Defense is back in Northern Virginia, but where is the occupancy growth?
Budget clarity, increased contract flow, surging revenues, heightened M&A activity. Sound familiar?
- Budget clarity, increased contract flow, surging revenues, heightened M&A activity. Sound familiar? Defense is back in Northern VA, but unlike the last growth cycle, occupancy growth has been slow to follow.
- Under the Trump administration, the defense budget has soared, growing by 16% since FY 2016. The current FY 2019 budget of $675 billion was the first in over a decade signed before the start of the fiscal year. The return of defense spending has created conditions reminiscent of the last growth cycle from 2003-2010. But there are some differences, too.
What’s similar this time?
- Surging revenues: The 10 largest defense contractors have reported revenue increases of 10% since 2017 and 16% since 2016.
- Increased contract flow: After only a 1% increase from 2016-2017, defense contract awards in NoVA are up 15% in the last 12 months, and will continue to rise in FY 2019.
- Spike in major M&A activity: five major acquisitions totaling $77 billion occurred this year, in addition to two mega-mergers.
What’s different this time?
- Occupancy growth is lagging: In 2018, 45% of contractor leasing activity entailed growth – totaling 612,000 s.f. – but on the other hand, one of every four tenants reduced their footprint, a loss of 306,000 s.f. Of the 10 largest contractor leases in 2018, three grew, three shrunk, and four remained stable. The three who shrunk reduced their footprint by an average of 20%. Since the last growth cycle, space utilization has changed dramatically, to the detriment of absorption.
Will occupancy growth reappear moving into FY 2019?
- The Pentagon’s increased focus on cyber defense and warfare, cloud computing and artificial intelligence offers the most significant opportunity for occupancy growth, as these fields have a 70%+ contract outsourcing rate versus 55% for defense initiatives overall. Looking ahead, occupancy growth from these sectors will stem from a combination of large-cap contractors and more specialized smaller companies. The flurry of M&A activity is a product of lucrative tech contracts increasingly favoring single-awards, thus squeezing out companies in the middle.
- For the large-caps, upcoming cyber and cloud defense contracts totaling $28.4 billion offer the best opportunity for growth, including the $10 billion JEDI cloud contract.
- On the other end, smaller, specialized contractors are well-positioned due to a fragmented playing field. In cyber, for example, 65% of defense contracts are awarded to vendors beneath the top five, versus only 25% at civilian agencies.
Are there any outside-the-box submarkets for a growing contractor?
- For defense contractors focused on growth, the competition is intensifying, largely stemming from tech and tech-focused contractors. Traditional defense contractors will encounter increased competition from Fortune 100 tech peers and shrinking quality, transit-accessible blocks available, particularly for space > 50,000 s.f. along the Silver Line corridor of Rosslyn-Ballston, Tysons and the Toll Road. Only seven of these blocks are available, comprised of three existing, three delivering in 2019, and one delivering in 2020.
- Tenants looking for a less competitive market environment where pricing will not increase and present a significant cost discount can find those options in nearby off-Metro, car-centric, Fairfax Center, which has been all but written off this cycle. While vacancy has ballooned to 27.6%, up from a low of 6.5% during the last defense surge, Fairfax Center has seen an uptick in demand for a small number of buildings, either repositioned or new. As the Silver Line has been commanding the attention, activity in Fairfax Center within this subset has driven the number of quality available options > 50,000 s.f. down to just two, both of which are B+/A-. Pricing is 30% lower than Tysons or Reston and 7% lower than neighboring Herndon, where rent is poised to increase as Metro delivers in 2020. Fairfax Center’s remaining swath of B product – 40% vacant – offers investors the potential to follow recent successes and reposition an older asset, amenitize and push rate, while providing growing contractors a cost-effective alternative to the nearby Silver Line.