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Looming Sequestration Cuts: Back To Recession or Business as Usual?

If Nothing Else, Implementation of $1.2 Trillion in Cuts Could Clear Up Remaining Uncertainty Gripping CRE Markets
February 13, 2013
Having slogged through waves of economic uncertainty in the past year that have undercut investor forecasts and shaken consumer confidence, businesses are now confronting what they hope will be the last wave: the looming impact from sequestration or unprecedented cuts in federal spending.

The $1.2 trillion in mandated federal budget reductions over the next decade are set to start kicking in March 1 unless averted by an increasingly unlikely bipartisan accord in Washington. The mandated spending cuts are in addition to $487 billion in cuts already imposed by the Budget Control Act of 2011. The potential spending cuts are particularly onerous to the defense industry -- and the landlords who lease space to them.

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Exactly what the cuts may mean for commercial real estate isn’t clear, but they have already been impacting the industry for several months. Federal contractors have opted for shorter lease extensions and agencies have postponed decisions or called off new and renewed federal expenditures leaving contracts up in the air. Outlooks for revenues have been muted and calculations for expenses upped. Many landlords with federal-dependent tenants pushed aggressively last year to get renewals and pre-leases completed and also took efforts to shed properties that could potentially be impacted by a downturn.

“I think businesses sat there developing business plans for 2013 trying to figure out where the world was going to be,” Bill Hankowsky, president, CEO of Liberty Property Trust, said in the company’s quarterly earnings conference call. “In our minds, if you go all the way back to October, there were three waves of uncertainty that people had to sort through. The first was the election, the second was the tax side of the so-called fiscal cliff, and the third is now the spending side of the fiscal cliff.

“They kicked sequestration down the road,” Hankowsky said. “So if you’re a defense contractor, you really still don’t know what the defense budget is going to look like, how it’s going to get right-sized, et cetera… And that creates a little bit of this uncertainty and I think does affect customers.”

Hankowsky said he has seen lease commitments not get done as a result of the uncertainly over sequestration.

“It’s not (affecting) every deal,” he said. “We signed a ton of leases last year, so a ton of people were willing to lease 18.5 million square feet of space. That’s all great. But there is still this edginess that we feel is out there. I don’t think it gets clarified for a couple more months because I don’t think all this gets sorted out, which goes back to our premise for the year, which is 'Slow Start, Strong Finish.' "

(For a list of CMBS loans of concern with significant exposure to defense tenants, please see our story: Watch List: CMBS Loans of Concern with Defense Contractor Exposure. )

Jerry Sweeney, president and CEO of Brandywine Realty, said that his firm stands somewhere between those projecting sequestration to be Armageddon if it happens, and others who say, like the previous waves that have rolled through the economy, it won't really be that meaningful at all.

“We're very defensive on it, in terms of making sure that we stay in very close touch with our tenants and make sure that we understand what they are thinking and how they are thinking this impacts their space plan requirements,” Sweeney said. “It's hard to anticipate it being anything less than negative, the question is how negative it will be.”

To minimize the potential impact, Sweeney said the firm's Washington DC team ratcheted up efforts to pre-lease as much of square footage as possible starting in the third quarter of last year, resulting in a pre-leasing percentage near 86% and a strong pipeline of deals.

Some prospects are still in a holding pattern, though, said George Johnstone, senior vice president, operations and asset management, for Brandywine.

“In terms of our largest [renewal], clearly it's Lockheed Martin in our Maryland portfolio,” Johnstone said. “As we announced previously, they did extend the 137,000 square feet from 2013 into 2014 and they are stillgoing through their thought process on what they ultimately do with that space long term. They will be giving us back 78,000 square feet in Maryland.”

Johnson also said Brandywine executed a 5-year lease renewal with Lockheed Martin on 158,000 square feet in King of Prussia, PA, to take its second-largest open renewal off the table and the firm continues in negotiations with Lockheed over a 46,000-square-foot lease in Mount Laurel, NJ.

“I think we have signed 330,000 square feet in leases in the last 45 days in Northern Virginia with government contracting companies. We started to see a little bit more smaller contractors who have what they feel to be a secure contract or executing deals, those deals were 7, 10, and 12 years respectively,” Johnstone said. “I think the larger ones, the Lockheeds, Northrop Grummans of the world, are going to continue to analyze existing lease obligations and owned facility and most likely continue to require some flexibility in terms of early termination rights.”

Wesley G. Bush, chairman, CEO and president of Northrop Grumman, recently explained his firm's approach to investors.

“In the event of sequestration or other budgetary actions, our first challenge is going to be addressing whatever contractual changes come along,” Bush said. “But ultimately, we have to scale cost structure with that, and that's what our planning has been focused on, to enable us to do that in a smart way so that we're not doing something that undermines our ability to perform for the long term.”

Dan Allen, president and CEO of CACI International, an IT solutions firm to the defense industry, said his 2013 guidance anticipated that government would be operating under a continuing resolution for his firm's entire fiscal year.

"However, in the back half of our second quarter, which is the federal government’s first quarter, we began to see our customers becoming more cautious with contract awards and spending driven by the uncertainties around sequestration," Allen said. "As we look into second half of our fiscal year, the… potential for sequestration remain and we expect our customers to remain cautious with fewer contract awards and reduced spending.”

“The federal negotiations on the deficit and spending reductions and the continued threat of sequestration are not going to go away in the short term,” Douglas T. Linde, president of Boston Properties said. “In 2012, DC experienced really no net absorption and the suburban markets continue to experience some negative absorption.”

Roger Waesche, president and CEO of Corporate Office Properties Trust, said operating in these politically uncertain times is nothing new for his tenant base.

“Our tenants have been operating under four years of continuing resolutions rather than budgets. So if Congress kicks the can again that outcome would not represent a change in the way business has been done,” Waesche said. “Although business is not easy to win, we have managed to do pretty well including our record leasing achievements in 2012. If sequestration were to go into effect, we believe it would be only for a few months.”

“Under this scenario, leasing will become more challenging, but our franchise will still be intact,” he added. “Our confidence stems from the fact that we have shed most of the non-strategic properties that acted as a drag on our past results. The portfolio we now have is both lean and well aligned with demand drivers that support missions that the nation cannot afford to cut, or at least not cut materially.”

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