Most signs point to a continued, though selective, office construction boom in the Washington area, despite high interest rates, mounting construction costs and a probable slowing of commercial real estate construction nationally. The price, however, will be high -- experts estimate that the higher construction cost factors will translate into rental prices in the $25-to-$32 range when the latest crop of buildings come on the market in 1982-83.
The District's prime commercial real estate currently is considered to be among the most attractive in the nation by most traditional commercial property lenders. The city has a strong, stable economic base, and investors believe the continued impact of the federal government on local employment bodes well for office buildings.
Nationally during the past several months interest rates have continued their generally volatile pattern of the last two years, wreaking havoc on the already battered construction industry. Interest rates have increased following recent indications that the Federal Reserve was again restricting monetary policy.
Until recently, short-term rates had declined dramatically January, hile long-term interest rates had started to inch up, again reflecting what many believe to be a substantial pent-up demand by corporations and federal, state and local governments for long-term funds.
Phillip E. Kidd, director of economic research for the F.W. Dodge division of McGraw-Hill Information Systems Co., sees funds slowly moving back into the long-term market: "Monetary policy will remain tighter than it has during the past building recoveries to gain credibility with the financial community after last year's gyrations in money growth. At the moment we have an inverted yield curve [when short-term interest rates are higher than long-term rates]. It's slowly changing as short-term rates inch down and long-term rates inch up. As the economy loses some of its robustness, credit demands will weaken, short-term rates will move below long-term rates, encouraging investors to slowly move funds into the long-term market. In order to keep their confidence and keep them moving into the long-term market, monetary policy will have to keep the money supply within the published targets."
Until rates come back into alignment, however, life insurance companies -- traditionally the primary source of permanent commercial property financing -- will continue to shift their investable funds from commercial real estate mortgages to direct placement bonds last that are providing higher yield with less perceived risk.
"We're totally out of the mortgage market again," says income property lender David C. Tolzmann of the Connecticut Mutual Life Insurance Co., a leading source of permanent financing for commercial income-producing properties such as office buildings, shopping centers and major apartment developers, "and we now expect to be out of the mortgage market at least another year."
The historically minimal amount of funds currently available consists of "bullet" money -- lender's jargon for 5-year term financing now producing a 15 percent yield. To a lesser extent, some 10- to 15-year term money is available today at a rate of 14 1/2 percent with a five-year call provision. In today's turbulent interest rate environment, many lenders change the quoted rate almost daily.
J. Thomas Montgomery, vice president for urban investment of the Travelers Insurance Co., like many other major lenders explains that the volatility and uncertainty on the financial horizon fosters a general reluctance to make lending commitments for future closings on fixed-rate mortgages has generally been a losing game for permanent lenders for the 30 years I've been in this business. When the rates go up, we have to close them -- and when the rates go down, developers sometimes expect to renegotiate them." Montgomery currently sees much more portfolio and client interest in owning rather than lending.
What does this mean for the future of office construction? Nationwide, with few exceptions, office building construction, which has been very strong for several years, has been at record levels for the past two years. Dr. Kidd of F. W. Dodge expects construction of office buildings "to slide from its peak, but the demand is still very strong so that it's unlikely to fall more than 10-12 percent from 1980's exceptional level, remaining higher than it has been in any year but the past two."
The Washington area, however, is expected to escape even this attenuated slowdown. "Washington, D.C., is probably one of the strongest markets in the country," says Robert F. MacSwain of The Hartford Insurance Co. "While we are experiencing a slowdown in commercial development nationally due to the cost of money, Washington will probably feel it less than other parts of the country," he adds. However, the fundamentals for shopping centers, nursing homes and hosptial-type financing may not be as attractive, MacSwain warns. " tend to think that there won't be much new prime construction started in Washington on a 'speculative' basis, as in the past. Developers can be expected to line up some tenants before putting up a $25 or $30 million structure."
Washington mortgage banker, Mallory Walker, president of Walker & Dunlop, agrees with MacSwain's assessment of the office building market. "There is a great demand in our local real estate market, particulary in the office and commercial sector. Even with permanent loan interest rates in the 14 percent-plus area and the construction loans in the 20 percent area, construction continues for two basic reasons: one, tenants have accepted a rental structure that provides for both the pass-through of operating expenses and CPI [consumer price index] increases; and, two, developers have recognized that long-term interest rates are not at a 'temporary' high but one that will most likely remain with us for years to come. Developers have recognized that long-term interest rates are not at a 'temporary' high but one that will most likely remain with us for several years to come. Developers have also accepted the lender's need for immunization from the effects of inflation and have been willing to share true profit growth in order to obtain long-term mortgage financing. Rents, which were in the range of $18 to $19 per square foot at the beginning of last year, are probably in the $25-to-$28 range for 1982-83 delivery."
Foster Shannon, president of Shannon and Luchs, one of the area's largest real estate concerns, says, "While the downtown Washington central business core is very strong in office building, some of the suburban areas are a bit soft since that's where most construction has occurred during the last year."
Continued high interest rates have been primarily responsible for driving up the cost of rentals to around $23 to $25 per foot in the downtown Washington area. According to Shannon, "If you rolled back the clock to just five or six years ago, you were talking about $7-$8 per foot. The cost of land has also had an effect. It has skyrocketed. D.C.'s downtown core is not that big. So the land is very dear, having risen from $150 to $200 a foot three or four years ago -- to about $500 a foot now, in some cases even more."
Donald M. DeFranceaux, president of DRG Financial and developer of the National Press Building, echoes Shannon's thoughts: "Current land values have just been absolutely out of control, starting off with the famous auction of the parcel located at 14th Street and New York Avenue. When combined with the current level of interest rates, you find a tremendous cost-push impact on rents, where if you are going to acquire a site and think construction, you have to start looking at rents of $28 to $32 a foot. Those are pretty high numbers for D.C., and, while they may be relative, it will be interesting to see how it shakes down during the future."
"Despite the current high interest rates and construction costs," DeFranceaux says, "there doesn't seem to be a real slowdown in Washington, D.C., office building construction. There's a lot of activity in terms of speculation and assemblage going on east of 14th Street. In terms of office building construction, there is still land that can be added, a lot of sites to be developed, but expensive -- you really have to pay to get them. If you couple this with the current cost of short-term money, it is really tough for a developer to make his numbers work. He has to think $30 a foot rental rates."
Despite the current surge in demand for coffee space, the long-term story of the availability of money to finance construction for the downtown area will depend on the same economic factors as in the rest of the country. During the next few months, at least, anticipated tight monetary policy and government fiscal policy will confront major long-term demands for credit from the business sector, from state and local government and from the consumer sector.
Traditional permanent lenders for office buildings can generally be expected to have little incentive to increase the proportion of their assets being invested in long-term real estate loans until inflation appears to be under control. And on the question of inflation, most economists believe that the jury has not yet returned a verdict.
Kidd believes that availability of income property mortgage money will improve in the next several quarters, but that the money won't become very plentiful until lenders "see the yield curve returning to a positive slope and until they are convinced that inflation is first and foremost being contained."
Trautman is a real estate specialist with the New York based investment banking firm of Donaldson, Lufkin & Jenrette.