Making the Most of Public Assets
Despite an infrastructure plan failing to materialize in Washington, investors still see opportunities to spend.
by Beth Mattson-Teig
Once a niche market, government-leased facilities are attracting a bigger pool of investors. Government-leased facilities have exploded into a broad investment category that includes everything from public infrastructure to single-tenant commercial buildings. Capital has been pouring into the space over the past five years, with new funds and more new players that are putting greater pressure on the supply of investment deals available.
"We are seeing a lot of competition and not much in the way of product," says Marcy Owens Test, senior vice president, federal lessor advisory group, with real estate services firm CBRE in Washington, D.C.
There are several factors fueling growing demand in single-tenant leased government buildings. Some investors view the asset type as simply another alternative in a crowded real estate investment market, while others like the diversity and the low-risk profile.
"When it comes down to it, the federal government is the largest catalyst in the economy. It is one of the largest employers and one of the largest office tenants and it is pretty insulated from economic cycles," says Scott Briggs, Esq., an associate director at the Stan Johnson Co., a brokerage specializing in net lease assets, in Tulsa.
The government is a long-term occupant with strong credit, and many investors see a strong value in having a government entity as a tenant. In addition, there has also been more transparency in the sector in recent years.
"We are now seeing a lot more data and trends in terms of long-term renewals. That also is helping to get non-traditional investors in this asset class more comfortable;' Briggs says.
Many of the same drivers are funneling more capital into infrastructure projects around the country. For example, Blackstone launched a new U.S. Infrastructure fund this year that it expects to grow to $100 billion. "Since the global financial crisis, people like real assets and they like infrastructure because the presumption is that these are business models and revenue streams that are secure," says Joel Moser, CEO of Aquamarine Investment Partners, an institutional investor and manager of private equity in the real asset classes of energy, infrastructure and core real estate.
The challenge here is that there is more capital than there are quality investment opportunities. "There is really not a big inventory of these traditional civil infrastructure assets," says Moser. So what most infrastructure funds tend to invest in is energy, such as oil and gas pipelines. There is also a scattering of about half a dozen transportation projects that come to the market each year. "There is a huge disconnect between what investors think they want exposure to in North America and what is actually there," Moser notes.
Road blocks to infrastructure spending
President Trump made a campaign promise to leverage private capital to spur $1 trillion in new infrastructure spending over the next decade. Trump had sketched out a proposal of spending $200 billion in federal money into projects, with a goal of generating $1 trillion in overall investment.
The $1 trillion figure would be the result of federal funding, incentives for private sector investment and expedited projects that "would not have happened but for the administration's involvement," according to a budget request proposal the administration submitted in May.
In August, Trump signed an executive order "establishing discipline and accountability in the environmental review and permitting process for infrastructure projects."
But the press conference where the order was unveiled quickly got sidetracked.
It was days after James Alex Fields Jr. drove a car into a crowd of protesters in Charlottesville, Va., killing Heather Heyer. Fields, who was charged with second-degree murder among other counts, was part of a "unite the right" rally that took place that day bringing together disparate far right groups, who, among other issues, were defending a Robert E. Lee statue slated to come down in the town. Heyer was part of a group of left-wing counter-protesters against that rally.
Trump's response to those events in the subsequent days was highly scrutinized and the infrastructure press conference quickly devolved into comments on the rally and his own response. Since then, the administration has done Little to push the executive order or any further plans on infrastructure investment.
On the positive side, the Government Services Administration (GSA), the entity in charge of administrating the federal government's real estate and leasing, is set to receive a new head. Emily Murphy was among 42 senior level appointments announced by the White House in early September. Murphy has been a senior adviser to Timothy Horne, the GSA's acting administrator. Murphy also served as the chief acquisition officer for the GSA from 2005 to 2007.
"There are a lot of people who are watching Washington to see if there is a real catalyst for infrastructure spending," says Nathanial Sager, senior managing director, CTL and structured debt products, at Mesirow Financial in Chicago.
