The following is an excerpt from a presentation I gave at the National Federal Development Association conference last month in Washington, D.C. The presentation covered three themes: 1) The size of the federally leased property market is small; 2) It is getting smaller, and; 3) There are five factors that could return the market to future growth. This article profiles the final theme. To read about the first click here and to read about the second click here.
In the previous part of this series of articles I noted that the federally leased property market is shrinking due to mandates such as Freeze the Footprint and, more recently, Reduce the Footprint. It is not just the square footage that is getting smaller but also the investment potential. Is there any hope for future growth? In this article I will profile five ways the federal real estate market could grow again.
#1 GDP Growth
Presidential candidates stumping on the campaign circuit often tout GDP growth as the magic elixir that will cure all of our economic ills. A faster growing economy would create more tax revenue, reducing deficits and allowing for easing of austerity measures (though rising GDP will also likely cause inflation, which will increase expenses, but that’s a matter for a different article). On the whole, GDP growth would be great, primarily because it would also decrease debt relative to GDP, which is the measure we care about.
The problem is that most economists share a pretty dour outlook on GDP growth. Gross Domestic Product is, simply put, Employment x Productivity. Unfortunately, labor force participation in the United States has been declining for years, hampering employment growth. Now that the first Baby Boomers have reached retirement age, the labor force is destined for weak growth, at best.
Productivity growth holds better promise for GDP recovery but annual productivity growth would need to be twice that forecasted by the Congressional Budget Office (CBO) to cause an appreciable long-term reduction in the national debt. In fact, it would take sustained productivity growth between 2.5% and 4.0% for 25 consecutive years to whittle the debt-to-GDP ratio down to the historic average by 2040. In context, the record average annual productivity growth for any 25-year period since 1950 is 1.9% (See CRFB’s excellent post on this topic).
GDP growth in the United States has been on the decline for decades. While modest recovery seems achievable, GDP faces demographic headwinds. Economic growth will help, but it will not fully resolve the austerity measures imposed upon the federal property market.
#2 Tax and/or Entitlement Reform
More likely, we will need to get down to the difficult business of tax and entitlement reform. As demonstrated in the graph below, federal spending, even in inflation-adjusted dollars, has been steadily rising for decades and the reason is mandatory spending (primarily entitlements such as Medicare, Medicaid and Social Security). Those expenses are obligated by law and, with the population aging and health care costs rising, mandatory spending is forecasted to continue growing.
Congress now has appropriations control over only about 30% of the nation’s spending. As you can see in the trend graph below, Congress has kept discretionary spending largely in check over the decades but, even so, it cannot keep overall spending from increasing.
If the trend continues, the discretionary share of the federal budget will get smaller and smaller, squeezed both by growing entitlement spending and also an inevitable increase in net interest payments on the national debt. As the discretionary budget is where rent is paid, we must expect that austerity measures in the federal property market will persist.
The only way to reverse this trend is to to either create more revenue (increase taxes) or reduce expenses (reform entitlement programs). More likely, some combination of both will be necessary.
With the next presidential election drawing closer, there is new optimism that it may be possible to hammer out some sort of Grand Bargain in 2017. Yet, if history is any guide, it won’t happen. Congress hasn’t enacted major tax reform legislation since 1986 and efforts at entitlement reform legislation have only nibbled at the problem.
If Congress is successful enacting meaningful reform legislation then it may create headroom for future recovery of the federal property market. Yet, it will take tremendous political will that has, so far, been lacking.
#3 Bigger Government
Earlier this year, the Wall Street Journal calculated that federal spending growth under Bernie Sanders’ plan would be $18 trillion over 10 years. $18 trillion is roughly the size of the entire U.S. economy. Put another way, it’s a 50% increase in annual federal spending.
Very, very roughly, if spending growth correlates to inventory growth, that level of spending would lead to about another 100 MM SF of growth in GSA’s leased inventory. It kind of makes you want to vote for the guy (except that any profits would probably be taxed back to the government!).
