An investigation into the credit tenant characteristics of Department of Defense contractors

Journal of Real Estate Portfolio Management, May-Aug 2003 by Rivetti, Daniel, Worzala, Elaine

Abstract. In the next few years, it is anticipated that the Department of Defense (DoD) and other government agencies will begin to outsource their civilian workforce to private contractors. The real estate and facility management sectors are prime areas for this privatization strategy. Current regulations favor DoD contractors that are tenants rather than owners. This will create a high credit lease opportunity for real estate investors. This study explores the impact of the privatization trend toward creating high quality office and industrial investments for the real estate marketplace. Given the government contract bias toward renting, a new group of credit tenants may appear. A hypothetical DoD tenant is used to explore the implications of the new regulations on the real estate market. This study posits that large office and industrial park complexes will be positively affected and properties in the right location to attract the new credit tenants that have been awarded privatization contracts will become more valuable, especially to the institutional investor.

Introduction

In the next few years, it is anticipated that the Department of Defense (DoD) and other government agencies will begin to outsource their civilian workforce to private contractors. The real estate and facility management sectors are prime areas for this privatization strategy. This follows closely the trend of the last decade where large corporations have moved to outsourcing the real estate function. In addition, the current political environment has resulted in increasing defense budgets that will also grow the demand for space by defense contractors. This study posits that large office and industrial park complexes will be positively affected by these two trends. Properties in the right location to attract these new credit tenants with long-term occupancies that have been awarded these privatization contracts will become more valuable, especially to the institutional investor.

Current regulations favor DoD contractors that are tenants rather than owners of their real estate. This will create a high credit lease opportunity for real estate investors. This study focuses on the existing role of real estate in the federal government but more importantly will explore the impact of the privatization trend toward creating high quality office and industrial investments for the real estate marketplace, particularly the product starved institutional investor. Given a government contract, companies will be forced to rent. Government outsourcing will also initiate a new level of credit tenant that could provide much more stable income and returns to the institutional investor.

A case study approach is offered here to explore the new streamlined Federal Acquisition Regulations (FAR). In future work we plan to explore the potential lease terms and the likely geographical location for recipients of the federal contracts. This knowledge can be used by real estate investors when making investment decisions.

Where Have all the Credit Tenants Gone?

With the recent collapse of the stock market, coupled with the poor economic conditions and fraudulent financial activities of some household names, owners of office properties need to think twice about how they classify their credit tenants. Typical strategies such as using rating agencies and analyzing company financial statements do not work if ratings can be changed over night and the audited financial statements turn out to be fabricated. Exhibit 1 details the twelve largest bankruptcies that were declared in 2001/2002. Their combined asset value before bankruptcy was estimated at close to $400 billion and these companies employed over half a million employees. Not all of them will completely close down but even using a conservative estimate of 50% of the employees being laid off and 250 square feet of space per employee, these twelve companies alone could conceivably empty 75 million square feet of office space. Not only have these companies laid-off employees but they have created legal and financial nightmares for their landlords.

Office space is the number one allocation of institutional investors. According to the National Council of Real Estate Investment Fiduciaries (NCREIF), 40% of the NCREIF Property Index was allocated to the office sector in 2002 (NCREIF, 2002). In 2002, the office sector clearly underperformed most of the other property sectors and many of the "trophy buildings" held by institutional investors are plagued with credit tenant problems. In addition, with the flight of capital from traditional stock and bond investments to real estate investments (particularly the high quality, trophy assets), there is a surplus of cash that is seeking good quality real estate with low-risk tenants. Given the recovering economy and the military situation in Iraq, the DoD is one of the few industries that are in a growth phase right now. Indeed, the federal government is moving toward outsourcing the majority of their contracts. Therefore, defense contractors are likely to become a major source of the credit tenancy in the future.