REITs become developers as property prices climb
Office buildings in top US markets are getting so expensive that landlords are choosing to build rather than buy, spurring the most development by real estate investment trusts in at least a decade.
Office REITs, led by Boston Properties, Vornado Realty Trust and Kilroy Realty Corp, are planning to plough almost $11bn (€8.1bn) into new projects, triple the amount just two years ago and the most in data going back to 2004, according to research firm Green Street Advisors. Much of that is focused on the coasts, including San Francisco and New York, the areas with the most demand from both tenants and investors.
Prices for office buildings in major markets have surged past previous peak levels, lifted in part by sovereign-wealth funds and pensions willing to accept lower yields than other investors because they are seeking safe investments. For REITs, which have to answer to shareholders seeking higher returns, building is often a better option than competing with institutional buyers.
"They're selling assets and they're developing," Michael Knott, a managing director at Green Street in Newport Beach, California, said in a telephone interview. "They're going out the risk-reward spectrum by starting more developments rather than buying."
Projects in the works include Boston Properties' $1.13bn tower in San Francisco that will be the headquarters of Salesforce.com Inc. and the city's tallest building. SL Green Realty Corp. plans on constructing a 1,200-foot skyscraper in midtown Manhattan. Cousins Properties and Brandywine Realty Trust are developing offices in Austin, Texas.
For Boston Properties, the biggest office-focused REIT by market value, the "vast majority" of new investments are in development, Chief Executive Officer Owen Thomas said on an April 30 conference call with analysts. The Boston-based company has about $3.2bn in projects, according to Green Street.
"In our core markets, we are at that point in the real estate cycle where new properties can be delivered at lower cost per square foot and higher yields than where existing older properties are trading," Thomas said.
Prices for central business district office properties in six major markets -- Boston, New York, San Francisco, Chicago, Los Angeles and Washington -- were 16pc above the 2007 peak as of April, according to data from Moody's Investors Service and Real Capital Analytics.
Capitalization rates, a measure of returns derived by dividing a property's net operating income by its purchase price, have tumbled as a result.
The average cap rate for Manhattan office buildings was 4.5pc in the first three months of the year, close to the low of 4.4pc in the second quarter of 2008, according to Real Capital. It reached as high as 6.6pc as the property market cratered in 2010.
In San Francisco, cap rates were 5.4pc in the first quarter, down from 7.8pc in the second quarter of 2010.
They hit a low of 5pc in 2009.
Institutional investors such as sovereign-wealth funds and pensions are buying properties in major markets in part because they view those areas as being less risky, Ryan Severino, senior economist at Reis Inc., said in a telephone interview. The yields they get from those buildings are still above 10-year Treasury securities, which yielded about 2.61pc this week.
Norway's $890bn sovereign-wealth fund, the world's biggest, is trying to fill a 5pc real estate allocation and is looking to invest in Washington, San Francisco, New York and Boston, Karsten Kallevig, the head of real estate, said in a May interview. Canada's two biggest pension funds last month announced separate purchases of stakes in Manhattan office towers.
"A lot of these private-equity funds and some of these sovereign-wealth funds are going to do things differently than the public REITs would," Ian Goltra, a money manager overseeing real estate funds at Forward Management in San Francisco, said in a telephone interview. "They're just going to capitalize the acquisition differently and they're going to out- compete the public REITs for the same building."
Goltra, who manages funds that own shares in REITs including Boston Properties, Vornado and SL Green, said he'd rather see publicly traded office owners construct new properties than buy a building for a cap rate under 5pc.
"That's why the public REITs are left to build buildings," said Goltra, whose firm manages about $5bn.
There is a "big disconnect" on how Boston Properties is evaluating acquisitions compared with institutional investors, President Douglas Linde said at a conference last month.
"They've got a lower overall total return objective than we do," he said at the conference, sponsored by the National Association of Real Estate Investment Trusts. "We have the alternative of investing capital in development and being able to find a place that we think we can better allocate our dollars."
While returns vary depending on the development, they're generally averaging around 7pc for Boston Properties projects under way, Linde said.
In addition to the Salesforce tower, Boston Properties is developing 601 Massachusetts Avenue, a 478,000-square-foot building in Washington, and 535 Mission Street in San Francisco. Arista Joyner, a spokeswoman for the REIT, didn't return voice messages seeking comment on the development plans.
Investors have so far rewarded the company's strategy, with shares up 13pc in the past year, compared with an 8.3pc gain in the Bloomberg REIT Index. Vornado has jumped 25pc, while Kilroy is up 16pc.
Vornado, which has been selling assets and is spinning off its shopping-center division to focus on its core office and retail projects, has $3.1bn in developments planned, according to Green Street. Those are mainly retail and residential projects, including a condominium building on Central Park South in Manhattan that Green Street estimates will cost $1.35bn.
New York-based Vornado declined to comment. (Bloomberg)