Development Strategies Provide REITs with More Growth Opportunities

By Michael Fickes

For the first time since the beginning of the modern era of real estate investment trusts (REITs), many equity REITs, in addition to traditional developers, are pursuing some kind of development strategy. To maintain growth in today's world of high prices and low cap rates, development opportunities have become more attractive for many companies.

"Until the modern REIT era, most REITs never developed anything," says Ralph Block, real estate strategist with Phocas Financial and author of "Investing in REITs." "When modern REITs formed in 1993 and 1994, they were run by people with significant development experience."

But REITs didn't turn to development immediately. In the aftermath of the real estate recession of the late 1980s and early 1990s, the Resolution Trust Corporation (RTC) seized billions of dollars worth of defaulted properties and sold them for pennies on the dollar. The low prices and high cap rates made development much less profitable than acquisition. In the late 1990s, REIT stock prices fell as money flowed into dot-com companies. With capital in short supply, development proved difficult, Block says.

However, with the recession in 2000 and its aftermath from 2001 through 2004, "most real estate sectors started turning around in 2005," Block says. "The turnaround coincided with very strong real estate prices. REITs didn't want to compete with pension funds for high priced properties producing low returns. But they could develop."

"Right now, REITs can get much greater returns for risk adjusted development," says Jan Svec, a director in the REIT Group at Fitch Ratings. "So many REITs in every sector want to ramp up development pipelines."

Today, a savvy real estate developer can earn premiums of 2 percent to 4 percent over current cap rates, according to the REIT officials interviewed for this article. As a result, REITs are adapting their individual real estate strategies to the challenges posed by development.

Building Industrial Strategies

Duke Realty Corporation (NYSE: DRE) is one REIT that pursues an aggressive development strategy. To date, the company has developed about 60 percent of its 117 million square-foot portfolio. The company also maintains a fully entitled land bank, which currently stands at 5,000 acres.

"Land position is the key to our development model," Dennis Oklak, Duke's chairman, president and CEO, says. "We have the capacity for 72 million square-feet of development on the best land in the best submarkets."

Duke has three types of developments: hold and rent; sell; and for-fee income paid by another owner. Typically, when one approach performs poorly, another approach performs well.

The New York Times Building, a transparent tower 52 stories high, located on 8th Avenue in Midtown in New York City, will be available for tenant occupancy in early 2007.

Today, Duke is developing industrial property with yields of 8.5 percent to 9 percent, Oklak says. The company has also diversified into other product types. "We also develop suburban office buildings," Oklak says, noting that yields for office assets are even higher, ranging from 9.5 percent to 10 percent.

On balance, Duke's strategic approach to development seems no less agile and flexible than the strategy pursued by the privately held Industrial Developments International (IDI) of Atlanta.

Founded in 1989 as a dedicated development company, IDI has developed more than 450 projects in 32 states, Mexico and Canada, representing a total of 107.7 million square feet with a value of $4.7 billion. The company has also carried out $948 million in joint venture acquisitions with institutional partners.

"Development is still the core of our business," says Frank J. Petkunas, vice president and regional development officer for IDI. "The development business, however, is cyclical in nature and the revenues derived from such can be volatile or sporadic. We therefore supplement our development revenue with the more steady cash flows from joint venture acquisitions."

IDI has also participated in development joint ventures, particularly as a strategy for entering new markets. "Not only can a local developer be your eyes and ears on the ground in a new market, but he often can help you identify opportunities and risks not readily noticeable," Petkunas says.

Petkunas characterizes the overall industrial development market today as robust and competitive. "The fundamentals look good," he says. "Demand is up. Supply is low. Rental rate is growing. Cap rates are healthy and institutional demand for product is steady. It is competitive because a lot of capital is chasing industrial product, and a lot of developers are building."

Different Approaches to Office Developments

Office REITs are tailoring their development efforts to the requirements of specific markets and building types. For example, Corporate Office Properties Trust (NYSE: OFC) specializes in both acquisitions and development in a single market.

"Our particular niche is the U.S. government and the defense contractors that service the government," says Randall M. Griffin, Corporate Office's president and CEO. "We're probably the largest owner of secured buildings in the country—other than the government."

