Sequestration is shining a spotlight on an obstacle to the commercial real estate recovery—federal belt tightening.

Nationally, the U.S. economy will take a hit from the sequester’s $85 billion in federal budget cuts planned for fiscal 2013. The forced reductions that began on March 1st will have real consequences for the U.S. economy, including eliminated and reduced government contracts, reduced private and public sector jobs and furloughed workers. “It will slow us down a little bit, but it won’t be fatal in any sense of the word,” says Jon Southard, managing director of the Econometric Advisors Group at CBRE in Boston.

Economists are predicting that the sequester will reign in economic growth by about 0.5 to 0.6 percent this year. Gross domestic product expanded at a 2.5 percent annual rate during the first quarter, which is below the 3.0 percent growth pace that economists had anticipated. Last year, the U.S. economy achieved a 2.2 percent growth rate. The bigger issue is that the burden of the sequester is not being spread equally. Markets with a high exposure to federal spending will feel the brunt of the blow.

Sequestration was trigged by the failure of a Congressional deficit reduction committee to arrive at a long-term deficit reduction plan late last year. The resulting budget cuts officially became law on March 2nd. Potentially, the $85 million in cuts expected this year could be just the tip of the iceberg. There are an estimated $1 trillion in total federal spending cuts that are slated to take place over the next decade.

The sequester magnifies a broader trend of reduced government spending that began in 2011. For example, the federal government initiated about $30 billion in budget cuts last year, and since January 2012 the federal government has already shrunk its workforce by about 69,000 jobs. “When you look at commercial real estate, it is hard to separate the impacts from the sequester or just the longer term slowdown in government spending,” says Mark Vitner, a senior economist at Wells Fargo Securities in Charlotte, N.C.

Risk markets

The states that top the list for the highest amount of federal spending as a percent of 2010 GDP include the District of Columbia, Maryland and Virginia, all of which report 19.8 percent of economic activity tied to federal spending. Other states that rate high for federal spending include Hawaii, at 15.8 percent, Alaska, at 13.3 percent, and Kentucky, at 9.9 percent, according to Wells Fargo Securities.

Clearly, the nation’s capitol is a prime target for cuts, with a high concentration of government agencies and federal contractors. In Northern Virginia, for example, government contractors account for nearly 40 percent of the office market, notes Scott Homa, a vice president of research for the Mid-Atlantic region at Jones Lang LaSalle in Washington, D.C. “So, this is an office market that is highly exposed to any fluctuations in government spending,” he says. “Any lack of clarity associated with fiscal policy and long-term budget priorities really impedes growth in the market.”

The fact that there has not been an official federal budget in over four years, coupled with the threat of looming cuts from the sequester, has tempered demand for office space among both government contractors and federal agencies. “As a result, everyone is handcuffed and unable to make any sort of long-term space decisions,” says Homa.

The metro D.C. office market reported 3 million sq. ft. of negative absorption in 2012. Government contractors are consolidating, disposing of excess space and being very conservative in their real estate decisions, notes Homa. Federal agencies also are completely on the sidelines now, with the mandate that the government is to freeze its existing property footprint.

The cuts are aimed at both defense and non-defense spending. The defense cutbacks will potentially reduce wages and employment in areas with a strong defense presence and regions with large defense contractors. Cuts in non-defense programs will affect a large number of hospitals, government contractors and research institutions.

The more technical operations and knowledge-based contracting, such as cyber-security, are expected to be more immune to cuts. Regions with high concentrations of federal contracts for manufacturing face a bigger risk if the Department of Defense cuts back on orders for big-ticket items such as ships, fighter jets, missiles and ammunition. For example, St. Louis has a high exposure to the aerospace industry and more than one-fourth of its economy, 26.5 percent, is tied to federal spending.

“Those are markets where if the DOD pares back its orders for planes and ships, that has a very dramatic impact on the labor market in those secondary and tertiary markets,” says Homa.

Gauging the impact

The sequester and cutbacks in federal spending will create ripple effects that will spread through the broader economy. One question that remains is how far—and how quickly—those ripple effects will be felt. Cuts have the potential to impact everything, from consumer confidence to federally funded construction projects.

According to a report from the Associated General Contractors of America, the cuts could translate to more than $4 billion in reductions to federal construction spending. Projects that are on the chopping block range from military housing to investment in new infrastructure for drinking water and wastewater facilities.

The reality is that the sequester is still in the early stages, and the full impact of the budget cuts has yet to be seen. “I think the longer the sequestration goes on, the greater the impact will be,” says Vitner. There has been an impact on the hours worked as government employees are furloughed. “The real test will come down the road when the cuts get a little bit bigger,” he adds.

Yet the forecast is not all gloom and doom. “We’re not out there sounding the alarm and saying that things are going to get worse and we’re stuck in this quagmire,” says Homa.

Yes, the cutbacks in federal spending will create a drag on the economy and present bigger obstacles to recovery in some regions of the country.

However, Homa is optimistic about the long-term outlook for the national economy and national office market. There are positive indicators in terms of improvements in business spending, job growth, housing market recovery and returning consumer confidence. “There are all these green shoots that are out there that are going to compensate for this pullback that we have in the federal realm,” adds Homa.