Office buildings in top U.S. 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 Real Estate Investment Trusts (REITs), led by Boston Properties Inc. (BXP), Vornado Realty Trust (VNO) and Kilroy Realty Corp. (KRC), are planning to plow almost $11 billion 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 Inc. 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 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’ $1.13 billion tower in San Francisco that will be the headquarters of Salesforce.com Inc. and the city’s tallest building. SL Green Realty Corp. (SLG) plans on constructing a 1,200-foot (366-meter) skyscraper in midtown Manhattan. Cousins Properties Inc. and Brandywine Realty Trust are developing offices in Austin, Texas.
Vast Majority
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 $3.2 billion 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 16 percent above the 2007 peak as of April, according to data from Moody’s Investors Service and Real Capital Analytics Inc.
Falling Returns
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 4.5 percent in the first three months of the year, close to the low of 4.4 percent in the second quarter of 2008, according to Real Capital. It reached as high as 6.6 percent as the property market cratered in 2010.
In San Francisco, cap rates were 5.4 percent in the first quarter, down from 7.8 percent in the second quarter of 2010. They hit a low of 5 percent 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 2.61 percent yesterday.
Norway’s $890 billion sovereign-wealth fund, the world’s biggest, is trying to fill a 5 percent 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.
Different Strategy
“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 LLC 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 5 percent.
“That’s why the public REITs are left to build buildings,” said Goltra, whose firm manages about $5 billion.
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.
Better Allocate
“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 7 percent for Boston Properties projects under way, Linde said.
In addition to the Salesforce tower, Boston Properties is developing 601 Massachusetts Ave., a 478,000-square-foot (44,400-square meter) building in Washington, and 535 Mission St. in San Francisco. Arista Joyner, a spokeswoman for the REIT, didn’t return voice messages seeking comment on the development plans.
Stock Gains
Investors have so far rewarded the company’s strategy, with shares up 13 percent in the past year, compared with an 8.3 percent gain in the Bloomberg REIT Index. Vornado has jumped 25 percent, while Kilroy is up 16 percent.
Vornado, which has been selling assets and is spinning off its shopping-center division to focus on its core office and retail projects, has $3.1 billion 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 $1.35 billion.
Mark Semer, a spokesman for New York-based Vornado, declined to comment.
New office development in the U.S. has been concentrated in 10 markets, including San Francisco, New York and Houston, with 70 percent of new construction in these areas, according to Arthur Jones, senior managing economist at CBRE Econometrics Advisors in Boston.
San Francisco
Kilroy, based in Los Angeles, is making big bets on San Francisco, with five projects in the area. The city is the best-performing U.S. office market after four years of record leasing, led by technology companies, pushed occupancies to an all-time high of 70 million square feet in the first quarter, according to CBRE.
Kilroy will have an estimated cash return of 7.5 percent on its $1.5 billion of developments, Chairman and CEO John Kilroy said on a February earnings call.
New projects carry risks, including signing up enough tenants and construction costs, said Bob Bach, director of research at commercial real estate brokerage Newmark Grubb Knight Frank in Chicago. Office REITs try to have tenant commitments for half the space before starting construction, Goltra said.
Kilroy bought a site at 350 Mission St. in San Francisco in October 2012 and started construction without a tenant. By December, it signed Salesforce to take the entire 27-story building. It is scheduled to open next year.
Signing Tenants
Kilroy reduced the risks that are inherit in development by pre-signing tenants for its projects, said Michelle Ngo, senior vice president and treasurer. More than 62 percent of its projects under development preleased, she said.
The REIT is increasing its bets on San Francisco, spending $95 million last month for a 3.1-acre (1.3-hectare) piece of land in the Mission Bay area. It plans to spend an additional $355 million to build a 680,000-square-foot office campus.
Office rents are expected to climb 6.4 percent this year in San Francisco, the most in 30 U.S. markets, followed by San Jose, California, and New York, according to Reis.
“There are very few public REIT acquisitions of ‘A’- quality office buildings going on,” said Goltra of Forward Management. “The fact that they kind of step out and take some development risk in a market like San Francisco is OK to me.”