Corporate Office is one of the few office providers capable of creating space for the secure specifications required by a number of government agencies. "All but one of the projects underway at the end of 2005 were in government and defense-oriented parks," Griffin says.

Corporate Office owns a land bank capable of accommodating 7.8 million square feet of additional development. Corporate Office also owns a site that can accommodate a 2 million square-foot development in the 130-acre M Square, a research development park adjacent to the University of Maryland. Finally, the company hopes to close on land that will provide the capacity to develop another 1.7 million square feet of office space at Fort Ritchie, Md. If that deal goes through, Corporate Office will own developable land equal to 80 percent of its current office portfolio of 15 million square feet.

Maguire Properties, Inc. (NYSE: MPG) takes another approach to office development. Maguire specializes geographically in the Southern California office market.

A long-time private developer with 30 million square feet of Class A institutional office space in its privately developed portfolio, Maguire went public in June 2003. The company used the money raised in its public offering to buy office properties from Los Angeles to San Diego.

It may appear that Maguire was turning itself into an acquisitive REIT, but that was not so, says Bill Flaherty, senior vice president of marketing with Maguire. "It was actually a development strategy," he says. "Every asset we bought had a remaining development component. As of the end of the first quarter 2006, we have bought 15 million square feet of new office space and gotten the fully entitled, development rights for 4.7 million square feet of space. Our development rights are incredibly valuable because of the extremely strong barriers to entry in Southern California."

With its targeted land acquisition strategy, Flaherty says that Maguire can pencil out developments that deliver yields of 10 percent, 5 percent above the region's acquisition yields. "Even if it took longer to lease than we planned, I wouldn't suspect that the yield would fall below 9 percent, which still gives us a 400 basis point premium," he says.

The Many Sides of Retail Development

Retail REITs across the board have waded into development in recent years. Firms that specialize in community centers, grocery anchored centers and regional malls have all developed unique strategies to get the most out of this development cycle.

For example, development projects characterized the operations of Regency Centers Corporation (NYSE: REG) between 1963 and 1993, when the company went public. After a few acquisition-heavy years, the company has returned development to its strategic thinking.

"We want to acquire and operate high quality shopping centers that produce reliable growth and NOI," Martin "Hap" Stein, Jr., Regency's chairman and CEO says. "We have a capital recycling and joint venture program to grow our portfolio. The third component of our strategy is development, which is a way to service the growth needs of our anchors and (national) side shop retailers."

At the end of 2005, the company owned 393 retail properties spanning 50.8 million square feet. Of those, 147 had been developed since 2000. Looking ahead, the Regency land bank will support more than 1 million square feet of community and neighborhood shopping center development.

New Plan (NYSE: NXL) traditionally preferred acquisition to development, says Glenn Rufrano, New Plan's CEO. In recent years, however, the company has carved out a strategy for redeveloping its own aging properties.

"We've done more than $300 million of redevelopment over the last five years and increased NOI on wholly owned redevelopments from 9 percent to 14 percent," Rufrano says.

Some of the redevelopments look more like new developments. For example, in Clearwater, Fla., New Plan owns an 850,000 square-foot two-level mall with four anchors. The redevelopment replaced the pre-existing mall with a 300,000 square-foot community center anchored by Lowe's, Costco, and SuperTarget.

The redevelopment strategy worked so well that Rufrano has expanded it to include new projects for tenants. Recently, for example, Home Depot, a major New Plan tenant, sold five of its existing store sites to New Plan. "We are developing the property surrounding those stores," Rufrano says.

Another New Plan tenant, A&P grocery store, asked the company for help with a developer that was not performing on a new store development in Fishkill, N.Y. New Plan bought the developer's contract and built a new A&P.

After six years focused on redevelopment and development, Rufrano says that New Plan's pipeline and portfolio now contain about 302 million square feet of projects.

Even mall REITs are pursuing development these days. "We have more developments in our pipeline than at any time in recent history," says Les Morris, a spokesman for Simon Property Group, Inc. (NYSE: SPG).

