon’s proximity to data center alley not to mention Dulles International Airport. With Amazon’s decision to locate its HQ2 in Crystal City coupled with the Silver Line expansion (set to deliver in Q3 2020), the submarket is poised for explosive growth. In fact, we may be seeing the beginning of this renaissance. Herndon’s vacancy rate is above the metro average, mostly due to large scale move outs, but saw a decrease of 0.7% in the past quarter in addition to a 348,800 SF positive swing in net absorption. Rents increased by $0.44/SF on average from last quarter. Currently there is more than 2,000,000 SF available but much of that is within half a mile of the Silver Line stations. Developers may be waiting to break ground due to the existing inventory and vacancy level, but there are more than two dozen projects in the proposed pipeline and sales volume in Herndon is the highest in Northern Virginia.

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Merrifield

  • RBA: 10,249,212 SF
  • Vacancy Rate: 13.4%
  • 12 Month Net Absorption: 57,300 SF
  • Average Asking Rent: $32.55
  • 12 Month Rent Growth: 3.3%

In 2015, Exxon Mobil vacated more than 1,200,000 SF when it moved its headquarters from Merrifield to Houston. As a result, the submarket’s vacancy rate skyrocketed to 25% and while it has since recovered it is still slightly above the metro average (13.1%). Inova filled the void by occupying the former campus, but has since scrapped its plans to develop/occupy 15,000,000 SF; returning the original proposal of 5,000,000 SF. This is still a significant expansion, on par with Amazon (6,000,000 SF by 2024). Time will tell if there is an “Inova effect;” characterized by increased demand from smaller tenants that wish to be close to the healthcare giant, but currently tenants are leaving the submarket for more urban environments along with Tysons Corner and Reston. This is evidenced by the lack of any new development in the past 10 years, none in the pipeline in the next 12 months, and sales of  little more than $10,000,000 since the start of 2018.

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Fairfax Center

  • RBA: 7,884,950 SF
  • Vacancy Rate: 20.9%
  • 12 Month Net Absorption: 186,000 SF
  • Average Asking Rent: $30.10
  • 12 Month Rent Growth: 3.6%

Fairfax Center has cause to be cautiously optimistic due to 6 consecutive quarters of positive net absorption; resulting in a significant decrease in the submarket’s vacancy rate. Still at 20.9% it is well above the metro average. The positive leasing activity can be attributed to the increase in defense spending in the recent budget, but in a submarket heavily occupied by large government contractor tenants it is especially vulnerable to large scale move outs.

What’s a 1031 Exchange?

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A 1031 exchange, otherwise known as a tax-free exchange, is a process by which an investor is able to defer paying capital gains taxes when selling an investment property by reinvesting the proceeds of the sale into a “like-kind” property or properties of equal or greater value within certain time limits as defined by Section 1031 of the U.S. Internal Revenue Code. This definition contains a number of operative terms that require elaboration.

“…defer paying capital gains…”

Capital gains are calculated by based on the investment’s adjusted basis, which is the original basis plus any capital improvements minus cost recovery deductions. The value of the cost recovery taken is taxed at a different rate and included in the taxable income from the sale.

“…when selling an investment property by reinvesting the proceeds of the sale…”

One of the requirements for a 1031 exchange is for the sale proceeds to be transferred to a “qualified intermediary,” an independent, third party, which then transfers those proceeds to the seller of the replacement property or properties. The seller of the original property can at no point handle the funds.

“…into a ‘like-kind’…”

This refers to the classification of the asset according to the Internal Revenue Code (IRC), in this case Section 1231, property held for use in trade or business. This means that a residential property can be exchanged for an office property and/or vacant land can be exchanged for an industrial property as long as they are held for investment purposes.

“…property or properties of equal or greater value…”

Sellers are allowed to identify 3 like-kind properties regardless of their market value (three-property rule) or an unlimited number of properties as long as their total market value does not exceed 200% of the property being sold (200% rule). Another less commonly known or used option is the 95% rule, which allows the seller to identify more than 3 properties with a total value that is greater than 200% of the property being exchanged IF they acquire at least 95% of the value of the properties identified.

