Building on your options
Development always has been a key element in the skill sets of some successful REITs and publicly-traded real estate companies, but market economics caused it to fall out of favour in the late 1980s and for much of the decade that followed.
However, to grow earnings in today's environment of low cap rates and high valuations, many US REITs are tapping into their development expertise as a way to enhance and diversify their strategies for growth. From their roots dating back to the 1960s, many of today's REITs are managed by teams of executives with significant experience in the business of real estate development.
The return to development has been deliberate and measured. In the aftermath of the real estate recession of the late 1980s and early 1990s, nationwide vacancy rates were at elevated levels. Low prices and high cap rates made development much less profitable than acquisition. Then, in the late 1990s, the flow of capital for development was severely constrained by the excessive amounts of capital invested in the technology sector.
Capital flows began to shift, however, following the technology meltdown in 2000 and subsequent economic recession in 2001. As economic growth accelerated following the recession, real estate fundamentals also turned around.
"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," says Ralph Block, senior portfolio manager for Phocas Financial Corporation.
"Right now, REITs can get much greater returns for risk adjusted development," says Jan Svec, a director in the REIT Group at Fitch Ratings. "Thus, REITs in every property sector want to ramp up their development pipelines."
For example, development projects characterised the operations of Regency Centers Corporation between 1963 and 1993 when the company went public. After a few years focused primarily on acquisitions, the company has returned development to its strategic planning.
At the end of 2005, the company owned 393 retail properties spanning 50.8mft2 (4.7m2). Of those, 147 had been developed since 2000. Looking ahead, the Regency land bank will support more than 1mft2 of community and neighbourhood shopping centre developments.
Another firm revisiting its development roots is Weingarten Realty Investors. Observing a sustained rise in demand for retail real estate, an abundant supply of capital and rising interest rates, coupled with higher prices for existing properties, the company's board determined in 2005 that the time was right to ramp up the REIT's development programme. In doing so, Weingarten returned to the growth strategy which the company had employed for the first 25 years of its existence, starting in the late 1950s until the early 1980s when acquisitions became its focus.
Under current market conditions, Weingarten's president and CEO, Andrew Alexander, says that the company can achieve better spreads with development than with acquisitions and has set a goal of $250m (€196m) in new projects annually by 2008.
oday, well planned real estate development can earn premiums of 2-4 percentage points over current cap rates. Those results are not lost on the ratings agencies or real estate analysts. Earlier this year, a Fitch Ratings report on REITs noted: "Fitch will consider more positively management teams that have demonstrated discipline with respect to development and joint ventures. Companies with varied access to capital and a large unencumbered asset pool will be credited with the best financial flexibility."
Duke Realty Corporation is one REIT that has maintained an active development strategy. To date, the company has developed about 60% of its 117mft2 portfolio. The company also maintains a fully entitled land bank, which currently stands at 5,000 acres.
Duke is developing industrial property with yields of 8.5-9%, according to Duke chairman, president and CEO Dennis Oklak. The company also has diversified into other product types. "We also develop suburban office buildings," Oklak says, noting that yields for office assets are even higher, ranging from 9.5-10%.
Similar return expectations also are driving long-time office developer Maguire Properties. With its targeted land acquisition strategy, Maguire senior vice president of marketing Bill Flaherty says that the company can count on developments that deliver yields of 10%, five percentage points 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%, which still gives us a 400 basis point premium," he says.
A similar story is being seen at multifamily REIT Camden Properties Trust. "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."
"In Washington, DC, I can build in a 7% or 7.5% cap rate, and I know that the market is probably around a 5% cap rate for acquisitions. That's clearly a big spread." The ability to earn such spreads has fuelled $1.8bn in Camden development projects since 1995.
s real estate fundamentals continue to strengthen, many real estate companies are moving ahead on new projects. However, some executives have begun to question whether 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%," says Campo. Others report equally disheartening cost hikes across the country.
Of course, no one expected that the economy would favour development indefinitely. "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."
Should cap rates begin to rise, the economics favouring development relative to acquisitions could change. If business opportunities then swing back in favour of acquisitions, prudent management teams can be expected to adjust their strategies once again to focus on the most profitable investment opportunities and to maximise returns for their shareholders.