Generating a decent yield todayis an elusive task. As competition has crowded the market and driven up prices, savvy investors have begun to look beyond the assets that they find most familiar.
For net lease investors in particular, this is a key question as cap rates have dropped on core assets. To generate additional yield, some players are straying from vanilla single-tenant office, retail and industrial deals and exploring government assets as a potentially lucrative investment opportunity. The reason: “Most government building trades at 6 percent cap rate and the highest-quality net lease trade at a 5 percent cap rate,” notes Nathaniel A. Sager, vice president with Chicago-based Mesirow Financial, which was involved in more than $100 million in Government Services Administration (GSA) deals in 2012.
But the competition is beginning to heat up. As a result, cap rates on government assets have compressed as much as 100 to 150 basis points over the past 12 to 15 months, Sager estimates.
Single-tenant properties occupied by the GSA are attracting a wide variety of investors, from wealthy individuals to institutional investors like REITs and pension funds. The organization, which acts as the federal government’s landlord, owns or leases 9,600 assets and maintains an inventory of more than 362 million sq. ft. of space, according to a report issued by the Republican leaders of the House Transportation and Infrastructure Committee.
“We created this company because we believed there was a niche in the public REIT space for a company with very high credit quality tenants that had a very high renewal probability, which translates into a very safe dividend and reasonable growth opportunities,” says David M. Blackman, president and COO of Government Properties Income Trust, a REIT that owns roughly $1.7 billion of office properties with approximately 10 million sq. ft. located in 31 states and Washington, D.C.
“An investor in buildings leased to government tenants is willing to accept a lower absolute return and potentially higher management responsibilities, but ultimately is going to have a saferthan one leased to a corporate user,” Blackman says. “These properties provide a safe and consistent income stream.”
What's the appeal?
Investors considering government assets are attracted to the combination of government credit and long-term leases. Moreover, there’s very little renewal risk, and the government reimburses owners for building expenses.
Sager says smaller investors are just as keen to invest in government properties as large investors. He offers this comparison: a drugstore in Middle America that sells for $5 million and a 6 percent cap rate versus a Social Security Administration building in a similar market for the same price but with an 8 percent cap rate.
“The difference is that the investor has to manage the building,” Sager points out. “But you can also think about it this way: someone can come along and build another drugstore, but there’s only going to be one SSA building. In this case, the GSA is the best risk-adjusted yield.”
The opportunities to invest in government assets are varied because there are buildings priced from $3 million to $5 million to well above $100 million. In the past 12 months, for example, several large GSA deals have traded. In Washington, D.C., for example, Sumitomo acquired the 236,054-sq.-ft. U.S. Mint building for $147.5 million. The purchase price translated into a 4.6 percent cap rate.
Because investors currently are focused on quality assets and desperately seeking yield, government assets are highly coveted. “When they come to market, they get a lot of activity,” says Brian Saal, vice president with Jones Lang LaSalle’s agency leasing group. “We’re seeing cap rate compression, and it’s a good time to be a seller.” He estimates that cap rates are in the mid–6 percent rate on average, although there are examples of properties that have traded at much lower cap rates.
Saal adds that government assets are unique in that they can overcome market specific biases. For example, an FBI building in Omaha, Neb., or Huntsville, Ala., would trade at similar cap rates to those in larger markets.
Pension funds and life insurance companies are increasingly interested in investing in government deals, Saal says. The appeal is understandable since these types of institutions are working off fixed-income strategies. Northwestern Mutual, USAA and CalSTRS are among the institutions that are actively seeking these deals. He also noted that foreign capital is chasing such assets. This makes for an interesting dynamic; foreign ownership of GSA space has to be vetted and approved.
At the same time more investors have entered the market, and supply is less than robust. Lease awards in fiscal year 2012 fell 96 percent year over year. Without clarity on agency budgets, federal tenants were forced to delay space decisions or execute short-term renewals to ride out the uncertainty. New GSA lease awards fell from $1.2 billion in fiscal year 2011 to just $45.9 million in the comparable period of 2012.
For example, Government Income Properties Trust started acquiring assets in 2009 and was very active from 2009 through 2011. Blackman attributes that activity to lack of debt available toowners. The REIT was not as active in 2012, closing $250 million in acquisitions compared to $444 million in 2011.
Blackman points to two causes: the GSA suspended its build-to-suit program, which impacted the supply of possible investments, and the thawing of the credit markets made it possible for government building owners to hang on to their properties.
Better than Treasuries
For property investors that are concerned about their tenants’ credit quality, it’s easy to understand the appeal of government buildings. Each GSA lease is an unconditional general obligation to the federal government, backed by its full faith and credit, and the federal government has a perfect track record of rent payments.
Even the U.S. credit downgrade and concerns about sequestration haven’t been enough to scare away investors. In fact, most are nonchalant about it.
"There is the risk that the U.S. government could shut down in 2013 because of politics,” Blackman acknowledged. “But I am 100 percent certain that it will pay its rent. It can print money if [it has] to… it can raise taxes. The point is that the government will survive.”
