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Article

The Next Big Boon

Marketplace conditions are favorable. Learn how enhanced use leasing yields profits for the military and private sector.

April 2006 Issue of Defense Communities

Download the PDF version of this article.

By Jay Brown, Managing Director
Alvarez & Marsal Real Estate Advisory Services, LLC

Since being amended by Congress five years ago, the Department of Defense’s (DoD’s) out-leasing authority (Title 10, Section 2667), commonly referred to as enhanced use leasing (EUL), has become an increasingly valuable tool for attracting private-sector capital and expertise to acquire, construct, or upgrade military facilities and related infrastructure. With the tremendous success of DoD’s military family-housing privatization program—which has attracted nearly $15 billion in private capital—military properties are of growing interest to product-starved developers, investors, and financial institutions. EUL is the next big opportunity for public-private real estate investment, giving DoD an unprecedented opportunity to leverage its current success, take advantage of favorable market conditions, and maximize EUL’s benefits through a strategic approach designed to yield long-term financial benefits for DoD.

While DoD has long been able to outlease certain underused real estate, it previously had little incentive to do so because military installations received minimal benefit from the process. Installations were limited in terms of the type of assets that could be out-leased, the amount of proceeds that could be received, and how those proceeds (cash or in-kind services) could be used. That changed when Congress amended the law as part of the National Defense Authorization Act of 2001. Under the revised program, there are no limits on the types of assets that can be out-leased, installations are permitted to retain half of all cash and 100 percent of all in-kind proceeds, and the proceeds can be used to acquire or construct new facilities. The result—significant opportunities to generate revenue, offset costs, and build and improve facilities and infrastructure.

While each service plans to pursue EUL as a key component of its asset management strategies, the Army appears to be leading the way in aggressively developing and executing EUL projects around the country. The Army Corps of Engineers is overseeing 22 current and proposed EUL projects at 19 military installations throughout the country. Additionally, the Army is expected to sign up to five leases this year. The map above shows the Army’s current and proposed EUL projects.

Each lease is structured as a longterm ground lease, typically lasting 50 years. While the military entity retains ownership of the property, the private sector partner is responsible for developing the asset and leasing out the space at market rates. Unlike military housing privatization, there are no government-appropriated funds to subsidize or provide an income stream for EUL projects. While federal government tenants may ultimately lease space from an EUL developer, the viability and approval of that EUL project must be based upon non-federal government demand for the space. Moreover, the ground lease can’t commit the federal government to any lease-back obligation.

Phenomenal Potential

DoD owns more than 450 million square feet of building space and nearly 6 million acres of land that are potentially available for EUL. These assets offer the chance to attract billions of dollars in capital investment and generate significant cash and in-kind proceeds to military installations over the term of the leases. Successful projects have or will include office, warehouse, and distribution space, medical offices, labs, power plants, historic properties, and even sports venues.

At Walter Reed Army Medical Center, for example, a lease was signed with Keenan Development Ventures to renovate and operate a 200,000-square-foot historic lab building as state-of-the-art office space at a cost of more than $60 million. At the same installation, Higgins Development Partners will lease vacant land to develop 500,000 square feet of office, laboratory, and parking space at a cost of more than $150 million. Many more projects are in the pipeline as well, including an 800-acre property on the edge of the Arizona National Guard Installation near Volunteer Mountain at Camp Navajo, which is being made available for industrial development, and a 2,400-acre site at Yuma Proving Ground, Arizona, where a hot-weather test track will be developed for use by automobile and related manufacturers.

While DoD (and the Army in particular) is moving forward with EUL, it can do even more to use EUL to its maximum advantage and avoid leaving money on the table as it seeks to put these underused real estate assets to work. Here’s how:

• Encourage and motivate installation commanders to think about “value” as they plan (and master plan) for their installations’ future needs. EUL projects will not be successful without a champion (with clout) at the installation level. The best way to get installations to proactively identify and execute EUL projects is to ensure that significant benefits accrue directly to them.
• Determine the property’s economic viability through a comprehensive, objective market/feasibility analysis. The analysis should determine the property’s highest and best use among a range of potential uses. The highest and best use should yield the best price per square foot. An analysis will determine if sufficient non-federal government demand exists to generate adequate cash flow to provide market rates of return to private investors. Don’t take the opportunity to the marketplace until there is reasonable certainty regarding its economic viability.
• Structure the project in a manner that will satisfy both the explicit and implicit concerns of the Office of Management and Budget (OMB) regarding budgetary treatment. The recent amendment to OMB Circular A-11 requires that every EUL project go through that office for review. OMB should be briefed early on—at concept development—to address any issues it may have with the transaction’s structure.
• Run a developer selection process that is cost effective and efficient from the private sector’s standpoint. The process should respect the industries’ time and money. The Army process uses a “Notice of Opportunity to Lease” (NOL), which is a competitive real estate transaction, but not “procurement.” The developer is selected based upon qualifications, experience, past performance, financial capabilities, and vision. A short list of offerors is invited for oral presentations, and then a final selection is made. This part of the process is cost effective and speedy—45 to 60 days from issuance of a NOL to selection.However, the selected developer will spend four to six months and a significant amount of money developing a Business and Leasing Plan that contains all of the final development details, lease terms, and business arrangements, including ground rent and other financial considerations accruing to the installation.
• Look for opportunities for long-term cash-flow sharing. While DoD is required to receive at least fair market value (FMV) for the out-leased asset, the installation should look to do even better. Beyond FMV, cash-flow sharing, use of facilities, and other services and considerations are fair game during the negotiations.

As more EUL projects are executed and the process becomes more common, interest from private industry will continue to grow. There were approximately 100 attendes at an industry forum for the Camp Navajo EUL in January, including many of the country’s top industrial developers. That same week, a conference for more than 100 bond underwriters, insurers, and investors featured EUL under the topic, “What’s Next” [after military housing privatization] in terms of DoD-related real estate investment and financing opportunities.

For DoD, this represents an outstanding opportunity to work closely with the private sector in a mutually beneficial way. However, the key is to make the most of the process through a strategic approach that yields immediate value as well as financial benefits over the long term.