“…within certain time limits…”

The timeline under a 1031 exchange are measured from the sale of the property being exchanged. Sellers have 45 days to identify/nominate (in writing) the prospective replacement property or properties and 180 days to acquire/close on the same (not 45 days plus 180 days).

“…as defined by Section 1031 of the U.S. Internal Revenue Code…”

The IRS strictly enforces the rules and regulations governing 1031 exchanges and due to their complexity it is advised that investors seek the guidance and assistance of licensed professionals when handling such transactions.

Pop Quiz, Hotshot: The Build Out Cost Came in Higher Than Expected. What Do You Do?

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Construction costs have been going up for years.  I remember when I started in the industry in 2008 when $40-$50/SF would cover a full, turnkey office build out. Today, it seems like $70/SF is a minimum estimate. Granted, there’s more glass than ever in “building standard” build outs, but VCT (Vinyl Composition Tile), which looks like real hardwood but is more durable and costs the same as commercial carpet (tiles), is also standard. Exposed ceilings, all the rage, are significantly more expensive than ceiling tiles, which have seen a dramatic increase in quality coupled with (dimmable) LED lights.

We’re still in a relatively tenant-friendly market. Landlords are still having to compete for tenants, but due to oversupply, access to mass transit, etc. rates have not increased as much as construction costs. The DC market average asking rent is $37.53/SF. If you use easy math and divide $70/SF by the average asking rent you get 1 ¾ years before the landlord makes back their initial investment… and that’s not taking into account brokerage commissions, actual net rent, etc.

Whatever the reason, 5-year terms can no longer justify the cost of a full, turnkey build out. We live in a world of 6 and 7-year leases now… but what if your client wants a shorter term? What do you do?

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One option would be to increase the base rental rate by amortizing the improvements (above the cap) over the term of the lease. If the build out costs $90/SF and the landlord’s pro forma has only allotted $70/SF for the negotiated rate and other economic terms of the lease, there would be an outstanding balance of $20/SF. Without taking into account the time value of money or the amortization rate, for a 5-year lease that would equal an additional $4/SF/yr… and that escalates annually. While rental payments are fully deductible, it’s still more cash out of pocket and the landlord may not agree to this deal structure; preferring a longer term.

Another option would be to “give back” any months of rental abatement previously negotiated. The economic value of the free rent could potentially offset the additional build out costs. If we use the previous case in which the tenant prefers a 5-year term and there exists a $20/SF balance, the rent would need to be $40/SF for 6 months of free rent to offset the amount and $48/SF if the tenant is only able to negotiate 5 months of rental abatement. Both of these rents are well above the metro average, which means that in most cases rental abatement forfeiture would not be sufficient; requiring additional economic concessions on the part of the tenant. The benefit of this strategy is that it involves no money out of pocket for the tenant. The downside is that free rent is very helpful to offset up front costs associated with leasing commercial space, i.e. moving, furniture, cabling/wiring, etc.

The simplest and most obvious solution is for the tenant to pay for the balance in cash. Of course, the “easy way” is rarely the best and this option is the least desirable for a number of reasons. The time value of money states that money today is worth more than money tomorrow. By coming out of pocket today the tenant is expending capital that could be put to more productive and profitable uses. Also, while a tenant enjoys beneficial occupancy of the real estate they do not own it, and at the end of the lease term the space reverts back to the landlord; meaning the tenant is paying to improve someone else’s property. Office build outs are generally “turnkey-ed” by the landlord; meaning they manage the entire process from architectural drawings to permits to the actual construction and are responsible for all the costs (and risk). Tenants do not want to have to run their business AND manage a construction project, but if the landlord places a cap on the allowance and the estimates exceed that cap they suddenly have an interest in the management of the build out. This is because the landlord knows that they will have to spend the $70/SF (in this case), but anything above that will be at the tenant’s expense. Therefore, they don’t necessarily care if the project costs $90/SF or $100/SF… it’s not their money at that point. In cases such as this the tenant will want to hire their own construction manager to oversee the landlord’s work to ensure it’s done to budget, on time, etc.

