2007 is set to be a record year for Washington DC, and with continuing high levels of government investment the outlook is bright, as Stephanie Schwartz-Driver reports
Washington DC remains a beacon for institutional real estate investment. Buffered by the presence of the national government, the city continues to perform well, offering investors stability and a reasonably sure bet, although returns have traditionally been relatively lower than in other, more volatile urban markets. While international investors in particular were once committed to buying only trophy properties in the city centre, today opportunities in urban renewal projects also appeal.
International investors have always viewed Washington DC positively. In the annual Association of Foreign Investors in Real Estate (AFIRE) surveys, Washington DC has always been in the top five of global cities for attracting international real estate investment. In 2006, it fell to fourth place internationally, but in the AFIRE rankings of US cities, it has consistently been running a close second to New York City as a favourite.
This year, investment in the Washington DC metropolitan area looks set to surpass previous years quite significantly. According to figures provided to IPE Real Estate by Real Capital Analytics, for the first two quarters of 2007, total investment across all sectors was nearly $17bn (€12.6bn) in Washington DC and its suburbs in Maryland and Virginia, including Baltimore. This compared most favourably to total investment for 2006 of nearly $24bn. "We're looking at another record year for investment sales in the DC area," said Dan Fasulo, managing director at RCA. "The only hiccup is in the single family home sector, with some impact on condo sales - but his has driven people back to rental apartments."
The Washington DC area is booming because it is undergoing an evolution of sorts. Following the mid-1990s real estate slump, the city's real estate market was somewhat moribund, with low prices, stagnant returns, and few interested buyers. Many properties remained in the control of long-time owners who saw little reason to sell.
But this real estate cycle has been friendlier to the DC market. There has been lots of catch-up in terms of prices. Rising prices have been bringing old-line family owners to the table for the first time in many years, and at the same time, institutional investors who bought early in the cycle have hit their return thresholds earlier than expected, so, betting that they might be at the top of the curve, they are also selling. And they are not having any trouble finding buyers. In Washington DC, "the historical problem has been finding willing sellers", says Fasulo.
Bill Kaye, executive vice president with CB Richard Ellis capital markets, agrees: "The investment community has always wanted to be here. Some investors find it a little expensive based on the return thresholds, but competition for investment-grade buildings remains strong."
The federal government is the engine for consistent job growth inside the Beltway (the ring road that encircles Washington DC and its inner suburbs in Maryland and Virginia), as the DC metropolitan area and its immediate suburbs is known. Seasonally adjusted unemployment in Washington DC proper has consistently hovered around the 6% mark in recent years, according to federal government statistics - but looking at the DC-Virginia-Maryland-West Virginia metropolitan area, the picture is even brighter, with unemployment rarely hitting even the 3.5% mark. This is compared to a national jobless rate of 4.5% at June 2007.
Not only is joblessness at a low rate in Washington DC, but jobs, generally related to the presence of the federal government, are being created every year - in the broader DC metropolitan area, around 60,000-70,000 jobs are created annually, with more than half of these office-using jobs. "The whole economy is driven by the presence of the federal government, and there is tremendous job growth and creation," said Kaye. Median household income in the DC area tops $70,000.
For many European investors, the office market has been the first port of call, and many have focused on the central business district (CBD) and the East End. The office market in these areas is closely related to the government offices nearby. The presence of the federal government also ensures that office complexes are full. The broader Washington DC area has remarkably low vacancy rates, at less than 9%, compared to some 15% nationally - and in Washington DC proper, vacancy rates are closer to the low 6% range.
"Much of the traditionally desirable sub-markets are approaching build-out, which is a governor on the supply side," said Kaye. In addition, he pointed out that there is a height restriction on new buildings, which further constrains supply.
There are 10 office projects under construction in Capitol Hill at the moment, totalling 3.3m ft2, and 11 projects, totalling 4.5m ft2, are in the planning stages.
Within these central areas of Washington DC, many European investors, particularly the Dutch and the Germans, focused on trophy properties, notes Kees Bruggen, principal of Urban Investment Partners. In a study conducted four years ago, Dutch institutional investors owned 0.8% of real estate in Washington DC - but around 28% of all trophy buildings in the market.
For such investors, buying in areas around the White House was "defensive", said Bruggen, and they have been willing to take lower returns on their investments, knowing that the properties will retain their value even if the market dips.
Stability is not Washington DC's only strong point for European investors. Properties are also smaller than they are in New York City, DC's east coast rival for investment. "You can find a class A asset at around 200,000 ft2, as opposed to 400,000 ft2 in New York City," says Bruggen. "You can be a player even at that smaller size."
For those investors going into the Washington DC market with lower return expectations, the past few years have been a particular pleasure since "just about everyone hit their returns several years early", said Fasulo.
However, a substantial amount of new office space is coming on stream this year - around 9m ft2 will have come available by the end of 2007, compared to 8.7m ft2 the previous year.
