COVER STORY, APRIL 2012

BIDDING WARS
Investment market heats up for Class A office properties in Washington, D.C.
Savannah Duncan

In mid-March, Rockrose Development Group acquired the 225,000-square-foot Republic Place, located at 1776 Eye St. NW in Washington, D.C., from Washington Republic for $119 million.

The sale is the most recent in a string of Class A office properties in Washington, D.C., surpassing the $100 million mark.

“Investors are seeing quality opportunities that are well-tenanted, whether it’s trophy properties downtown or even in the suburbs,” says Jim Molloy, senior vice president of Jones Lang LaSalle’s Washington, D.C., office.

According to New York-based Reis, the office vacancy rate in the fourth quarter of 2011 in D.C. was 9.4 percent, the lowest in the Southeast, if not the country. By comparison, the fourth-quarter vacancy in Atlanta was 20.7 percent, while Miami posted a vacancy rate of 17.1 percent.

The standout performance of the D.C. office market resonates with investors. “Washington, D.C., is a target market of Wells REIT II because it has always had significant demand driven by government tenants, and also by non-government tenants,” says Nelson Mills, president and director of Norcross, Georgia-based Wells REIT II. “It’s the nation’s capital and a key center for foreign and international companies to locate.”

In addition, supply constraints on the market due to height restrictions and a lack of developable land keep demand strong, Mills adds.

That’s not to say the D.C. office market is immune to what’s happening. “There is a cloud of uncertainty related to the government,” says John Blaylock, a director in Invesco Real Estate’s Dallas office. “That may turn into a buying opportunity for some people, or it may prove to be a real problem. The truth is, no one knows right now.”

According to the Bureau of Labor Statistics, in 2011, the federal, local and state governments combined lost an average of 22,000 jobs per month.

This concern hasn’t stopped properties from trading at astronomical prices. On average, capitalization rates for core properties are approximately 5 percent, with some core plus properties trading closer to 4 percent, says Marc DeLuca, managing director of Clarion Partners’ Washington, D.C., office.

Sales Activity

The largest office sale in the D.C. market for 2011 and 2012 occurred last March when Wells REIT II purchased the 679,710 Market Square, located at 701 and 801 Pennsylvania Ave., for $615 million, according to Real Capital Analytics. Beacon Capital Partners sold the two-building property, which borders the U.S. Navy Memorial.

“Our fund is reaching a mature stage, and we had capacity on our balance sheet and capital allocated for substantial acquisitions,” Mills says. “Market Square is a cornerstone and was a great way to round out our portfolio.”

USAA Real Estate Co. also made a sizable purchase with the acquisition of 1100 and 1101 Fourth Street at Waterfront Station last June for $356 million. The two buildings total 631,000 square feet, of which the government of the District of Columbia leases 553,330 square feet.

“These buildings will be an exceptional addition to our U.S. Government Building Fund portfolio of assets,” said Pat Duncan, chairman and CEO of San Antonio-based USAA Real Estate Co., in a press release. “Securing quality, long-term tenants such as the D.C. government makes this an attractive investment opportunity for this fund with excellent cash flow in a rapidly expanding area of D.C.”

The largest sale year-to-date as of the end of March is Mitsui Fudosan America’s $252 million purchase of an 80 percent partnership interest in the 421,901-square-foot Homer Building, located at 601 13th St. NW. Australia-based Investa Office Fund was the seller. The transaction closed in mid-January.

“The building’s rich history, historic architectural design and premier location are central to our strategy to invest in high-quality assets in established, growing markets,” said Yukio Yoshida, president and CEO of New York City-based Mitsui Fudosan America, in a press release.

Clarion Partners represented Investa Office Fund in the transaction. DeLuca of Clarion Partners says the company had a change in investment strategy and decided to dispose of the asset.

Currently, Transwestern is marketing the 154,584-square-foot Lion Building for sale on behalf of Clarion Partners, which owns the asset on behalf of a separate account client.

Additional notable office sales include the $199 million acquisition of the 291,480-square-foot 1101 K Street NW. A partnership between The Rockefeller Group and Mitsubishi Estate New York bought the property from a joint venture between The JBG Companies and Rockwood Capital. The sale closed in March 2011.

Competitive Bidding Environment

The bidding environment for Class A office properties in D.C. has continued to heat up.

“A lot of times, assets are bid up to such a level it becomes a cost of capital issue,” says Blaylock. “Investors are making investment decisions predicated on the need to fill a necessary void in their portfolio. One group may look at the asset and be able to take a little bit lower return than another group. In D.C., it’s so competitive that sometimes an investor wanting to penetrate the market or add to their portfolio may have to be more aggressive than Invesco is comfortable with.”

Blaylock adds that generally Invesco would choose to not invest in an asset rather than risk overpaying. “Just buying a property to put it up on the board doesn’t meet our goals in the long run. The returns for your client aren’t going to be very good, which should be the ultimate driver for investing.”

For the sale of Market Square, Mills says the property was heavily contested, with several other bids around the same price as the one offered by Wells REIT II. “Every asset we buy is a competitive bid situation,” he adds. “Often, we aren’t even the highest bidder, but because of our ability to close and our reputation, we win.”

Mills says that before bidding on a property, Wells REIT II spends time thoroughly analyzing the local market and submarket in which a property is located. That way, the company knows exactly how much capital it can safely deploy.

While concern about government cutbacks and the impact of the presidential election prevail, the fundamentals of the Washington, D.C., office market remain strong.

Molloy says that with the volume of office investment sales in the Washington, D.C. metro area rising — $6.1 billion in 2011 compared to $5.7 billion in 2010 — the nation’s capital will continue to appeal to investors.

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