Another factor that bodes well for new infrastructure development is that people generally recognize that there is a big need in the country to upgrade and replace critical infrastructure. "So regardless of whether this administration is successful, or the next administration, I think we are going to see increased activity in the (third-party) market, because there is going to be a huge demand for investment in infrastructure and essential government assets," Sager says.
Infrastructure has been an investable asset class globally for some time, but it has only taken off in the U.S. over the last decade. The first privatization of a U.S. highway occurred in 2005, with an investment group acquiring the 7.8-mile Chicago Skyway toll road. That was followed by the Indiana Toll Road deal in 2006. "All of a sudden, the concept of infrastructure being an investable asset class in the U.S. exploded," says Moser.
There have been numerous pilot projects around the country over the past decade, some successful and some failures, and the U.S. is still grappling with how to make privatization work, notes Moser. One challenge is that projects are not easy to finance. Lenders are wary about underwriting infrastructure projects with revenue risk, or those projects that are reliant on collecting revenue from operations, such as toll roads.
Private capital is always willing to make a risk-adjusted return, and there is no lack of capital in the marketplace. The municipal bond market, for example, is very liquid with lots of capital. Adding a new form of capital in terms of private or institutional equity doesn't change anything. "I am a little bit disappointed to hear that the current administration's $1 trillion infrastructure plan is in no way connected to some new expenditure of federal dollars," says Moser.
The big stumbling block is where the money will come from to repay the capital that has come into the project. If someone builds a new bridge, does the revenue go to pay a yield on the bond or does return for investors come from a government tax or perhaps user fees? Ultimately, that funding needs to be a government policy decision, says Moser. "So all this discussion about private sector finance is a red herring;' he says. "The only way there will be $1 trillion in infrastructure in America is that if government, at one level or another, decides that there will be."
Growing investor appetite
Investing in core infrastructure projects such as roads and bridges that also require some type of operating revenue remains a specialized niche. The more traditional route for investors has been to focus on government-leased facilities, which is a sub-category within the broader net lease investment market.
Historically, even that net lease niche has been dominated by a handful of investment groups, such as The RMR Group and Government Properties Income Trust. However, that investment pool is expanding. "Over the last five to seven years, there has been more focus on this niche investment with more players and more activity," says Brian Saal, assistant vice president on the Government Investor Services (GIS) team in Washington, D.C. For example, Boyd Waterson Asset Management is one well-capitalized and highly motivated investor that has been able to break into the sector and amass a large portfolio relatively quickly, he adds.
The bigger buyer pool is putting pressure on what appears to be a shrinking pipeline of deals, at least at the federal level. On the federal side, the most visible agency is the GSA. Although some federal agencies do negotiate their own deals directly, almost all federal agencies utilize the GSA, notably for bigger leases or deals in urban areas.
"The primary trend in GSAs real estate right now is space reduction and consolidation," says Test. The quantity of leases has dropped from 9,231 at their peak in 2010 to 8,179 as of April 2017 data, which equates to an 11.4 percent drop in quantity of leases, according to CBRE.
The total inventory of GSA-leased inventory has also been steadily declining over the past five years, from 195 million sq. ft. in 2013 to a projected 188 n1illion sq. ft. in 2017, according to real estate services firm JLL.
The GSA went through a transition several years ago under the Obama Administrationn, with executive orders that first put the brakes on new real estate activity followed by an order to "do more with less;' says Test. "So front about 2010 to 2013 there was very little long-term leasing transactions that occurred as the government was taking time to re-evaluate how to do more with less," she says. Now that process and formula is in place and is being implemented as leases expire. However, while leasing activity has resumed, investors are experiencing fewer "bites at the apple," as those lease deals involve smaller leases consolidating and rolling up into bigger leases, says Test.
Slowing deal flow on the federal side is shifting more focus to state and municipal deals. For example, Mesirow Financial financed a sports center for a municipality that was going to be used by the community. Through its lease and renewal options, the city will control that property for about 20 years. "So you do see all kinds of cases where governments are trying to see where it makes sense to tap the private markets," says Sager.
