Reduced federal spending may boost commercial real estatevacancies as tenants lose sales from one of their biggestcustomers: the U.S. government.

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Funding cutbacks would be felt most in such cities as Rockvilleand Bethesda, Maryland, where defense contractor Lockheed MartinCorp. has plants, and Norfolk, Virginia, home to the largest U.S.naval base, said Chris Macke, senior real estate strategist atCoStar Group Inc. Boston, San Diego and San Jose, California, wheretechnology companies are big employers, also may be affected,depending on the trims made, he said.

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“Federal spending cuts would have a widespread and materialimpact on private-sector employment and therefore commercial realestate space demand,” Macke wrote in a July 25 report. “Theproposed budget cuts may hurt private-sector employment more thanmost realize.”

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U.S. government outlays are set to be cut by as much as $2.4trillion over the next 10 years under a debt-limit plan approved byCongress and signed by President Barack Obama this month. Thecompromise prevented a U.S. default on the day the nation'sborrowing authority would have expired and followed a months-longdebate that reinforced partisan divisions over federal spending,which accounts for about 40 percent of gross domestic product.

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The budget fight arose as the U.S. office market started torecover from the crash that followed a 2007 peak in propertyprices. Office landlords had a net increase in occupied space forthe third straight quarter during the three months ended June 30,and vacancy rates fell in more than half of the 79 metropolitanareas tracked by research firm Reis Inc. The national officevacancy rate stood at 17.5 percent, unchanged from the firstquarter, New York-based Reis said.

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Contractors' Landlords
Investor concernthat landlords will have slower profit growth has contributed todeclines in the shares of real estate investment trusts that dependon government-related revenue. They have dropped even amid a12-month gain in the Bloomberg REIT Office Property Index.

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The shares of Corporate Office Properties Trust — a Columbia,Maryland-based REIT that gets more than half its revenue from theU.S. government, defense- and computer-related clients, and datacenters — have fallen 33 percent after dividends during the pastyear, compared with a 1.8 percent gain for the 18-member officeindex.

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Earnings estimates for Corporate Office Properties Trust werecut on July 13 by Sheila McGrath, an analyst at Keefe, Bruyette& Woods Inc. The landlord's properties typically are located inbusiness parks near large military installations, she said in areport.

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'Under Pressure'
“REIT portfolio growthwill likely continue to be under pressure due to a slow economy,high unemployment and defense budget cuts,” McGrath wrote.Corporate Office Properties Trust “needs to get past D.C. concerns— real and perceived — to get leasing velocity and sentiment movingin the right direction,” she said.

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The company's three largest tenants are the U.S. government,defense contractor Northrop Grumman Corp. and consulting firm BoozAllen Hamilton Inc., according to the landlord's website. Northropwas the No. 2 recipient of government contracts in fiscal 2010,with $10.8 billion of federal revenue, according to WashingtonTechnology, a website that ranks contractors. Booz Allen was ninth,with government contracts totaling $3.7 billion.

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Decline in Earnings
Northrop said July 27that its second-quarter earnings fell 30 percent on weak defensesales, sending its shares down the most in a year. The LosAngeles-based company said full-year sales will be about $27billion, $500 million lower than earlier forecast because of U.S.budget pressure and less war spending.

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“As wars wind down, there's typically a reduction in militaryspending,” said Randall Griffin, chief executive officer ofCorporate Office Properties. That will be countered by a focus oncyber-security and intelligence, he said. “We specialize in theknowledge-based, not the weapons-based, side of government so wethink that will be less prone, if not immune, to cutbacks ingovernment spending.”

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Government Properties Income Trust, which gets 94 percent of itsrental income from the U.S. government, state governments and theUnited Nations, has declined 6.8 percent during the past year.

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“A big part of the decline in our stock is a result of the fearand selloff in the broader markets,” David Blackman, president andchief operating officer of Government Properties, said in atelephone interview.

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IRS, Justice Department
The company'stenants include the Internal Revenue Service, the Department ofJustice and the Social Security Administration, Blackman said.“These are essential agencies of the U.S. government and we don'tbelieve that we will see dramatic cutbacks in employment with theseagencies,” he said.

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Government spending has more than tripled since 1969, benefitingsuch industries as defense and health care, according to Macke ofCoStar. The channeling of government spending to contractors hashelped boost private-sector payrolls, which increased 85 percent asfederal payrolls shrank 30 percent, according to the U.S. Office ofPersonnel Management, the government agency that manages the civilservice.

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The increase in private employment, to more than 142 millionpeople in 2009 from 76 million four decades earlier, has drivenleasing of commercial properties, Macke said.

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Defense Companies
Defense contractors arethe biggest recipients of government revenue, according toWashington Technology. The companies, anticipating federal spendingcuts, are reducing costs and eliminating jobs to preserve profits.Obama in April outlined $400 billion of cuts in national securityspending through 2023, in addition to the $78 billion five-yearreduction in the defense budget proposed in January.

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The top five federal contractors — Lockheed, Northrop, BoeingCo., Raytheon Co. and General Dynamics Corp. — received almost $50billion combined in government contracts in 2010, according toWashington Technology.

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Lockheed Chief Executive Officer Robert Stevens has cut 3,850jobs since last year in anticipation of the projected decline inU.S. defense spending. In July, the Bethesda-based company offeredvoluntary retirement plans to an additional 6,500 employees.

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The defense industry wasn't the only one to benefit fromincreased federal spending during the past 40 years, Macke said.Industries such as consulting, health care, engineering services,systems integration, telecommunications, information technology,construction and education have received federal contracts as well,Macke's research shows.

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Dell, Verizon
Computer and communicationscompanies also rank high among the 100 largest governmentcontractors, according to Washington Technology. They include DellInc. at No. 15, with $2.2 billion of federal revenue in fiscal2010; Verizon Communications Inc., No. 18, with $1.8 billion; andInternational Business Machines Corp., No. 21, with $1.6billion.

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“They all lease commercial space: office, industrial andretail,” Macke said.

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Juniper Networks Inc., the second-biggest maker of Internetnetworking equipment, said July 26 that second-quarter earningswere hurt by some customers delaying orders because of a slowingeconomy and a probable shrinking of government budgets.

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“The macroeconomic signals may impact enterprise and publicsector spending near-term,” Juniper CEO Kevin Johnson said on aJuly 26 conference call. “As governments and certain sectors of theenterprise look to reduce spending, there is a risk that this willimpact” information technology budgets, he said.

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Juniper's Revenue
Enterprise customers,which include federal, state and local governments, made up 35percent of Juniper's revenue in the second quarter, according tothe company.

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Investors need to focus on the impact of reduced governmentspending on corporate payrolls because that may dwarf the effect onfederal employment, depending on the size of the cuts, Macke said.It is possible, however, that American businesses may respondfavorably to trims in government spending and increase their ownbudgets, as they did in the mid-1990s, he said.

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“The final impact really all depends on how the private sectorreacts to the government's newfound attempt at austerity,” Mackesaid.

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Bloomberg News

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