Leasing to Uncle Sam

by | 09 September 2014

Despite growth in federal spending, the U.S. government’s real estate inventory is shrinking. Ironically, it is precisely because of ever increasing federal spending that both the White House and Congress have issued mandates to agencies to reduce their real estate inventories — a rare point of bipartisan agreement in an otherwise divisive political environment.

Both parties are clear on the goals: Freeze the footprint, reduce costs and improve space utilization. This downsizing is already in motion, although it is not yet fully reflected in market statistics.

From 2009, the United States has averaged more than $1 trillion of annual spending deficits, and the U.S. debt held by the public has doubled to nearly $13 trillion. Although Congress has tried mightily to bring spending under control, it can only authorize and appropriate one-third of the budget. The remaining two-thirds are mandatory spending, primarily funding entitlement programs such as Medicare, Medicaid and Social Security. This spending grows relentlessly each year, and congressional cuts to the remaining discretionary budget are an ineffectual counterbalance.

In the near term, it is unlikely that federal inventory growth will return. Rent for office space is paid from the discretionary portion of the federal budget, as are the salaries for the people who occupy that space. With the discretionary budget under pressure, federal civilian (non-U.S. Postal Service) employment has declined by 115,000 workers from its peak in May 2011. This decline in federal employment is expected to blunt demand for office space, but efforts to transform the workplace to improve space utilization will have an even greater impact.

The inventory is shrinking

The U.S. General Services Administration (GSA) is the landlord to most federal agencies. GSA owns properties that it leases to federal tenants, and it also executes private-sector leases on behalf of agencies, “subleasing” them through occupancy agreements to federal agencies. After more than four decades of relentless, inexorable demand, growth of the federal leased inventory has flattened.

This is primarily due to an Office of Management and Budget (OMB) policy known as “freeze the footprint,” which was formalized last year. In its policy memorandum, OMB ordered that agencies must “not increase the size of their civilian real estate inventory” and required any agency that increases its square footage to offset new space through “consolidation, co-location or disposal of space from the inventory of that agency.” Essentially, agencies must freeze their real estate inventories at the baseline square footage measured in fiscal year 2012. OMB also requires each agency to specifically demonstrate how it will reduce costs and improve space utilization.

So, inventory growth is clearly prohibited, yet agencies have also begun to embrace cost-reduction strategies. One such strategy has been to redesign federal workplaces to decrease the number of usable square feet (USF) required per employee. The government seeks to accomplish this through a complete rethinking of its use of space. The emerging design prototypes eschew traditional offices for open areas featuring benching systems and pods for collaboration.

Leading by example, GSA recently redesigned a portion of its headquarters to achieve a utilization rate of just 82 USF per person. This exhibition space represents the extreme in space efficiency. It was designed largely on the premise that many federal workers will embrace mobile working, enabled by the Telework Enhancement Act of 2010, legislation that makes one-third of all civilian federal employees eligible to work from home. Most proposed reconfigurations are not nearly this extreme, but it is easy to imagine a federal inventory reduction of at least 15 percent if new workplace standards are implemented across all agencies. On a national basis, such a shift would result in more than 30 million square feet of vacated space (over the course of several years).

GSA must coordinate with its tenant agencies to plan the significant consolidation and realignment required of these rebuilt offices. It is a difficult and time-consuming exercise, and we expect thoughtful efforts will take years to execute. In the interim, there have been more short-term leases, lease extensions and holdovers, resulting in an increased transactions load on GSA staff.

Outlook for investors

The federal government’s reluctance to execute long, firm-term transactions has made it a captive tenant in many instances. Short-term extensions have enabled lessors to maintain occupancy with very little capital input, and higher rents are often achieved in compensation for these extensions. So, purely on a current yield basis, GSA’s plight has provided financial benefit to property investors. However, for many owners, short-term extensions are nothing more than a consolation prize. In today’s market, longer lease terms are critically important. They are the prerequisite to refinancing or creating dispositions value.

When GSA does finally swing around to a long-term leasing approach, as congressional leaders are urging it to do, we can expect a new set of challenges for lessors. In recent years, the short-term lease extension has typically been GSA’s attempt to “buy time” to facilitate a full and open competitive lease procurement for a long-term lease for a smaller amount of space (or align leases for consolidation). In cases where agencies seek to downsize or dramatically reconfigure their space, incumbent lessors could find themselves at a disadvantage. Executing renewals in those circumstances can require phased renovation, swing space and other logistical complications. GSA will not always be willing to entertain this complexity, instead structuring its procurements to favor the “blank canvas” offered by a new location.

The business of leasing space to the federal government has become more demanding. Excellent opportunities remain, but successful investment requires greater diligence, hands-on asset management, and a strong understanding of the competitive marketplace and the emerging changes within each federal agency.

Kurt Stout is the national leader of Colliers International’s Government Solutions practice group, which provides government real estate services to private investors and federal agencies. He also writes about federal real estate on his Capitol Markets team blog. You can contact Kurt by email or on Twitter.