The dramatic increase in rental rates and purchase prices in 2005 through 2007 came to a halt last year, followed by a steady decline in pricing. Financial and residential real estate sectors have dumped approximately 4 million square feet of office space back on to the market in the last year and a half. Vacancy rates climbed to their highest levels since 1996 in San Diego. Average time on the market for available office space is approximately 20 months until leased. Class A office buildings are being leased at Class B rental rates. With the amount of commercial mortgage debt security maturities coming due in the next four years, the worst may be yet to come. It is likely that equilibrium will take another 18 to 24 months.
Regardless of the market turmoil, most companies in the defense industry continue to grow. Companies that are financially stable have an opportunity to capitalize on occupancy cost savings in several different ways.
One primary consideration for defense contractor clients is whether to buy or lease.
The first step in making this decision is to evaluate the length and security of the contracts secured. Buying commercial property requires a long-term commitment. If the defense company relies on a series of short-term contracts, buying a building could limit its options, and financing may be hard to secure.
A defense company may be limited in its ability to lease out excess space due to security concerns. Additionally, the company's customer(s) may be entitled to a credit for the rental income depending upon the structure of the contract(s).
Similarly, if the defense company decides to sell the building, the customer may be entitled to share in the profits, depending upon how the contract defines and treats expenses.
Generally, defense companies opt not to own real estate, but if the company can remain competitive despite increasing its overhead and administrative expenses on a long-term basis, an investment in real estate may pay off, provided the hold period is not too ambitious.
Leasing is a far more popular option, but the unique business structure of defense companies will impact lease negotiations. At times it may be difficult to accurately forecast space needs on a long-term basis. Some companies find flexibility by securing a series of smaller, separate leases across several buildings or floors, or by contract or business unit. Some larger clients stagger their lease expiration dates to hedge against fluctuating space requirements.
Implementing precautionary measures in the lease portfolio will increase the amount of time the company must spend managing its real estate commitments, but the resulting security and flexibility is usually worth the added workload.
On the flip side, securing first right of refusal for additional space in the same building within the lease provides more flexibility to expand if necessary.
When a defense company occupies space for the first time, or expands into additional space, its managers must be mindful of their customers' requirements as they apply to classified storage, sensitive compartmented information facilities (SCIF) and other classified spaces.
Another driving consideration in structuring leases, as well as making a buying decision, is whether the company's contracts are structured as Cost Plus contracts or Fixed Price contracts. Cost Plus contracts generally result in full reimbursement of expenses, where as Fixed Price contracts may not. A company unable to predict its expenses under a Fixed Price type contract is less likely to make a profit on the contract.
The Federal Acquisition Regulation (FAR), the primary federal regulation used by federal executive agencies in their acquisition of supplies and services with appropriated funds, outlines specific reimbursement rules pertaining to real estate ownership and rental costs, and a company should be clear about whether to treat the cost as overhead or administrative expenses.
Not all real estate costs are allowable under the FAR, including finance costs or interest expenses associated with buying real estate, though according to the Government Contractors Council Report, FAR 31.205-10 and CAS 414 specify that the cost of money may be recoverable for owned facilities or a plant under construction.
A defense company should be sure to understand these rules and work with a real estate agent familiar with the defense contracting industry.
Companies with a lease expiring in the next 12-24 months should develop a real estate strategy. Savvy tenants will deploy tactics far in advance of the expiration date even if their intent is to renew their existing lease. Competition among landlords is fierce and tenant retention is a high priority. Therefore, tenants may be able to benefit from a lease restructure and immediately reduce occupancy costs.
Tenants needing to relocate are not only negotiating greater rental abatement periods, but also increased tenant improvement allowances and reimbursement of moving costs and basic IT infrastructure. Subleases can also be a great way to capitalize on market conditions, although they can carry substantial risk.
Along with evaluating favorable terms available in today's office properties market, the prudent tenant will also evaluate risk, including landlord stability and even lender stability. As always, one cannot look at return independent of risk.
Wood, executive vice president at Jones Lang LaSalle, and Alan Baca, associate at Jones Lang LaSalle, work extensively with defense contracting firms, providing comprehensive tenant representation services.