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Sequestration has replaced “fiscal cliff” as the latest buzzword—or perhaps the latest buzz kill—in Washington, DC. But the sequester will make a far greater impact on commercial real estate in Washington, DC than in other metros in the nation. Or will it?

No other US region depends more heavily on federal government spending than Washington. Federal government spending is to DC like auto manufacturing was to Detroit—and the auto industry's demise has made near-devastating impacts on the Motor City. The budget cuts that follow the sequester will no doubt spur job losses—or at least stymie job growth—in the DC area.

Consider the facts: According to the George Mason University's Center for Regional Analysis, the sequester that went into effect on March 1 has the objective of reducing federal spending during 2013 by $85.4 billion from the baseline established by federal spending levels during 2012. DC is expected to lose more than 92,000 jobs. Maryland is set to lose nearly 85,000.

THE BIGGEST LOSERS

How does this trickle down to the commercial real estate industry? In a dramatic way, according to a report from the Associated General Contractors of America. “Sequestration and Its Possible Impacts on Construction” reveals that the cuts could mean a $4-billion-plus reduction this year in federal construction spending.

“Sequestration could have a significant impact on a wide range of necessary and worthwhile construction funding accounts,” the AGCA reports. “From an investment perspective, the American people would be the biggest losers in the sequestration process. Federal facility and infrastructure needs are obvious, and the value construction investment brings to all citizens is well-documented.”

The projects span the spectrum of government agencies, according to AGCA, from military housing ($1.5 billion) to a $135-million reduction in drinking water and wastewater facilities and infrastructure investment. Affordable housing will take a hit as well, due to cuts scheduled for the Department of Housing & Urban Development. HUD will lose $194 million, or 5.9%, of its Community Development Fund; $57 million (5.7%) from its Home Investment Partnerships Program and $107 million (5.8%) from its Public Housing Capital Fund. The Community Development Fund in particular will hurt affordable housing; it provides assistance for low-income community revitalization initiatives by funding the Community Development Block Grant program, which provides annual grants on a formula basis to cities, urban counties and states.

BUT COULD DC REAL ESTATE BE IMMUNE? 

The good news, relatively speaking, is that the DC area may have suffered the worst of it already. For starters, the federal government has been rightsizing for years.

Jones Lang LaSalle's Joe Brennan says the Obama Administration has released memos directing federal agencies to cut real estate costs by at least 20% and freeze space portfolio expansion. Likewise, he continues, congressional appropriators have reviewed large space requirements that require congressional approval, forcing agencies to work with higher space utilization rates in their procurements.

Also, the region has been buffeted significantly by the uncertainty coming out of Washington, DC. To finally get some idea of what will happen—even if it is across-the-board cuts—will, in a way, be a relief. “A lot of the real damage to the commercial real estate market has been done already with the scare tactics,” Brennan says.

The same can't be said about the local economy, which will clearly feel the pain of federal employees furloughed a day or more every pay period, or however the cuts come down. “That is something federal government workers are bracing for and it will have a ripple affect throughout the economy,” Brennan says.

These furloughed days, though, won't impact landlords too much. Brennan's conclusion: “It's unlikely that there will be significant federal space contraction due to sequestration in addition to current mandated contraction initiatives.”

While there certainly has been progress toward leaner federal portfolios, federal holdovers and short-term extensions have become more commonplace as GSA prioritizes near-term leasing decisions, Brennan says. This leasing triage allows landlords to take advantage of premium holdover and short-term extension rents and protects them from the immediate political threats of deficit reduction.

A federal leaseholder with a lease that is in the middle of its term has little reason to worry about sequestration or federal footprint reduction as well. More than likely, Brennan speculates, stringent federal real estate scrutiny will have passed by the time the lease rolls. A federal leaseholder with a short-term lease expiration might find the lease is scrutinized more than it has been in the past, “but budget uncertainty might force your tenant agency to seek a short-term extension at a premium.”

IS DC'S SHORT SUPPLY A SAVING GRACE? 

