Oct. 2 (Bloomberg) -- A guard clutching an assault rifle and another with a German Shepherd block the entrance to a parking garage on a quiet street in Arlington, Virginia, gateway to the Defense Intelligence Agency.
Heavy security at 3100 Clarendon Boulevard may not be necessary next year when the DIA, whose mandate is to protect the U.S. from surprise attacks, is scheduled to leave the 250,000 square-foot (23,000 square-meter) building.
Office vacancies in the Washington area have risen to the highest since 1991, according to data compiled by Bloomberg, as the government implements the 2005 Base Realignment and Closure Act and other cost-cutting efforts. Another $1.2 trillion of automatic spending cuts are projected over the next nine years as part of last year’s Budget Control Act, a deficit reduction plan agreed to by Congress and President Barack Obama, adding pressure to landlords including Vornado Realty Trust who are scrambling to find new tenants for buildings housing contractors and some of the Washington area’s most secret agencies.
“Certain submarkets are going to suffer when these move outs occur, exposing a lot of space that all of a sudden is going to be on the market,” said Lad Duncan, a Charlotte, North Carolina-based analyst for Wells Fargo Securities LLC.
Government agencies with leases set to expire because of base realignments and closures occupy more than 4.5 million square feet of office space in Arlington and Alexandria, Virginia that will be free by 2015, the bank estimates. More than a third of the leases are slated to expire by the end of the year.
Debt tied to six buildings with leases affected by the forced moves totals at least $2.8 billion, according to data compiled by Bloomberg and Wells Fargo. While the loans are included in 12 commercial-mortgage bond securities that have $36.4 billion outstanding, vacant office space can lower rents in a region and punish unrelated buildings whose debt is in other CMBS deals, analysts at Wells said.
An index tied to prices of commercial mortgage bonds created before markets crashed have risen 12 percent this year as Federal Reserve Chairman Ben S. Bernanke holds interest rates near zero and commercial property markets show signs of recovery.
While there are improvements, losses are starting to show up in higher-rated deals, particularly those made in 2006 and 2007, Bank of America Corp. analysts led by Alan Todd wrote in a September report. “It is only a matter of time until losses begin to creep up the capital stack,” Todd said.
Vornado stands to lose the most of the property owners with exposure to Department of Defense-related lease expirations, said John Guinee, an analyst with Stifel Nicolaus & Co. in Baltimore.
Earnings before interest, taxes, depreciation and amortization from Washington D.C. and Virginia properties made up about 26 percent of its overall earnings in the quarter ending June 30, with the biggest concentration of space in Arlington.
“The buildings are old and particularly stylized and poorly located,” making it harder to find new tenants, Guinee said.
Ownership of bearish Vornado options contracts, representing bets the company’s shares will decline, rose to a four-year high, according to data compiled by Bloomberg. The shares rose 0.5 percent to $80.71 in New York, after sliding 2.7 percent last quarter, including reinvested dividends. That compares with a 0.5 percent loss for the 16-member office index.
“Washington today is experiencing the perfect storm:” the base realignment plan, the government “trying to be more efficient, a presidential election, and a budget standoff creating uncertainty,” Michael Fascitelli, chief executive of Vornado, said in an Aug. 7 conference call.
Vornado predicts 2.4 million square feet of Department of Defense lease expirations because of realignment and consolidation, and estimates earnings this year from that segment will be as much as $60 million less than last year, the company said in a filing.
Other real estate investment trusts at risk from agency relocations include Corporate Office Properties Trust, a Columbia, Maryland-based REIT with U.S. government, defense- and computer-related clients and data centers, and Piedmont Office Realty Trust, owner of the DIA-occupied 3100 Clarendon Boulevard in Arlington, according to Guinee. A Corporate Office Properties Trust spokeswoman didn’t return calls seeking comment.
Piedmont has only one building with the Department of Defense as a tenant, and no debt on the property, according to Kerry Hughes, a spokeswoman for the company. Other Piedmont buildings are occupied by Lockheed Martin Corp. and the U.S. Food and Drug Administration, according to the company’s Web site.
The DIA’s lease has an early termination option in 2013 requiring at least a one-year notice and Piedmont has yet to receive that, Hughes said. The company is “soft marketing” the space, she said in an e-mailed statement.
Defense Intelligence Agency spokeswoman Laura Donnelly said the lease expires next year and the DIA intends to relocate personnel to other locations in Northern Virginia before then.
Atlanta-based Piedmont said in an August conference call with analysts that it has undisclosed plans to redevelop the property once the agency vacates.
“That location is fantastic, the building itself is pretty good,” said Donald Miller, Piedmont’s chief executive officer. Until they hand in notice, “it’s hard to get in and do a lot of work because it’s a very secure facility.”
Even companies without government tenants should brace for the impact of agency relocations, as increased vacancies throughout Arlington and Alexandria will probably lead to weaker demand in suburban Virginia, according to Wells Fargo’s Duncan.
Office vacancies in the Washington, D.C. metro area rose to 14.7 in the second quarter, the highest since 1991, from 13.3 percent a year earlier, according to CBRE Group Inc. data compiled by Bloomberg. The national rate, which has been declining since the first quarter of 2011, is 17.2 percent, Reis Inc. figures show.
The rate of Washington area office loans packaged inside CMBS that are 30 days late or more surged to 9.65 percent in September, compared with 3.68 percent a year earlier, according to data compiled by Bloomberg. The U.S. rate was 9.77 percent in September, Bloomberg data show.
A $678 million loan on a Vornado property, Seven Skyline Place, one of the six with leases affected by the forced moves, was transferred to a special servicer in March. The Defense Information Systems Agency relocated from the building to Fort Meade late last year leaving 430,000 square feet empty, according a July Wells Fargo report.
While more tenants are expected to follow when their leases expire, Answer Analytics, a research group serving the Air Force, signed in June to backfill about 20 percent of the space, according to the report.
Compounding the agency moves out of northern Virginia, the White House Office of Management and Budget said in a report to Congress on Sept. 14 that federal budget reductions through 2021, known as sequestration, would require chopping $54.7 billion from defense programs in fiscal 2013.
Lawmakers imposed the policy on themselves for failing in 2011 to negotiate a deal to cut deficits by at least $1.2 trillion over a decade. The across-the-board reductions were devised by Democrats and Republicans last year as last resort in case no plan emerged. They’re scheduled to begin in January unless Obama and Congress reach a deal to delay or alter them.
Virginia, home to the Pentagon and the Norfolk naval base, along with Hawaii and Alaska, would have the most risk to its economy from the planned cuts, according to a July Bloomberg Government study. Almost 14 percent of Virginia’s gross domestic product comes from defense spending, the report found.
The government cuts may temper demand further for commercial real estate in the Washington area, where companies from Lockheed Martin, the government’s top contractor last year, to Science Applications International Corp. are based.
Science Applications International, one of the top suppliers to both the Health and Human Services and Homeland Security departments, has been monetizing its real estate holdings and said it may sell its corporate headquarters in McLean, Virginia which “may add further strain to an office market already weakened” by base closures, Lea Overby, debt strategist at Nomura Holdings Inc. in New York said in a report last month. Science Applications, which said on Aug. 30 it plans to separate into two independent companies, will see much of its leased space expire over the next year, according to Nomura.
The full effects of the potential defense cuts and the impact of the Base Realignment and Closure Act have not been seen, according to Guinee. “Bottom will not hit until 2014 to 2016,” he said.
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