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Is the D.C. Office Market Vulnerable?

Moves to cut budget deficit could hurt real estate fundamentals.

Washington, D.C. has become a favored target for institutional investors, including sovereign wealth funds, pension funds, real estate investment trusts and insurance companies. But with the U.S. government accounting for 23% of the local workforce, some analysts are raising a red flag.

What worries them? The U.S. is currently running a $1 trillion federal budget deficit and the recent drama surrounding a near shutdown of the government by opposing political parties could repeat itself by September. One proposal calls for cutting the federal workforce 10% by 2015.

“The recent moves to bring the federal budget under control represent a situational risk to investments made in these markets, a risk that I am not sure all investors have understood,” says Jim Costello, principal and director of strategy services at CB Richard Ellis Econometric Advisors.

A similar event unfolded in the mid-1990s, says Costello. When President Clinton's administration made budget cutbacks, the number of federal civilian workers in the District of Columbia fell nearly 6% per year in 1994 and 1995.

As demand for office space began to pick up around 1995 and 1996 across the rest of the country, net absorption of office space turned slightly negative in the District. A similar downturn in office demand occurred in 1982.

“There seems to be an assumption that the healthy demand for office space that D.C. has seen since 2001 will continue,” says Costello. “This demand, though, was generated at a time when the federal government spent money, in Senator [John] McCain's words, ‘like a drunken sailor.’”

That is not to say institutional investors should shun the capital or other major markets, but analysts recommend caution, especially if new cutbacks exceed those of the two previous downturns.

Major markets like Washington, D.C. recorded exceptional year-over-year gains in investment property sales volume in the first quarter of 2011, according to New York-based Real Capital Analytics.

The major markets, including Boston, Chicago, Los Angeles, Manhattan, San Francisco and Washington, D.C., outpaced the overall office market's first-quarter increase. But the capital recorded the largest increase in volume, with activity spiking on sales of trophy assets.

Notable transactions included Wells REIT II's purchase of Market Square East and West in early March for $615 million, or a record $905 per sq. ft. The two-building complex includes about 679,710 sq. ft. of office and retail space.

The D.C. market saw more than $1.6 billion in office sales in the first quarter, with 17 properties trading at an average of $498 per sq. ft. That activity beat out the perennial favorite, New York, where 19 buildings traded for just over $1.1 billion and an average $450 per sq. ft.

Recent trends in capitalization rates point to the gap between primary markets and everything else. Real Capital Analytics (RCA) reports that cap rates on major office sales in the first quarter in primary markets averaged 7.2%, compared with 8.1% in secondary markets and 8.5% in tertiary markets.

“Cap-rate compression in the major markets, and for prime assets in particular, reflects that strong capital inflows have propelled prices ahead of property fundamentals,” says Sam Chandan, global chief economist at RCA.

“There is a risk of a winner's curse in the markets that have led the recovery on account of investors' aggressive bidding for a small subset of very liquid assets.”

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