Not all European investors are staying with their trophy properties and well-known neighbourhoods. "A number of European investors are also willing to act like locals, doing residential development and investing in affordable housing, particularly in the southeast and northeast neighbourhoods, areas that are in constant flux," said Bruggen of Urban Investment Partners.
For these investors, DC is ripe with possibilities, says Victor McFarlane, managing principal, chairman and CEO of McFarlane Partners, a real estate development company with $15bn in assets under management, and specialising in urban investment.
McFarlane is committed to the Washington DC market, having opened an office there in 2006 (Victor McFarlane is also the majority owner of DC United, the city's major league soccer team, which he acquired before he began investing any institutional money in the city). "My guess is that we'll invest in properties worth $10bn in Washington DC over the next five to 10 years," says McFarlane. His second fund, a private investment fund, is expected to close in the summer, and the third urban fund is going later this year.
"There is a lot of redevelopment work, recapturing land," said McFarlane. "We are working in underutilised areas but only one mile from the capital." Some of his firm's major projects are in Washington DC's southeast quadrant, along the Anacostia River. Half Street, for example, is a mixed-use project combining office, retail and mixed-income housing that is being built near the new stadium for the Washington Nationals major league baseball team in a formerly neglected neighbourhood. In 2006, the Department of Transportation relocated to office space in the neighbourhood, giving a federal boost to the district.
The northeast of Washington DC also has revitalisation potential. NoMA, the area north of Massachusetts Avenue, traditionally the northern boundary of what is considered downtown Washington, is also a focus of developers - there is potential for up to 17m ft2 of development, more than is found in traditional neighbourhoods such as Georgetown. NoMA is already home to the Securities and Exchange Commission and the new headquarters of the Bureau of Alcohol, Tobacco, and Firearms.
Development fills two niches in DC: infill redevelopment of B-/C class office buildings into better projects; and in pioneering locations, such as NoMa and the area around the new ballpark. Although significant redevelopment of both types is underway, Kaye cautions that "these are emerging markets and are largely untested by traditional office users, except for the federal government". He notes, however, that the less central neighbourhoods offer a necessary price alternative. Rents in the East End and the central business district (CBD) are high, out of the reach of some potential tenants. However, in those established neighbourhoods, "law firms are the growth engine, and the lawyers can afford to pay the most in rent".
It is also possible for investors to look farther afield, both within and outside the Beltway. Kaye classes the market inside the Beltway as "dynamic" but is more cautious when looking outside of it.
The Roslyn-Ballston corridor, in Arlington county, Virginia, benefits from its proximity to Washington DC and to the Metro transit system. This area has recently seen a significant amount of speculative building, although rental take-up is lower than in the city centre.
"Although there is more ground available, for example, out toward Dulles Airport, leasing velocity has slowed for all sizes of tenants. About 24-36 months ago, around 40,000 condo units came on the market, and the market is very soft now," says Kaye.
The bulk of the industrial market in the DC area is located either along the Dulles corridor, to the west of the city, or along the Baltimore-Washington corridor, running north from the city. The Baltimore-Washington corridor is traditionally a leading distribution centre, but there is very little bulk land available for purchase, so developers are looking toward redevelopment potential, or directing their attention even further north. In the Dulles corridor, land is also very expensive, especially in relation to current rental rates.
Some investors are willing to class investment in Baltimore as part of a Washington DC portfolio. Baltimore is a smaller market than Washington DC, with total sales of some $3.3bn in 2006, which fell from $3.5bn in 2005. In fact, sales in most property types fell between 2005 and 2006 - only a few big apartment deals bucked this trend.
The city is wrestling with ways to stem a historic decline, and while some investors see opportunity there, others are sceptical. Bruggen of Urban Investment Partners says: "Although the city wants it to be the case, we have not seen the kind of expansion we would like there." The city has suffered from irreversible declines in its traditional manufacturing base, and its transition to a service-based economy has been slow. Major development is ongoing in an attempt to revitalise the downtown area.
Bruggen sees many European pension funds investing in the Washington DC area with local partners. Urban Investment Partners raises funds and is currently working on its second tranches, with $240m from European sources, particularly from the Netherlands and Belgium, allocated to new developments.
Until recently, the firm's focus was exclusively on Washington DC, concentrating on developing affordable rental housing. In 2004, however, the firm agreed an exclusive arrangement with Netherlands-based Bouwfonds Asset Management, a subsidiary of ABN-Amro. The partnership is looking at opportunities in both commercial and residential real estate and is a springboard for Urban Investment Partners to broaden its geographic range beyond the DC area, particularly on the east coast.
Bruggen notes, however, that "Washington DC has been hard to beat over the last few years. It remains a great market and we are still able to find intriguing opportunities in the DC area - even though it is not as cheap as it once was."