Searching for new supply
Competition is keeping investors on their toes to identify new opportunities. According to a research report by JLL, those agencies with increasing space needs include the Department of Homeland Security, Customs and Border Protection, Immigration and Customs Enforcement, Department of Defense and the Department of Veteran Affairs (VA.). "Predominantly, if you are looking to play in the build-to-suit space as a developer or an investor, the VA. pipeline is the one to look at," says Saal. Secondarily is the FBI, although some of those projects have pulled back on new development, he adds.
The VA. has been a bigger source of investment opportunities in recent years thanks to a 10-year, $63 billion plan to modernize and update some of its facilities that was announced about five years ago.
"Were starting to see the fruits of that labor in terms of high-quality VA. deals coming on-line," notes Briggs. Historically, the VA. has owned those facilities and is now going into new build-to-suit projects as a long-term tenant, typically with 20-year leases.
Stan Johnson Co. recently represented the developer, Cullinan Properties in the sale of a V.A. outpatient clinic in Austin, Texas that the firm completed in 2013. Although the sale price on the 275,000-sq.-ft. facility was not disclosed, the sale marks the largest healthcare asset sold in the U.S. in 2016, according to research firm CoStar. That property attracted a deep pool of bidders and eventually sold to an investment group that was new to the sector and was buying the property as part of a 1031 tax-deferred exchange.
Nationwide, there are 22 active or prospective build-to-suit lease projects, ranging in status from projects in development to those under construction, according to the GSA. One of the challenges of those deals is that they are often years in the making. For example, the GSA awarded a contract to Bethesda, Md.-based Clark Construction Group in April to design and construct a 256,000-sq.-ft. facility for the U.S. Department of Justice Federal Bureau of Investigation Central Records Complex in Winchester, Va. Construction of the $135 million project is set to begin this fall, with completion set for the summer of 2020.
Demand puts pressure on cap rates
Demand has produced steady cap rate compression over the past several years, but cap rates have been relatively stable over the last year. Deal terms carry a lot of weight in pricing deals and there is a 300-basis point spread between the long-term premium deals and shortterm deals. Deals of 10 years or longer typically come in between 5.5 and 6.0 percent, as compared to shorter term lease deals that are trading at cap rates between 8.0 and 9.0 percent, says Marc Rampulla, an executive vice president in the capital markets group at JLL in Washington, D.C.
Investors underwrite state and municipal deals at a slight discount, 50 to 75 basis points higher, compared to federally-backed deals. "There is a good amount of additional inventory and nice opportunities at the state level, but it is a less standardized marketplace than dealing with federal leases and federal sales," says Rampulla. In the past, D.C. properties tended to trade at a bigger premium, given the strong pool of government tenants in the marketplace. However, the rest of the country has closed that gap in recent years, he adds.
The Trump administration could influence federal lease terms in the future. The investment community is anticipating that the Trump administration has a desire to re-interpret scoring rules that are used in budget analyses, says Test. What that means is that the federal government might take a different approach on real estate and infrastructure than it has in the past. For example, instead of doing 10-or 15-year leases, the federal government may be more willing to do 15- to 20-year terms.
The Trump administration may also allow for more flexibility in the sale-leaseback of federally-owned buildings. Right now, the ability for the private sector to invest in federally-owned buildings or land is very challenged, because the budget-scoring rules that exist restrict any kind of federal use of that kind of space once the private sector has invested in that product, according to Test. That makes the purpose of the whole concept behind government-leased investments fall apart, she notes.
If this administration is capable of making modifications or more liberal interpretations of scoring rules, then there are some real possibilities for investment in federal infrastructure, says Test. Achieving those modifications may not be as difficult as it seems as the interpretation of those rules occurs at the policy level of government rather than through passing new legislation. "Early tea leaf reading suggests that this administration would like to find a way to allow for more creative use of private sector investment dollars in real estate and on the infrastructure side," she says.