Capitol investment

The 100-square miles of Washington DC is considered one of the, if not the, most stable, real estate market in the US. What many consider to be a primarily core market though has many private equity real estate firms racing to invest. Zoe Hughes discovers why America's capital is proving so dynamic.

Real estate and politics have become increasingly intertwined of late in the US in the wake of the credit crunch. In Washington DC, however, politics is an everyday reality for the local real estate market. Accounting for a third of the total employment market, the US federal government is more than just a driver of the real estate economy – it is its entire backbone. As one real estate investor puts it: “The government really is the anchor tenant for the whole of Washington DC.”

Even in an election year that guarantees a change of administration, and ultimately a president, investors can rest assured the US government will continue to grow, and so too will its real estate needs. It's a fact of life, as Joe Robert, founder of JER Companies, based in neighboring McLean, Virginia, says: “As long as the US population grows, regardless of what happens with the economy, the government in Washington DC will grow as well.”

As a result demand for most types of real estate in the DC metropolitan area is extremely high, something private equity real estate firms are eager to capitalize on. And the demand is not just from the government. As the saying goes, where there's government there's also lawyers. But it's not just attorneys who need to be close to Capitol Hill, so too do contractors, lobbyists, associations, and all the service-related industries needed to support them.

Think of any single branch of government – defense, health, education, transport – and you will have a multitude of complimentary businesses that feed from that department's policies: life sciences, arms, biotechnology, schools, infrastructure, technology to name just a handful. “Corporate America is based here,” adds Steve Collins, managing director of Jones Lang LaSalle's International Capital Group. Washington DC is therefore considered one of the most stable real estate markets in the world, relatively insulated from the peaks and troughs of real estate cycles.

And when that heightened demand for real estate is combined with the city's unique – and historic – supply constraints, Washington DC makes for an attractive investment destination. Under Article One of the US Constitution, it was left to President George Washington, the US' first president, to select the exact location of the 100-square mile plot of land (each side of the square would be no longer than 10 miles) that would become the seat of the US government. That city, named in honor of the first US President, was found in the District of Columbia.

Reaching for the heights
But from 1910, in setting rules for the design of the city, it was decreed that no building could be more than 20 feet (six meters) taller than the width of the street on which it sat.

The ruling was intended to ensure the Washington Monument remained the city's tallest building. Although it has preserved the city's modest scale, not least in Washington's central business district surrounding the White House and Capitol Hill, it has meant that no building can be higher than 12 stories. The upshot of the constraints on building size have, of course, led to an almost-constant demand for quality real estate, but it has also imposed limitations on developers and investors, and even designers. “People have called Washington DC a canyon of boxes because of the limitation of designs with such strict height restrictions,” says Collins.

New developments in DC tend to be smaller, in the region of 200,000 to 500,000 square feet for non-government commercial office space, as compared to New York City where development projects often exceed one million square feet, according to JER Companies chief financial officer Tae-Sik Yoon. Developable land is an even rarer commodity, placing Washington DC among the tightest real estate markets in the US, if not the world.

A report by Grubb & Ellis earlier this year concluded that, even amidst a declining national market, “the Washington DC metropolitan region [is] one of the most stable and in-demand office markets in the US.” With an inventory of 285.7 million square feet – covering the prime DC market, Northern Virginia and suburban Maryland districts that immediately surround the city – in the first quarter of 2008, Washington DC metropolitan area boasted a “steady deal pipeline and core submarkets with very little available space.”

In DC alone, which has an inventory of 97.6 million square feet, vacancy rates were 8.4 percent overall – pushed up from 6.7 percent the quarter before primarily because the corporate industry body, Corporate Executive Board, relocated from its five offices in DC to a new development across the Potomac River in Rosslyn, Arlington, Virginia. Asking rents for Class A and Class B office buildings average $53.90 and $42.87 per square foot, per year, full service respectively. In the greater Washington DC metropolitan area, asking rents are $39.50 and $34.17 per square foot, per year, full service respectively, with a total vacancy rate of 11.4 percent. In the most sought after areas though, vacancy rates are almost non-existent – with offices around Union Station (close to Capitol Hill) reporting vacancy rates in the first quarter of 2008 of just 0.4 percent.

“The story is quite compelling,” says Chauncey Mayfield, chief executive officer and founder of Detroit-based private equity real estate firm MayfieldGentry Realty Advisors, which closed on an office property at 1522 K Street in April. “Even in the economic downturn it is one of the most stable markets you can invest in. I would argue it's even more stable and manageable them New York. That was a compelling argument for us to invest. We had to be in DC.”

Core vs. opportunistic
Investors ask however whether Washington DC is increasingly becoming a core office market. Prime office and residential properties may be able to command a premium in rental and sales valuations, but the cost of building the project or redeveloping an existing asset in the first place is also at a premium.

