Federal Real Estate: Pros and Cons

Federal Government Leases:  Pros and Cons

Across the country, the United States federal government leases office space.  The U.S. General Services Administration (GSA) is the federal government agency tasked with managing this leased real estate.  They negotiate and administer the leases on behalf of various agency tenants, including the Social Security Administration, Department of Agriculture, Federal Bureau of Investigation and the Bureau of Land Management, to name just a few.

Like any real estate investment, federal government leases come with certain benefits and risks.  For investors considering purchasing these types of properties, understanding these qualities is critical to making a prudent investment decision.

Pros of GSA Leases

Tenant Strength

The most obvious benefit of having a federal agency as your tenant is the credit guaranteeing the lease.  The “big three” credit rating agencies -- Moody’s, Fitch and S&P -- give the federal government a credit rating of Aaa, AAA and AA+, respectively -- at or near the top of each company’s rating system.  Few companies have credit ratings that rival the U.S. government.  With a tenant of this caliber, you can generally count on getting your rent payment each month.

Long-Term Tenancy

Historically, federal government agencies have had a reputation for regularly renewing their leases, occupying a leased space for a long time.  How long can vary depending on a number of factors, including who you ask.  Some sources, primarily real estate brokers who operate in the GSA sector, cite lease renewal rates of up to 95% and average tenancy periods of 30 years or more.  In fact, both are overstated.  According to the GSA itself, average tenancy is 23.3 years (when weighted by size/SF, as reported at www.gsa.gov/real-estate/real-estate-services/leasing-policy-procedures/leasing-outreach February 23, 2017 Industry Outreach Conference Call Minutes).  As for the quoted 95% renewal rate, it comes from the GSA’s own annual Lease Turnover Analysis — but it is not a measure of true renewals.  Rather, it is the number of leases that continued past the current year – including those that have yet to expire and still have years of firm term remaining.  If we look at actual renewal rates – i.e., what happened in 2016 (the latest year reported as of Jan. 2018) with leases due to expire in 2016 – we see that 74% were extended, renewed or replaced in the same building.  About one quarter were terminated or moved to another building.  (FYI:  This data is cited on the same Lease Turnover report from the GSA – so anyone citing the 95% figure hasn’t studied the data closely enough.  To access the latest report, please visit www.gsa.gov/real-estate/real-estate-services/leasing-overview and click on “Lease Turnover Totals FY2001-2016”.)

That said, historical trends may no longer be relevant, as we seem to be embarking into new territory.  In 2013, the White House issued the “Freeze the Footprint” policy.  In March of 2015, the White House announced a new “Reduce the Footprint” policy, requiring federal agencies to reduce, rather than simply freeze, their footprint beginning in 2016.  (For more information, please visit:  www.whitehouse.gov/blog/2015/03/25/national-strategy-reducing-federal-government-s-real-estate-footprint.)

As these policies have taken hold, we’ve seen tenant agencies respond.  For example, the Social Security Administration (SSA) has announced its intent to “strategically reduce and re-align” SSA offices by implementing online, phone and videoconferencing services to replace some in-person services, as well as promoting flexible staffing arrangements like telecommuting, in addition to straightforward consolidation of certain support functions.  In other words, the SSA intends to change how it delivers services in order to reduce the number of SSA offices around the country and save money. 

We cannot forecast precisely how these new strategies may impact average tenancy periods for GSA properties going forward, but it seems clear that past history is NOT an acceptable basis for projecting future practice. Thus far, federal agencies have reduced their FY 2012 office and warehouse baselines by 24.7 million square feet through FY 2015 (www.gsa.gov/real-estate/real-estate-services/leasing-policy-procedures/leasing-outreach February 23, 2017 Industry Outreach Conference Call Minutes).

Higher Investment Returns

In terms of cap rates, GSA leases can offer returns 1 to 3 percentage points higher than those of high quality, single-tenant net lease properties. 

This, of course, begs the question:  Why do GSA leases offer higher returns, when they are backed by such a high-caliber tenant as the US government and have historically offered long-term tenancies?  As you undoubtedly know, risk and return are always related, and the answer lies in the risks of GSA properties, as we will discuss below.

Cons of GSA Leases

Residual Value

When it comes to the risks of GSA leased properties, this is possibly the biggest and the least talked about. 

The issue stems from how commercial properties are valued.  The price of a commercial property is generally determined by applying a market cap rate to the net operating income (NOI) that the property generates. (NOI is simply gross rent revenue minus cash operating expenses).  All things being equal, the higher the NOI, the higher the property value or purchase price.

So if a lease calls for above-market rental rates, that property is generating an inflated NOI, which in turn inflates the property’s purchase price.

GSA lease rates frequently exceed prevailing local market rental rates.  This is due in part to the fact that they are custom-built to government agency specifications, which can include extensive security requirements and tenant improvements.  Additionally, the required lease approval/pre-construction procedures for a custom federal building constitute a long, bureaucratic process that can take years.  For both these reasons, GSA buildings are simply more costly to build. 

An above-market lease rate is great for the landlord, as long as the tenant remains in place.  However, if your government tenant vacates, a new tenant may pay only the prevailing market rental rate.  If the new, lower rental rate results in significantly less NOI, then your building may have just lost value compared to what you originally paid for it. 