The best alternative for the tenant is to agree to the longer lease term with a termination option after 5 years. This option allows the tenant to retain all the rental rate and abatement concessions and only pay the unamortized transaction costs (brokerage commissions and build out cost) and a termination penalty IF they decide to terminate. Termination penalties are generally quantified in terms of months of rent. Timeframes for notice and the point after which the tenant can terminate the lease are also points of negotiation. The greater the notice period the more time the landlord has to market and relet the space thereby providing justification for a lower termination penalty. A good rule of thumb is to analyze the average absorption rate for the submarket, asset class, and property type and negotiate a combination of notice period and termination penalty based on that time. For example, if the average rate for similar spaces in the submarket in which the property is located is 2,000 SF per month and the tenant is vacating 18,000 SF the tenant might propose a notice period of 6 months with a 3-month termination penalty.

12,000 SF (2,000 SF x 6 months) + 6,000 SF (2,000 SF x 3 months) = 18,000 SF

In this scenario the tenant gets to have their cake and eat it too. They are able to negotiate a market rental rate, keep their rental abatement (potentially negotiate additional months based on the longer lease term), get a full turnkey build out (no capital outlay), and control the space all while shifting the risk to the landlord. Understandably termination options are not favored by landlords, but if the tenant is financially strong and the terms are reasonable the landlord should be willing to agree to one in order to get the deal done.

Northern Virginia’s Town & City Submarkets Q3 2019

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Northern Virginia’s Town & City submarkets include Fairfax City, Falls Church, Vienna, McLean, Oakton, and Great Falls (in order to rentable building area). Of the combined 13,509,588 total square feet only 1,592,828 SF is comprised of 4 & 5 Star properties (11.8%). The fact that these submarkets’ average asking rents are below the metro average ($37.53/SF) is the result of the predominance of 3-Star and 1 & 2-Star properties and not necessarily due to supply and demand fundamentals as evidenced by the fact that all but Oakton have vacancy rates below the metro average (12.95%). Tenants that choose to locate their business in these submarkets do so for different reasons than traditional office users; making these submarkets unique when negotiating lease terms. Oftentimes, it’s “take it or leave it.”

Fairfax City

  • RBA: 5,047,260 SF
  • Vacancy Rate: 10.8%
  • 12 Month Net Absorption: 46,300 SF
  • Average Asking Rent: $24.78
  • 12 Month Rent Growth: (0.6%)

The number of office condos in Fairfax City and non-institutional landlords/owners impact market fundamentals in a way that is more reflective of said owners’ individual, financial “market” than outside market conditions.

City of Falls Church

  • RBA: 2,829,773 SF
  • Vacancy Rate: 12.6%
  • 12 Month Net Absorption: (32,600 SF)
  • Average Asking Rent: $25.49
  • 12 Month Rent Growth: 1.1%

Town of Vienna

  • RBA: 2,007,856 SF
  • Vacancy Rate: 7.5%
  • 12 Month Net Absorption: (9,500 SF)
  • Average Asking Rent: $28.56
  • 12 Month Rent Growth: 1.5%

Vienna apparently has 662,589 SF of 4 & 5-Star properties, but you’d be hard-pressed to identify them.

McLean

  • RBA: 1,701,139 SF
  • Vacancy Rate: 10.6%
  • 12 Month Net Absorption: (45,500 SF)
  • Average Asking Rent: $31.38
  • 12 Month Rent Growth: (0.4%)

Despite having ZERO 4 & 5-Star properties, McLean has the highest average asking rent of these submarkets at $31.38/SF. Proximity to DC matters.

Oakton

  • RBA: 1,649,594 SF
  • Vacancy Rate: 16.4%
  • 12 Month Net Absorption: (5,400 SF)
  • Average Asking Rent: $27.26
  • 12 Month Rent Growth: 2.0%

Poor Oakton. At 16.4% this is the only submarket in this category that has a vacancy rate higher than the metro average.

Great Falls

  • RBA: 273,966 SF
  • Vacancy Rate: 7.2%
  • 12 Month Net Absorption: (5,000 SF)
  • Average Asking Rent: $25.97
  • 12 Month Rent Growth: 2.2%

Class Class Class, Tax Tax Tax

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

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

  1. Property held as a personal residence

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

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

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

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

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

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

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

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

 

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

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

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

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

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

Vacant Space

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

Available Space

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

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

Vacant Available Space

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