Even the most risk-averse investors like the government space. For example, Titanium Real Estate Advisors’ strategy for investing money on behalf of a Michigan-based pension fund is to sink money into GSA-occupied properties. Over the past 18 months, the-based investment manager has built a $150 million portfolio of 20 GSA properties totaling nearly 600,000 sq. ft.
Kris Jankowski, vice president of Titanium Real Estate Advisors, says the pension fund was looking for an investment that would provide a steady stream of income for a long period. “We identified GSA buildings as a good fit for them because of the federal government credit and the yield that met their actuarial assumptions,” he explains. “We look at this fund as an alternative to fixed-income investments. The spread between GSA assets and Treasuries is greater than 500 basis points, and that spread justifies having assets with less liquidity than a bond.”
Jankowski points out that investors with GSA assets are getting the same exact credit guarantee they would get if they invested in 10-year Treasuries (assuming the lease term for the properties is 10 years or longer). “The general theme,” he explains, “is that you can get 3 percent in fixed income today or you can go out on the risk spectrum to a moderate beta and get 8 percent. Why wouldn’t you do that?”
Blackman agrees that government-leased investments are similar to fixed-income investments, and as a result, a lot of investors buy into Government Properties Income Trust because of the spread between the REIT’s 7 percent dividend and Treasuries rates. “There should be a risk premium for real estate, but I’m not sure anyone thinks it should be 550 basis points,” he says.
Not true net leases
It’s important to clarify that GSA does not sign net leases, so calling a government asset a net lease deal is slightly inaccurate. But since the assets provide similar credit profiles and lease term and are priced on those aspects, many investors consider government assets to be net lease investments.
Saal explains that the GSA structures leases differently than the private sector. Unlike the typical corporate office lease, government deals are almost always full service. On the rare occasion the lease might include net-metered electricity.
The GSA does end up reimbursing owners for expenses, but owners are on the hook for facilities and property management. Moreover, GSA leases don’t usually include rent escalations. In fact, the rent might actually go down over the lease term because the entity amortizes tenant improvements.
Another unique aspect of a GSA lease is the concepts of “firm” and “non-firm” leases—that is how long a time the GSA is definitively committing to and how much of it is optional. In most instances, GSA leases consist of both firm and non-firm periods that collectively make up the total lease terms.
For example, the FBI might sign a lease for 20 years, but only 10 years is firm, which means that the GSA has agreed to stay in place and pay rent for that period. The remaining decade would be a non-firm term, which means that the GSA could cancel the lease at any time in the second 10-year period without owing additional money after its cancellation.
But even with the firm/non-firm elements of GSA leases, one of the most attractive elements of this kind of deal is renewal certainty. On average, the GSA stays in place for close to 30 years.
Jones Lang LaSalle reviewed federal leases from 2002 to 2011, and found that 77 percent of all GSA leases renew in place upon expiration. For single-tenant assets, 92 percent of GSA leases renew, and for single-tenant, build-to-suit assets, 96 percent of GSA leases renew.
In contrast, Blackman estimates that private sector tenants renew in place probably 50 percent of the time.
Not created equal
Investors new to the government space might make the mistake in thinking that all GSA-leased buildings are the same. That’s not the case, Saal says, explaining that different agencies have divergent requirements and tenant personalities. Saal warns investors to scrutinize government assets just as carefully as they would private sector investments, paying careful attention to the agencies occupying the buildings and how essential the properties are for conducting business.
Saal points to this example: a single-tenant building in Austin, Texas, is leased to the IRS. The lease term is less than 10 years, and the IRS uses the facility for a call center and processing location. He says investors might want to think about how “sticky” this tenant will be when the lease rolls over because the IRS is moving away from phone and paper and embracing online filing and electronic document management.
“The credit is the same, but investors don’t feel the same about all agencies,” Saal says. “You can get a better premium for certain agencies in certain markets.”
In general, Saal says that agencies with bipartisan and defense-centric missions tend to receive higher priority from congressional appropriators and are given greater leniency to make real estate decisions. They prefer to lease space where they are the only tenant in the building and are very sticky tenants due to the expense of their space build-outs. The most attractive organizations are the FBI and intelligence agencies (CIA, NSA, etc.) and the Dept. of Veterans Affairs, Dept. of Defense, Dept. of State, Dept. of Homeland Security and Dept. of Justice.
“Investors can achieve so many layers of diversification with GSA assets, more so even than they can with traditional net lease deals,” Jankowski says. “You can very easily achieve agency and geographic diversification.”
Neediest tenant of them all?
The biggest drawback to investing in government assets is the government itself. To describe the GSA as a needy tenant would be an understatement, according to nearly every expert in the space.
“They’re a pain in the ass,” said one source who wanted to speak anonymously for fear of ending up on the IRS’s radar.
Investors who seek out net lease assets because they want to reduce their management oversight should avoid investing in government-occupied assets. Blackman notes that government tenants are generally “high touch” and speak a different language than most users and owners. “It takes a certain type of expertise to keep them happy in your buildings and to renew them,” he says.
“I think most typical institutional investors will look at government deals and say they don’t want the headache,” Jankowski notes. “The management piece is really a critical component of why you would or wouldn’t want to invest in GSA.”