An Interview With: John Donovan Part 2

John Donovan was head of Washington operations for CarrAmerica until his retirement June 1. He continues in a consulting role for the remainder of the year, dividing his time between Virginia and Massachusetts. In the previous Entrepreneur Weekly, 14 October 2005, John discussed what he has been doing since leaving, as well as the frenzied growth of the DC market. Below is the conclusion of our interview where he discusses the future of commercial real estate in Washington.

Bisnow: What’s the next area we should be watching?
Clearly there’s been a great deal of fervor about Anacostia. North of Massachusetts Avenue (NOMA) never took off in its initial incarnation as a technology corridor because the dot com bubble burst, and Washington was having a hard time getting momentum. The type of groups that were leasing in that technology base were less sensitive to location, more sensitive to price, and actually preferred suburban locations. It’s just a matter of time before the NOMA area transforms. The East End is just oozing block by block by block.

The definition of the East End is changing rapidly, it seems. 

If you drew a line 5 years ago around what you would define as the East End, and then you drew a boundary around how you would define it 3 years ago, and again around it today, the box surrounded by the lines would be bigger each time. When CarrAmerica was leasing 1201 F Street, back in 1998 and 1999, we were competing against Boston Properties down on 9th Street between D and E. When they first started marketing that building, nobody wanted to talk to them about it. But by the time the building was completed, it was 80% plus leased and it had a blue chip tenant roster. Right after that we announced our plans at 7th between E and F, and people looked at us like we had lost our minds. But the Terrell Place project has been a huge success because groups like Venable law firm took a look, and then leaped. They saw the bright future, and lent instant credibility to our project.

How about another example of this type of development?

901 New York Avenue. When Boston Properties acquired that site from another developer and announced that building, people thought that they had become unhinged. They couldn’t imagine a huge Class A law firm quality building at 9th street between New York and K. But the building was masterfully developed and marketed and it turned out to be an enormous success. Then with 901 New York anchoring the eastern most boundary of the East End, Louis Dreyfus and Tishman Speyer started gobbling up the sites at 11th and New York, which were now ‘in bounds’ and very desirable. It was happening almost quicker than you could imagine. It’s not going to stop. The East End is going to extend all the way down to Georgetown Law School, down past the Pension Building, and the National Building Museum, all right down into 1st Street, North Capitol Street and Union Station. It’s all one big market.

Do you think this was inevitable, that Washington would develop through what was so downtrodden and peripheral, or are you surprised?

I’m not really surprised. We have a lot of wonderful fundamentals in the Washington market. It is the capital not only of the United States, but it’s the most important city in the world. The big quasi-public and international organizations like the World Bank, the IMF, the OAS, and the Inter-American Development Bank, among others, are all here. The Federal Government is a huge magnet for trade associations, law firms, lobbyists, and all manner of business seeking to do business with the federal government. Our buildings are, with rare exception, relatively small for a major city’s commercial core. So it seemed to me, the city was going to have to spread out.

Do the height limits have any effect on development?

The building height line is a key element. A developer, unlike in another city, can’t say, “I see good demand here, I’m gonna throw up a building with forty floors of 25,000 square feet to capture it.” There is always going to be strong demand for new space, and thus for the city to spread out. This process of spreading out and filling in new areas has been gradual. In years past demand was tempered by a significant level of out-migration by tenants leaving a poorly governed and financially unstable DC for the ‘greener pastures’ of the suburbs. But Washington has been on such a roll recently--solvent, well-governed, safer, and cleaner--that office space demand has become stronger and the push into once marginal areas has been accelerated.

Quite a bit different from the Marion Barry days?

I sat on a committee, part of the DC Building Industry Association, informally called the Early Warning System Committee. We met every month or so, and our job was to exchange information with each other, to try to identify any downtown users of office space that were in danger of defecting to the suburbs because of their fears that DC was going to become unaffordable, undesirable, or both. That was a real problem, and more often than not when we did identify those defectors, we did not succeed in changing their mind.

Those fears are gone?

Now people feel so much better about Washington. It’s viewed more favorably up on Capitol Hill, and because it’s in the black, it’s more mixed-use, and it’s truly 24/7, more and more people want to be downtown. DC has the fundamentals necessary to maintain it as long as the District of Columbia Government is functioning effectively and it appears to be a stable, desirable place to do business. I do believe that right now, there are a lot of tenants who feel they’ve got to be in Washington or that they simply want to be in Washington. The Committee still meets, but less frequently and less intensely, and without the dramatic name, to continue to keep a lookout for users headed out of downtown to the suburbs. Presently the stakes are a bit lower but that can always change.

Is it possible for too much money to be available for development?

That’s happening now. There are buildings going up that don’t have a real economic basis. They’re just simply betting on an inexhaustible amount of demand. Yet, at the same time, construction costs are spiraling upward at really dizzying rates. Nobody is going to build buildings on a philanthropic basis, they’re going to want to make money. So when your construction costs are getting up to $450-$500 or more per square foot, do the math and extrapolate what rents you’re going to have to charge for it, what the tenant market is willing to pay. That’s a very thickening plot!

You talked about the new areas as far as development, but what about new types of investors? Are we going to see more overseas investors?

I think we’re always going to see a lot of foreign capital. The nature of it depends on the tax structure and regulatory environment for investment within those countries. The Germans have been extremely active in investing in Washington over the last 5-7 years but they will generally not invest in development. Generally, the Germans appear when buildings are substantially complete, and 80% leased. That has a lot to do with the investors’ required returns and tax laws back in Germany, and new development and construction risk factors don’t fit well into the equation. We see Australians come and go, Japanese come and go, investors from the U.K. come and go. It all depends on capital availability in their home economies, and what investment goals are like from time to time. The Japanese were very active back in the late 80s and were actually fairly notorious for overpaying for real estate. But as the economy back in Japan became very troubled, they disappeared. The pension funds are always in the market to have a certain percentage of real estate in their portfolio. The way it’s done right now, people have allocated a great deal of money to real estate, it almost feeds on itself, and people say, “Geez, if we’re not active in real estate, we must be missing the boat, because everybody else is in.” At some point, there’s got to be some air let out of the tire.

I think we’re always going to see a lot of foreign capital. The nature of it depends on the tax structure and regulatory environment for investment within those countries. The Germans have been extremely active in investing in Washington over the last 5-7 years but they will generally not invest in development. Generally, the Germans appear when buildings are substantially complete, and 80% leased. That has a lot to do with the investors’ required returns and tax laws back in Germany, and new development and construction risk factors don’t fit well into the equation. We see Australians come and go, Japanese come and go, investors from the U.K. come and go. It all depends on capital availability in their home economies, and what investment goals are like from time to time. The Japanese were very active back in the late 80s and were actually fairly notorious for overpaying for real estate. But as the economy back in Japan became very troubled, they disappeared. The pension funds are always in the market to have a certain percentage of real estate in their portfolio. The way it’s done right now, people have allocated a great deal of money to real estate, it almost feeds on itself, and people say, “Geez, if we’re not active in real estate, we must be missing the boat, because everybody else is in.” At some point, there’s got to be some air let out of the tire.