Reduced federal spending may boost commercial real estate vacancies as tenants lose sales from one of their biggest customers: the U.S. government.

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

“Federal spending cuts would have a widespread and material impact on private-sector employment and therefore commercial real estate space demand,” Macke wrote in a July 25 report. “The proposed budget cuts may hurt private-sector employment more than most realize.”

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

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

Contractors' Landlords
Investor concern that landlords will have slower profit growth has contributed to declines in the shares of real estate investment trusts that depend on government-related revenue. They have dropped even amid a 12-month gain in the Bloomberg REIT Office Property Index.

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

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

'Under Pressure'
“REIT portfolio growth will 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 moving in the right direction,” she said.

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

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

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

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

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

IRS, Justice Department
The company's tenants include the Internal Revenue Service, the Department of Justice and the Social Security Administration, Blackman said. “These are essential agencies of the U.S. government and we don't believe that we will see dramatic cutbacks in employment with these agencies,” he said.

Government spending has more than tripled since 1969, benefiting such industries as defense and health care, according to Macke of CoStar. The channeling of government spending to contractors has helped boost private-sector payrolls, which increased 85 percent as federal payrolls shrank 30 percent, according to the U.S. Office of Personnel Management, the government agency that manages the civil service.

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

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

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

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

The defense industry wasn't the only one to benefit from increased 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.

Dell, Verizon
Computer and communications companies also rank high among the 100 largest government contractors, according to Washington Technology. They include Dell Inc. at No. 15, with $2.2 billion of federal revenue in fiscal 2010; Verizon Communications Inc., No. 18, with $1.8 billion; and International Business Machines Corp., No. 21, with $1.6 billion.

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

Juniper Networks Inc., the second-biggest maker of Internet networking equipment, said July 26 that second-quarter earnings were hurt by some customers delaying orders because of a slowing economy and a probable shrinking of government budgets.

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

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

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

“The final impact really all depends on how the private sector reacts to the government's newfound attempt at austerity,” Macke said.

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Budget Cuts Threaten Property Gains

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