Bernie’s camp is quick to point out that they are simply proposing to nationalize functions that are currently provided by the private-sector. Overall goods and services spending would, therefore, be unchanged, but the federal government’s role would grow substantially.
I don’t expect that Bernie Sander’s platform will carry the day, but it is entirely possible that a more subdued version of his plan is implemented, especially in a Democratic regime. What if, for example, the federal government determined that it would insource more of its functions? Overall federal spending would not necessarily change but more of that spending would flow to agencies and not to contractors. That would certainly create growth in the government’s appetite for federal real property.
So, whether it is President Bernie Sanders, or someone else, there is the possibility that the federal government’s role could grow, even if its budget doesn’t.
#4 Crisis!
Nine days after the 9/11 attacks, Congress committed $40 billion to launch a global offensive against Al-Qaeda. The following year it appropriated an additional $36.5 billion and the year after that another $44 billion. As we know now, that was just the beginning.
This spending found its way into the federally leased property inventory as many of the federal buildings built since 9/11 accommodate the newly created Department of Homeland Security, tremendous growth in the Department of Defense and in the Intelligence Community, rapid growth in federal law enforcement–especially the FBI, and growth in Veterans Affairs clinics and hospitals.
9/11 accelerated a federal construction boom that had, in fact, already started due to an earlier crisis: the Murrah Building bombing in 1995. Shortly after that event, President Clinton created the Interagency Security Committee, which established new federal security standards that were the catalyst for construction of a host of new physically secure leased facilities. As an example, nearly four dozen new, highly secure FBI field offices built since that time are the product of design standards established after the Murrah bombing.
Yet, not every crisis accrues to growth in the federal lease inventory. The Global Financial Collapse was a major economic crisis that led to the American Recovery and Reinvestment Act, which ultimately totaled $831 billion in stimulus spending to stabilize the economy. A $5.5 billion slug of that money was spent by GSA to modernize its federally owned facilities and we are now seeing that the completion of those improvements is siphoning demand from leased buildings.
We don’t wish for crises, and they can cause unpredictable results. But they do sometimes provide a catalyst for growth in the federal real property inventory.
#5 Longer-Term Leases
It is a fact that, over the long run, lease terms have generally become shorter in GSA’s lease inventory, primarily as a result of kicking the can due to budget distress and the difficulties planning for downsizing. Now, half of all leases expire in the next five years so, logically, there are relatively few long-term leases. This has made the market feel especially small for property investors because the purpose of investing in federally leased properties is to access the outstanding credit afforded by the U.S. Government. Yet, that credit isn’t worth much with a short term lease.
Perhaps the most realistic prospect for growth is not in growing the size of the federal property inventory but rather in the investment potential of that property inventory. The market can grow for investors if GSA begins signing more long-term leases.
Fortunately, there are signals that the government will do exactly that. As agencies determine how they will comply with OMB’s “Reduce the Footprint” mandate they will find that they must completely redesign and reconstruct their workplaces. That will cost money and they will seek tenant improvement allowances from property owners. In turn, they will need to agree to longer-term leases. These long-term leases will also yield better rents, so in most respects long-term leasing is a symbiotic effort.
Already we’ve begun to see a little improvement in the weighted average lease term but that is primarily due to deliveries of the last buildings in the previous wave of build-to-suits. The dwindling pipeline of new buildings will be a challenge for property investors but, even in lieu of a pick-up in the pace of new construction (which generally yields the longest leases), we see ample evidence that leases generally will get longer and that 10 year non-cancelable leases will become more prevalent.
Outlook
In the near term, I expect GSA’s leased inventory to continue to shrink. The most likely positive outcome–all other factors remaining status quo–is growth in the number of long-term leases. These “long-term” leases will be shorter than those delivered through the build-to-suit process but they will serve to grow the investment market, hopefully providing enough new investment opportunity to keep capital focused on the sector. Long-term, sustainable inventory growth, if it arrives, will probably result from an amalgam of the other trends described above.