Another saving grace may be DC's short supply. Investors are likely to continue flocking to the local market, even if—and perhaps especially if—a cut in federal construction dollars impedes new development there.

The $175.6-million trade of the 12-story 333,948-square-foot Arlington Gateway showed that class A product in the DC market still has its chops with investors, despite the uncertainty emanating from official Washington. Although that object lesson didn't really require any illustration. Indeed, a dearth of class A offerings on the market is causing some angst on the part of buyers—and is certainly driving pricing, says Bill Prutting Jr., Jones Lang LaSalle's managing director for capital markets.

“Based on the number of offerings on the market now, we expect pricing to continue to increase from a yield standpoint,” he says. “Yields could go even lower based on the capital that is currently chasing very few offerings.”

This is especially true for product of the highest quality, he says. It is also true of B product that is in a great location. One of the main drivers of this trend is the lack of quality offerings in the market or, as Prutting says, “an elasticity of demand that is transcending quality. Every buyer we speak with has the same angst about how few properties there are on the market and that there is no way the lack of supply can have a price impact.”

One reason some companies are not putting properties on the market, Prutting theorizes, is because they are afraid of being locked out after they sell off their holdings. “Investors recognize how difficult it was to make those initial acquisitions. They fear selling a property and reporting the proceeds to their shareholders—and not being able to duplicate that.”

Currently, top quality buildings with long-term leases are trading in the low- to mid-4% cap rate range, Prutting says. Pricing for good quality B buildings is ranging in the plus-or-minus 5% to 5.5% cap rate.

THIS NEEDS TO HAPPEN 

Whether you think it's good or bad for Washington, DC, many commercial real estate players think the sequestration-induced spending cuts are a necessary evil. In a recent GlobeSt.com reader survey poll on the question “Sequestration: What is it Good For?”, 58% of the respondents answered that the cuts have to happen—it is time. Twenty percent said they were still trying to get their heads around the issue and 22% said it would be a mess for CRE.

The numbers are understandable, says Kurt Stout, executive vice president of government solutions at Colliers International. “I think what you are seeing is a reflection of the economic principles of the readership, which believes there needs to be a reduction in spending,” he explains. “I don't believe that people think sequestration as a method for reducing spending is good—I think they view reducing spending in general is good.”

Also, the cuts will be felt disproportionately in the DC area, he adds, which might also explain why 58% of the readers who answered the survey were sanguine about sequestration. “Of course it will have an impact wherever government contracts are met, such as in Texas and California,” he says. “The DC area, though, is clearly at the epicenter of that.”

One myth that needs to be debunked, Stout adds, is the perception that sequestration will hurt the public sector more than the private sector: The easiest way for the government to make immediate cuts is to cancel or defer contracts, which are held by private sector firms.”

THE BIGGER ISSUE

Joel Ross, principal of Citadel Realty Advisors in New York City, says the sequester is not the issue. Rather, the point for commercial real estate is the uncertainty of where we go from here, the attack on carried interest taxation, potential space reductions, and other cuts to make everyone's life miserable.

But there are bigger concerns: What is the Fed doing? What is happening in Italy and the rest of Europe? Will France continue on its Socialist path to economic problems? What is real unemployment? Is there any prospect that employment and consumer spending will improve over the next 24 months?

Ross goes on: Will Israel attack Iran in the next few months? Will the whole Middle East explode into new civil wars and disruption of oil markets? Will New York's Gov. Andrew Cuomo, and Obama, get out of the way of fracking and allow the US to produce much more low-cost fuel and have energy independence to drive factory growth in this country? What will happen in the currency wars now taking place? When will interest rates begin to materially rise, creating an uptick in cap rates and lower returns to CRE? Will Obamacare crush profits at low-wage companies like hotels and restaurants, meaning less ability to pay higher rents for retail or to develop new hotels due to lower returns to investors from a combination of higher rates and higher costs?

“These are the real issues, not ridiculous and phony political blather out of the White House about the sequester,” Ross says. “We need to be focused on the long-term macro issues and plan and invest accordingly.”