Washington, D.C., remains a hot market for real estate investment, even after the terrorist strikes. Why? The District has good fundamentals and offers stable performance in an insecure world. In Wall Street parlance, the District is not a "high beta" performer but will deliver cash flow and capital protection, if not appreciation, year after year.

The average size of a D.C. building is 200,000 square feet or so and, even at today' prices, the full ticket is no more than $80 million. Yields are in the 8 percent range, which appear quite high to investors who see 5 to 6 percent yields in Europe. Two or three Class A buildings in the District cost the same as one building of similar quality investment in other cities. Mayor Anthony Williams has brought new jobs and more people to the city, and the mood prior to September 11 was upbeat. The federal government was running at a surplus, will probably stimulate the local economy now with deficit spending - and is a major element in the stability of the local economy. Information remains the critical commodity for business, and information starts from the place where the laws and the regulations are enacted. The District may not be recession-proof, but it is in a better position than most cities to weather an economic storm.

The District has not been a "high beta" performer in recent history, but even in the pits of the industry depression in the early 1990s, District values retained a relatively high percentage of peak value. On the other hand, District value increases have never matched the dramatic rises experienced in Boston, San Francisco or New York City. It would seem that the District' geographic and height restrictions, combined with a relatively long development approval process, would restrict supply, creating an imbalance between supply and demand. Since the District has not been experiencing "high beta" performance, something must be restricting demand. Some place the blame on lawyers.

Over the past 20 years, law appears to have evolved from a profession to a business or, more accurately, a collection of individual service providers under the umbrella of a partnership or professional limited liability corporation. As such, these individuals are much more directly and intimately affected in their respective wallets by an increase in occupancy costs than the average corporate executive occupying space in other parts of the country.

Total occupancy costs include not only rent but operating expenses and real estate taxes. Shopkeepers have traditionally assumed they can afford total occupancy costs between 10 and 15 percent of sales. Senior partners from several large firms have put the percentage for lawyers at 10 percent. Therefore a $1 increase in total occupancy costs would necessitate $10 in additional revenue ($1 divided by 10 percent) per square foot. Space planners normally figure an efficient floor plan for a law firm will require some 650 square feet per attorney. Multiplying the $10 per square foot by the 650 square feet results in required additional revenue of $6,500 annually to support a $1 increase in occupancy costs.

If the average billing rate for a Washington attorney is $300 per hour, the $1 increase translates to more than half a week' work, assuming a 40-hour work week. The District' real estate taxes on office buildings went up $1 per foot this year and rents typically escalate 3 percent a year (or more than $1 per year for rents above $33 per square foot). If billing rates do not escalate accordingly, the lawyer has to add a week' work to his or her year.

Law firms are still the major tenant in the market. If rates go too high, lawyers delay moving or create a temporary space solution. Does this prevent rent increases? No, but it does stop sharp climbs in rents. This is not necessarily a bad thing; moderation may not be appreciated during economic upswings, but it is quite comforting in downturns.

Do real estate investors take all of this into account when they consider the price to pay for a Washington building? For at least for 90 to 95 percent of the pricing, real estate investors examine the local economy, supply and demand, comparable sales and replacement costs. But, for 5 to 10 percent, I fear we are all worshippers of IRR, the internal rate of return.

Purchasing a building in Washington is competitive and you must "push" the returns to win. A number of measures, such as comparable sales or replacement costs or first year returns, are quite inflexible when you need to be creative. That is when the IRR helps. IRR is calculated based on a myriad of assumptions projected over 5, 10 or 15 years. Growth rates, capitalization rates and turnover assumptions provide a wealth of opportunities for obfuscation. Even the calculation itself contains assumptions regarding reinvestment rates, which are arguable and ambiguous.

Therefore, the IRR is a gold mine for pushing acquisition costs to new heights. Many a winning bid has been preceded by the statement "Yeah, I know first year yield is low and the offer is high relative to comps and replacement costs Sç but look at this IRR!" Sometimes you win, sometimes you lose. So the bulk of the purchase price is based on good, solid fundamentals but, for that last 5 to 10 percent, the fundamentals are IRR-elevant!

John Flavin is president of Grosvenor in Washington, D.C.

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