Simon built three developments under 1 million square feet that combine specialty retail, conventional anchors, big box and restaurants. The company is also currently building two open-air centers that are both more than 1 million square feet and combine retail concepts with housing, office and other mixed-use components. "These are franchise-type assets," Morris says.

An example is the $281 million Coconut Point in Estero-Bonita Springs, in the Naples-Fort Myers corridor in Florida. It will offer 1.2 million square feet of retail space, 45,000 square feet of office condominiums and 305 residential condos.

The retail concepts include a village anchored by Dillard's, Muvico Theatres, Barnes & Noble and four restaurants; a community center with 12 big box anchors such as Bed Bath & Beyond, Best Buy and Old Navy; and a third component with casual and sit-down dining and also smaller shops.

Raising the Roof on Multifamily

Not to be left out, multifamily REITs have also entered into the development market. Camden Property Trust (NYSE: CPT), one of the largest multifamily REITs in the nation, owns 188 properties containing nearly 65,000 apartments in virtually all of the major U.S. markets, from the East to the West coast.

At the beginning of 2005, Camden merged with Summit Properties and increased its assets from more than $2.5 billion to about $4.5 billion. The merger stoked the company's already considerable development pipeline, adding $650 million in developable land and raising total development land capacity to $1.4 billion.

"While we've relied on both development and mergers to grow, development gives a higher risk-adjusted return than acquisitions," says Richard J. Campo, Camden's chairman and CEO. "That's important today considering the compression in cap rates."

Campo requires a minimum of 100 basis points above the yield for a similarly priced acquisition to justify a development project. He prefers 200 basis points. "In Washington, DC, I can build in a 7 percent or 7.5 percent cap rate, and I know that the market is probably around a 5 percent cap rate for acquisitions. That's clearly a big spread." The ability to pencil out spreads has fueled $1.8 billion in Camden development projects since 1995.

REOC Developments

Real estate operating companies like Forest City Enterprises, Inc. (NYSE: FCEA) have historically relied on development for growth. The current development cycle is no different. Forest City's development work this year pushed the firm to $8 billion, up from $7.2 billion in 2005. One of the firm's three business units, Commercial Group, pushed its total assets up to $5.4 billion and increased earnings before depreciation and taxes (EBITDA) to $229.9 million, compared to $182.5 million in 2004. The company operates as a C-corporation, instead of a REIT, as part of a capital strategy aimed at reinvesting in business, company spokesman Tom Kmiecik says.

Frame construction of IDI's Building G at Plano Business Park. The 83,350 square foot project was completed in 2002.

Another feature of Forest City is its diversified real estate portfolio. According to the 2005 annual report, company assets break down as follows: 33 percent retail; 29 percent office, 27 percent residential; 5 percent hotels; 3 percent land; and 3 percent corporate holdings.

James Ratner, president and CEO of the company's Commercial Group, characterizes Forest City primarily as a developer. "We do acquisitions," he says. "But the focus over the years has always been development."

A current example of that development focus is the 52-story New York Times headquarters slated to open in 2007. Designed by renowned architect Renzo Piano, the building is destined to become a signature shape on the New York City skyline.

Developments on the Horizon

While REITs, REOCs and private real estate companies are moving ahead on new developments, some have begun to wonder if rising construction material costs may soon begin to cut into development returns.

"Over the past four years, we've seen construction costs in the Washington, DC market increase by almost 70 percent," says Camden's Campo. Others report equally disheartening cost hikes across the country.

It's enough to make a developer think twice. "If you were an investor, would you buy an empty building right now for $1 million or would you develop a speculative building?" asks Petkunas of IDI.

"Today's situation is unusual. You might be better off buying the building and letting it sit vacant until you can lease it up," he says. "That fixes the material costs. As long as you are carrying costs for the building that are lower than the construction material cost increases over the same period, you'll come out ahead."

Of course, no one expected that the economy would favor development forever. "A few years ago, it didn't' make sense to develop," says Svec of Fitch Ratings. "The rents would not support development. Now they do. But at some point, supply will pick up and the economics won't work."

Sooner or later, cap rates will begin to rise. Economics favoring development can't hold sway forever. The pendulum will eventually swing back in favor of acquisition.