Bottom line:  Before deciding to purchase a GSA-leased building, it’s critical to compare the rental rate in the GSA lease to local market rental rates for similar use properties.   Because if that government tenant is paying an above-market rental rate and someday terminates the lease, that building may suddenly be worth less than what you paid for it. 

Gross Lease Structure

GSA leases are structured as gross leases, which simply means that the landlord is responsible for all operating expenses associated with the property.  From utility bills to janitorial service, real estate taxes and structural repairs and everything in between, the landlord is responsible for day-to-day management of these duties and for paying all the bills.    

Of course, the active management responsibilities can be delegated to a property management company, making the investment a more passive one.  But that doesn’t change the fact that the gross lease structure makes it more difficult to predict what net operating income the property will generate, and what your actual income will be each month, as operating expenses will often fluctuate. 

Shorter Lease Terms

Generally, GSA leases are structured with a fixed firm term only or a full term, which includes both a firm term and a soft term.

With a firm term lease, the lease spells out the lease rate and the number of years that it will be in effect -- usually 5 or 10 years -- after which the lease terminates. 

With a full term lease, there will be a fixed lease rate for the initial firm term, after which the GSA may terminate the lease or choose to remain in place under a soft term that generally spells out a different lease rate for another period of time.  For example, with a 10-year full term/5-year firm term lease, the GSA may vacate after 5 years or may stay for another 5 years at a pre-determined rental rate. 

Occasionally you can find GSA leases with 15 years of firm term, but they are rare.  Ten-year firm term leases made up only 25% of new GSA leases in 2016 (www.gsa.gov/real-estate/real-estate-services/leasing-policy-procedures/leasing-outreach February 23, 2017 Industry Outreach Conference Call Minutes).  In fact, as federal lease terms have shortened in recent years, the majority of new leases we have seen on the market have offered only 5 years of firm term.  This is far shorter than single-tenant NNN leases, which often offer 20 years or more of firm term.

Early Termination Rights

GSA leases that contain a soft term, as mentioned above, will grant the government agency the right to terminate the lease at any time after the expiration of the firm term.   So for a 10-year full term lease with a 5-year firm term, the GSA can terminate any time after the first 5 years.  Some GSA leases even grant the tenant the ability to terminate the lease at any time upon sufficient notice (e.g., 120 days).

Flat or Decreasing Rents

GSA leases generally are designed to be flat over the lease term, offering no rent increases.  However, functionally, many GSA leases actually call for decreasing rents over the full term of the lease due to the way the GSA handles tenant improvement costs. 

Tenant improvement costs, or “TIs”, are a component of rent in a GSA lease; other components include shell rent, operating costs, and security costs.  The shell rent is the base rent for the basic structure and the TIs are the costs incurred to convert that shell to finished, usable space according to the government tenant’s specifications.  The GSA can choose to either 1) pay for the TIs with an upfront lump sum payment before they move into the building, 2) amortize the TI costs over the lease term, paying a prorated amount to the landlord (including interest) each month with their regular rent, or 3) a combination of both an initial lump sum followed by smaller prorated monthly payments. 

The majority of government tenants choose to amortize TI costs over the lease’s firm term.  Thus, when a lease contains both a firm term and a soft term, this means that rents will drop after the TI amortization is completed at the end of the firm term.  This will result in a decrease to the average net operating income over the lease’s full term, so you must factor this into your valuation of the property for purchase or sale. 

On the plus side, GSA leases usually include Consumer Price Index (CPI) adjustments that provide the landlord with a hedge against inflation.  This is not a rent increase -- just a provision that operating expenses will be increased according to any increases in CPI.  However, this same provision also states that a downward adjustment will be made if CPI ever declines.

Lease Payments Made in Arrears

The federal government gets preferential treatment when it comes to the timing of their rental payments.  GSA leases allow the government to pay rent one month in arrears.  In other words, the GSA will occupy your building for a month before paying any rent.  Each rent payment they make is for the previous month.  

Dealing With the Government

Let’s face it, dealing with the federal government can be unpredictable and frustrating.  We’ve heard many GSA developers voice this repeatedly.  Accordingly, lease renewal negotiations can be a long, frustrating process.  A competent property management company with GSA experience is almost a necessity for landlords who have no experience in dealing with the government. 

Consolidation/Downsizing

As we stated above, the federal government has launched efforts to consolidate and reduce the federal real estate footprint.  With continuing federal budget deficits and growing U.S. debt, the pressure is on to cut budgets and that could translate into early lease terminations, fewer lease renewals and shorter lease terms for the ones that are renewed.  Frankly, it’s impossible to predict what effect the state of our country’s financial picture will have on the GSA lease sector. 

Conclusion

GSA leases are a unique real estate investment, offering exceptional tenant credit and higher returns than many other single-tenant properties.  However, as we have presented, they also come with more risk.  For many investors, the investment decision is a trade-off between great credit and higher returns versus no rent increases and significant residual value risk.  Investors should seriously consider whether this is a risk they want to take on, particularly in light of shrinking lease footprints and shorter lease terms.

We’ve provided the information in this Straight Talk guide for general educational purposes.  It is not intended as specific tax or legal advice.  Please consult a professional for specific advice regarding your particular situation.

© 2018 Jack Sauther & Diana Sauther