“It is the stability of government jobs and the growth of the federal government that creates the perception of stability and safety in the local commercial real estate market,” says Yoon. Washington DC has not been an area of particular focus for new investment activities for JER for the past few years as yields and returns have been driven down by strong flows of capital into the market. JER has continued instead to invest in markets with more attractive “risk-weighted returns” including Latin America and Russia. However past deals completed by JER in the Washington DC region have included office/laboratory space in suburban Maryland. One deal closed at the start of the millennium enabled the firm to take advantage of demand for research space arising out of increased spending by the federal government and the private sector as part of defense initiatives following the September 11 attacks. “There continues to be strong flows of capital coming into Washington DC,” adds Yoon. “The market is heavily bid which increasingly makes it a prime market. To generate higher returns in the market, an investor needs to focus on those deals that have complicated debt structures or ownership issues, where the real estate asset is fundamentally well located and sound but is mismanaged or the current owners lack sufficient capital to maximize the value of such assets.”

When seeking out opportunistic returns, private equity real estate fund managers are targeting the redevelopment of existing (generally older real estate stock) or ground-up developments, particularly in what are seen as up-and-coming “hotspots.”

MayfieldGentry acquired the 81,094-square-foot Class B, K Street office property – its first real estate transaction in Washington DC – with the strategy of repositioning the building into a strong B+ player. It is currently 89 percent leased to 30 tenants including architects, lawyers and the National Sleep Foundation. Three blocks from the White House and next to the newly-renovated St. Regis Washington hotel – owned by Dublin-based investment firm Claret Capital – K Street is an area with a growing reputation among young professionals as an upscale entertainment location. It's a trend, Mayfield says, he is hoping to invest in the area in the future by redeveloping older office buildings into high-rent multifamily units targeted specifically at Washington's affluent workers.

“Yes, you have to search hard for opportunities but on a price per square foot basis you get a better deal in Washington DC than you do in New York City,” Mayfield says, adding: “I would even add that the improvements you make to a property in Washington DC would be on average 65 percent of the cost of doing a similar improvement in New York City.”

Little room in the capitalA snapshot of office market vacancy rates in the Washington DC metropolitan area in the frst quarter of 2008 by Grubb & Ellis reveals an average vacancy rate of 11.4 percent. In Washington DC, that rate drops to 8.4 percent. Next to Capitol Hill, there was almost no space available. The average office vacancy rate in the US, according to Cushman & Wakefeld, was 10.2 percent in August.

Sq ft under Class A
Submarket Total sq ft Vacant sq ft Vacancy rate construction asking rents *
Central business district, DC 30,409,942 2,599,100 8.5% 2,099,483 $53.20
East End 33,605,749 2,789,565 8.3% 1,616,908 $57.44
(North of Massachusetts Avenue) 5,773,474 825,048 14.3% 22,338 $44.86
(known as the “government ghetto”) 13,159,348 1,088,468 8.3% 1,919,526 $51.06
Union Station 3,139,504 14,083 0.4% 590,000 n/a
Bethesda, Maryland 8,046,155 636,704 7.9% 295,000 $40.32
Crystal City/Pentagon City 11,763,592 1,609,911 13.7% 360,000 $36.94
I-395 corridor 8,596,896 685,098 8.0% 202,234 $30.75
Rosslyn-Ballston corridor 18,836,210 1,475,451 7.8% n/a $39.85
Twinbrook/Rockville 6,467,052 458,673 7.1% 706,881 $35.10
Total CBD DC 97,668,527 8,200,648 8.4% 7,424,101 $53.90
Total Washington DC metro area 285,714,686 32,707,532 11.4% 13,455,247 $39.50

Metropolitan suburbs
Of course, it's not just about the District of Columbia. The Washington DC metropolitan area, which covers DC as well as the neighboring areas of Northern Virginia and suburban Maryland, are also attracting their fair share of opportunistic players. MacFarlane has teamed up with The JBG Companies and Morgan Stanley Real Estate to develop 42 separate sites throughout the DC metropolitan area. The project – due to be completed by 2013 – the development and renovation of 8.6 million square feet of office space, 2.4 million square feet of retail space, 2,500 hotel rooms and 13,200 multifamily residential units. Approximately two-thirds of the sites are located next to or near transit stations along the DC's area's Metrorail light-rail system. One core segment of the $7.5 billion scheme runs along the Rosslyn-Ballston corridor, in Arlington, Virginia.

Much of Rosslyn was built in the 1960s and 1970s when concrete and above-road “skywalks” were all the rage. Little street-level retail was developed, because of the raised pedestrian walkways, with consequently little downtown residential development.

Today, Rosslyn in particular has new developments happening on almost every corner. The MacFarlane/JBG/Morgan Stanley venture has two large projects next to the Rosslyn metro stop that, when completed, will total almost one million square feet of office space, 366 for-sale condos, 198 hotel rooms and 52,400 square feet of retail (most of it at street level). Demolition is underway at one of the sites, Central Place, while construction is expected to begin at Rosslyn Gateway – less than 50 yards away – in 2010. According to the Grubb & Ellis report, office vacancy rates in the area were 7.8 percent in the first quarter of 2008, attracting rents of $39.85 per square foot, per year, full service for Class A properties and $35.17 for Class B.

Viall argues that although the credit crunch has made life slightly harder for investors in Washington DC, not least in securing financing (“It takes more time in today's market”), but that the US capital is still one of the most attractive markets in the country in terms of size, strength and stability. “There are very, very few markets like this,” she adds.