The Letter – Americas | 45 | May 2015

The U.S. government leases more than 196 million square feet of space through the U.S. General Services Administration, or

GSA. As the largest public real estate organiza-tion in the country, the GSA is comparable in size to the office markets in Los Angeles or Dal-las (see graph on page 46, “Size of office mar-kets compared to GSA footprint”).

Being Uncle Sam’s landlord is not always easy, particularly when decision making depends

on a Congress that has become synonymous with dysfunction. Potential investors have raised the question: Do the benefits of investing in assets leased by the GSA outweigh the uncertainties clouding this sector? The short answer is, “yes,” but the long answer is a lot more interesting.

To start, having the full faith and credit of the U.S. government certainly enhances this sec-tor, especially during the underwriting process. Property owners typically receive fair market

Real estate investing with Uncle SamGovernment-leased properties have particular

challenges and opportunities

By Will McIntosh, John Kirk and Mark Fitzgerald

The Letter – Americas | 46 | May 2015

Investing in federal property can be a worthwhile opportunity for the right situation, as it ensures a high-quality tenant that can consistently deliver healthy income returns with limited volatility.

rents from an AAA-rated tenant that just so hap-pens to be a global superpower. Furthermore, most federal tenants request long-term leases of 10 years or more, guaranteeing a strong income stream for at least a decade.

The risk-adjusted returns are compelling as well. Investors receive reliable cash flows similar to government bonds, except real estate yields are more attractive. Today, a U.S. 10-year Treasury bond delivers roughly 2 percent, as short-term rates have been near zero since the financial crisis. Government properties do not have a specific index, but a typical invest-ment can deliver a long-term average unlevered cash-on-cash income return of approximately

6 percent to 7 percent, plus an additional 1 per-cent to 2 percent appreciation return. Moreover, having high-quality tenants with long-term lease commitments can help stabilize a real estate portfolio by reducing volatility.

Government tenants have a higher prob-ability of renewing their leases, rather than shopping for new office space. Recent data indicates government leases tend to renew upon expiration at a 30 percent to 40 percent higher rate than private-market leases. In addi-tion, anecdotal evidence suggests GSA leases tend to renew at or slightly above prevail-ing market rent rates. This high renewal rate

creates sizable cost savings over the life of an asset, given that investors spend significantly more capital to attract new tenants than to retain existing ones.

Clearly, this investment strategy is appeal-ing but, as previously mentioned, political grid-lock and budgetary differences have created an uncertain environment for both government agencies and federal-property investors.

In 2011, more than 380 federal leases lapsed into holdover (i.e., when a lessee remains in a property after the lease term ends). In most cases, these leases were in holdover status because of congressional delays on issues that affect real estate, such as new employ-ees, relocations and building expansions. By contract, lessees must continue to pay rent while in holdover, in addition to any penal-ties, which is a near-term benefit for property owners. The downside, however, is landlords find themselves in the precarious position of not knowing whether the tenants’ leases will renew. Some property owners have remained in limbo for more than a year before poli-ticians came to a resolution. To be fair, the number of leases in holdover status declined to roughly 100 in 2014, as the GSA has worked diligently to reduce the backlog. Nevertheless, recent data suggests more than 2,000 leases — roughly one-quarter of the government’s lease inventory — are set to expire during the next two years, and many of them likely will fall into holdover status.

Political disagreements regarding fiscal spending also have hindered this sector. Not counting armed-services workers, the federal government employed approximately 2.7 mil-lion people at the end of 2014, the lowest employee count since 1966. Over the past few years, budget cuts have prevented growth in the number of federal employees and created real estate mandates such as “Freeze the Foot-print,” which requires government agencies to limit expansion of their domestic footprint. Consequently, many property owners have been unable to retain financing or make long-term decisions without a lease commitment from the government. A considerable level of uncertainty exists among some landlords, and ongoing congressional conflict only adds to the ambiguity; however, for the well-capitalized, sophisticated buyer, these items can be lev-eraged into positive buying opportunities or recapitalization events.

Fortunately, investors have reasons to be optimistic. In November 2014, the Republican Party gained control of both houses of Congress

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Sources: CBRE-EA, GSA, USAA Real Estate Company

The Letter – Americas | 47 | May 2015

for the first time since 2005. Apart from political ideologies, a unified Congress could bode well for federal-property investors, particularly if offi-cials can expedite routine real estate decisions through the legislative process. In addition, ini-tial 2015 budget proposals include a notable increase in new government jobs, and some agencies already have initiated hiring plans that should lead to a stronger outlook for the sector. The amount of space per employee likely will trend lower because of new workplace man-dates, but these adjustments are consistent with the private sector and should coincide with an increase in government demand for buildings that are more modern and efficient.

Investing in federal property can be a worthwhile opportunity for the right situation, as it ensures a high-quality tenant that can con-sistently deliver healthy income returns with limited volatility. In 2014, transaction volume for properties where the GSA was the primary ten-ant topped $2.8 billion; more than a 100 per-cent year-over-year increase, but still well below the average of $4.2 billion annually from 2005 to 2007 (see graph to the right, “Annual trans-action volume on properties where GSA is the primary tenant”).

In the end, investing in real estate with Uncle Sam can be a rewarding experience for those interested in steady returns with few risks, but success does not always come easy. v

Will McIntosh is global head of research at USAA Real Estate Company, and John Kirk and Mark Fitzgerald are research analysts with the firm.

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Sources: Real Capital Analytics, USAA Real Estate Company

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