As the Washington Business Journal reported earlier this month, GSA has canceled its efforts to replace the 343,000 RSF State Department lease at 1801 N. Lynn Street in the Rosslyn submarket of Northern Virginia. In its posting on FedBizOpps GSA wrote that “the Government is now evaluating federal ownership for this requirement, therefore, a long term lease is no longer required.” Wow.
So, how did this happen? Simple: the rental market for space at 1801 N Lynn is well north of $50 (possibly even $60), full service, yet OMB caps most Northern Virginia prospectus-level transactions at $39, full service. Though the State Department’s Bureau of Diplomatic Security (which is the specific tenant in the building) has unique legislative authority to exceed this figure we must assume the pricing gap was still too wide to close.
Everyone knew that the State Department would be facing a steep rent increase at 1801 N. Lynn, one of a handful of trophy towers in Rosslyn, Virginia, directly across the Potomac River from the commercial heart of the Washington, DC. GSA leased 1801 N. Lynn as the spec building was nearing completion in 2002. It was a different time. In the post-9/11 chaos large corporate tenants were hard to find. When GSA stepped in and leased the entire building it was a good deal for the government and perhaps a lucky one for the developer, JBG Companies (who since sold the property to Morgan Stanley). GSA and its tenant agency, State, received a great deal, paying $35.90/RSF in what we believe was a fully-serviced lease. The base rent today, 10 years later, is still just $42.38/RSF. Yet, in that same 10 years Rosslyn–along with the rest of the close-in Northern Virginia commercial markets–has been improving dramatically and rents have climbed steeply, despite the recent recession and BRAC. OMB’s rent expectations have not kept pace.
Normally, this would simply result in GSA selecting a building in a less expensive location, even if it meant searching outside the Beltway to do so. Yet, State presents a special circumstance: the agency has a Memorandum of Understanding (MOU) with GSA allowing it to focus its office space near the Harry S. Truman Building, State Department’s headquarters. Originally, that meant that State offices were clustered primarily in the Foggy Bottom district of Washington, even though that is outside the city’s central employment area. Yet, as the agency expanded over time it took up residence across the Potomac River in Rosslyn and invested heavily to do so, including the extension of its secure telecom cabling.
Everyone knew this would be a tough renewal, which underscores the imbalance between the market and the government’s rent expectations. Morgan Stanley and GSA held preliminary discussions but those did not produce an agreement, so last April GSA announced a procurement to replace the lease. This meant that GSA would pit the rental offer received from 1801 Lynn against other buildings in the market. In a gambit to increase competition, GSA extended the search area to include Crystal City and Pentagon City, submarkets that were experiencing growing vacancy due to the BRAC-related exodus of Department of Defense tenants. GSA’s solicitation undoubtedly received some very enticing rent offers but, ultimately, GSA must weigh these against the cost to relocate State and replicate its space. As a practical matter, that advantage was nearly insurmountable. Further, State really didn’t want to move (and that is a point that can’t be overemphasized). So, after a protest was filed by the owners of another Crystal City property, GSA finally cancelled the procurement altogether.
Now what?
We are believers in King of the Jungle decision making. The King of the Jungle is the one who, swinging through the canopy, makes sure he has grabbed the next vine before letting go of the one he is holding. This is good common sense and it limits the possibility of catastrophe. Surely GSA and State are operating similarly and already have its next move determined. Surely.
Here are some of State’s options:
Option 1: They buy 1801 N. Lynn. This seems obvious since it’s likely Morgan Stanley planned to sell upon the lease renewal anyway, and the Government would not need to relocate and re-build its space. 1801 N. Lynn is a wonderful asset to own but the price would be steep. Sales of other class A office buildings in the Rosslyn-Ballston Corridor have been in the $400/SF to $530/SF range and a fully-leased 1801 Lynn should fetch much more than that. So, count on a market valuation easily exceeding $200 million. And yet: the primary occupant of 1801 N Lynn is the Bureau of Diplomatic Security. In the wake of the Benghazi embassy attack, the State Department has requested an additional $1.3 billion for diplomatic security around the world. This, on top of a diplomatic security budget that has (according to a GAO report) swelled from $200 million in 1998 to $2.3 billion this fiscal year. Somewhere in this budget may be the funds for a purchase like this. Further, State is no stranger to buying its leased buildings. The agency exercised a below-market purchase option just last year to acquire the 500,000 RSF 2401 E Street, Washington, DC.
Option 1a: They condemn 1801 N. Lynn. We would hope this isn’t the government’s planned approach yet it must realize its strategy is backstopped by this option.
Option 2: They buy a different building in Rosslyn or Foggy Bottom (which is where they want to remain). We are intrigued by the idea that there may even be an option or two available to them but, again, the budget hit will leave a welt, and the costs of relocation and space replication will be heaped on top.
Option 2a: They buy a building elsewhere and re-shuffle tenants. If the Bureau of Diplomatic Security needs to remain near the Truman Building maybe some other function doesn’t. It’s possible that State could look further afield at options like the Intelsat building (as reported by the Washington Business Journal) and then adjust its portfolio occupancy as required. This scenario would require some real finesse in order to make sense.
Option 3: The 1801 N. Lynn tenancy is relocated to space State already owns. In some respects this is a variant of Option 2a above. We are certain that State doesn’t have 350,000 RSF in its portfolio lying fallow. Therefore, the Bureau of Diplomatic Security would have to displace another State unit or a new building would have to be built. Through recent acquisitions State does now control sufficient property adjacent to its headquarters but it is years away from being ready for occupancy. We view this scenario as unlikely.
As backdrop, the clock is ticking. The State Department lease at 1801 N. Lynn expires at the end of June. Whatever happens it will be interesting to watch. This is off-road driving for the Government.