October 21, 2003
Robust Building Sales vs. Anemic Leasing:
For some time now - the last two years - the sales market for downtown buildings has been brisk. Owners have put record amounts of commercial investment property on the market and have reaped riches the likes of which have not been seen in this town since the Japanese and Dutch invasion during those heady days of the late 1980s.
The popular discussion between commercial real estate professionals (and I use the term loosely) centers around whether: (i) interest rates have hit historic lows and alternative yields are subpar relative to real estate; therefore, purchasing real estate investments at historically low cap rates and above replacement cost makes sense; or (ii) investors purchasing commercial property at inflated prices are locking in historically low yields, from which they will never recover.
To many, the answer to this question is superfluous, in that many commercial real estate investment entities rely on the purchase, sale and management of investment assets to perpetuate their livelihood. The ones who should be asking this question are the pension fund advisors, insurance companies and related investors that are forking over record amounts of cash for these buildings.
There are several premises that are quite clearly established: Investors in commercial real estate are paying much more for existing cash flow streams than two years ago. Also clear is that Washington, D.C. has experienced job loss in the private sector. With a downtown vacancy of 8.2%, there exists almost 9.5 million sq. ft. of vacant space in a market of more than 115 million square feet. Compared to other major metropolitan markets, Washington, D.C. is viewed as comparatively safe. However, the softness in the national economy has a direct impact on the law firms and associations of the nation's capital: less money spent on non-core expenses, such as lobbying and regulatory and less money to non-profits.
We think the truly interesting question for newly minted commercial real estate investors, who passed up investments in alternative "down" markets, is what the District of Columbia world will look like in 5 years.
Since the lead time in commercial real estate is so long, one can predict a fairly long way towards that 5 year horizon: We know that there is nearly 5 million square feet of new office product in the pipeline. Absent new and dramatic jobs creation, what will occur is a shell game, reminiscent of the early 1990s. New buildings will lure tenants from older buildings with rental abatement, concessions and attractive rates. The older buildings will be forced to compete. To the extent that an investor purchased its asset during the frothy period we now find ourselves, and locked in a low cap rate based on current rents, they may experience a declining yield, more vacancy and acute attention from their subject investors.
History often provides clues to the present. The Japanese who paid exorbitant amounts for downtown commercial properties fifteen years ago contended that their purchases were justified because their cost of borrowing was null. We hear a similar drumbeat now.
There must be healthy and consistent job creation to reduce Washington, D.C.'s vacancy to the 5% level, which most consider analogous to structural full leasing. Unfortunately, that type of growth is not typical of the businesses, which populate downtown D.C. Reliance on government leasing is fraught with political risk - remember, Washington, D.C. has no representative in Congress and there are moves afoot to decentralize Federal agencies, for security and economic reasons.
Finally, the barriers to development that exist in other international cities, which rate nosebleed prices, do not exist in downtown D.C. Cheap land is plentiful and abutting established commercial areas. Of course, the height limitation serves to reduce commercial structures, but that does not mitigate the plentiful land available in the Northern Virginia area, not to mention large vacant buildings in Crystal City and other parts of nearby Virginia.
© 2003, Myers Commercial Inc. All rights reserved.