Is the Love Affair Between Foreign Investors and DC Ending?

WASHINGTON, DC—Net foreign investment in the Washington, DC office market fell into the negative in Q1 2019 after posting a sharp decline the prior year, according to a JLL research note. Prior to this overseas capital flooded the market at record levels from 2015-2017. Report author John Andril, Senior Research Analyst, Office Capital Markets notes that there are several reasons for this drop:

Lack of Trophy offerings: Foreign investors in Washington, DC heavily favor the downtown Trophy office segment, and over the past few years, there has rarely been more than one Trophy asset for sale at a time, Andril writes. “It has been seven months since the last Trophy sale, and there is currently just one Trophy building being marketed.” Compare that to the preceding five years, when a Trophy office building traded hands every four months on average.

Pricing/rent disconnect & cap rate compression: The competition for DC’s limited Trophy offerings has led to a series of record-priced sales over the past few years despite a complete lack of underlying rent growth. In fact, Trophy rents declined by 2.4% between 2017 and Q1 2019, Andril writes. “Absent any growth in rental income, Trophy cap rates compressed to an average of 4.0%-4.25%, pushing many investors to seek higher yield in other real estate markets or other asset classes altogether,” he says. Property owners decided to pull nine buildings from the market last year after failing to achieve their pricing expectations in the face of a thinning buyer pool—including two that were targeting more than $1,000 per square foot.

Rising hedging costs: Fluctuations in the US dollar have driven up the hedging costs associated with owning dollar-denominated assets including US real estate, according to the research note. “Currently exceeding 2% of total investment for European buyers, these costs erode potential returns and dramatically narrow the field of office investment opportunities that make financial sense,” it says.

Tightened CFIUS restrictions: As a result of the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA), a broadened range of foreign investments are subject to review by the Committee on Foreign Investment in the US (CFIUS). This process has the potential to impede or prevent foreign purchases of buildings that are leased to the federal government or are even proximate to such buildings, Andril writes. “Needless to say, a sizeable portion of the Washington, DC office inventory falls into these categories.”

The conclusion of the report offers a glimmer of hope to DC landlords.

“Although these factors have dampened demand and volume in Q1, expect foreign capital to return to Washington, DC over the remainder of the year,” according to Andril. He notes that there are currently four stabilized, core-profile Trophy/Class A offerings on the market alongside an additional six coming to the market—and these opportunities are certain to attract overseas investors.