Left to right: New London Mall in New London, Conn. New Plan bought this property as part of its JPMorgan joint venture in March for $42 million. 111 Huntington Avenue at the Prudential Center was developed by and is the headquarters of Boston Properties.

In today's market, are REITs better off using acquisitions or development to fuel growth?

By Michael Fickes

Acquisitions are part of every industry, and a great number of REITs have boosted their holdings either by acquiring individual properties or entire companies. During the 1990s, aggressive acquisition strategies made perfect sense. As real estate recovered from the downturn of the late 1980s and early 1990s, cap rates soared, with asset prices declining significantly. Beginning in the mid 1990s, REITs could buy low, lease high and live well.

Crescent acquired Fountain Place in Dallas in 1997.

Today, market fundamentals are different and investor expectations are at an all-time high. Across the commercial real estate world, cap rates have fallen, and prices have surged. Conventional acquisition strategies have become potentially expensive pursuits.

REIT executives say that acquisition remains an important component of any growth strategy. But they hasten to add that the nature of acquisition has changed. Today, REITs acquire more and more property through funds in which they hold a minority interest or by taking on joint venture partners. By co-venturing with other investors, REITs can offer their real estate expertise to others, adding property and asset management fees to their bottom line on top of returns gained from owning a portion of the property investment.

While most REITs have favored acquisition over development, today's real estate economics have brought traditional acquirers to the development side of the business, as well. Here, of course, returns are a little higher, but life can be a little more risky.

According to REIT executives from companies that have historically relied on development, this side of the business is changing as well.

Whatever strategy a REIT chooses to pursue—buying, building, or both—making a REIT grow in the early 21st century poses new and different challenges. Here's a look at how office, retail, multifamily and industrial REITs have renovated their growth strategies to meet today's market demands and, hopefully, exceed investor expectations.

Crescent: How To Grow Without Getting Bigger
"In the 1990s, bigger was considered better; today, better is better," says John Goff, vice chairman and chief executive officer of Crescent Real Estate Equities Company (NYSE: CEI). "There is no advantage to getting bigger and owning more assets. I don't think there are any big economies of scale. What works now is thoughtfully managing the capital you have with a strategy that maximizes return on equity."

“There is no advantage to getting bigger and owning more assets. I don't think there are any big economies of scale. What works now is thoughtfully managing the capital you have with a strategy that maximizes return on equity.” —John Goff

A diversified REIT, Crescent owns or has interests in assets valued at approximately $4.5 billion. The company's largest asset holdings lie in the office category and total about $2.7 billion or 60 percent of its real estate portfolio. Other real estate holdings include hotels, resorts, wellness centers and residential developments. In 2004, Crescent generated revenue of about $1.3 billion, up almost 20 percent from 2003. Net income for 2004 was $172.9 million, up 565 percent from 2003, thanks in large part to the company's new acquisition strategy.

Goff describes Crescent's model for growth as becoming a kind of investment manager for institutional investors that want to own real estate directly. Crescent will acquire and manage properties with these investors in joint venture structures and then collects fees for asset and property management services. Crescent will also invest its own capital in the undertakings and collect an equity share promotion at the end of the investment for meeting its partners' investment goals.

Under this joint venture model, Crescent contributes 20 percent to 25 percent of the equity to a venture, brings in the rest from institutions, borrows against the equity, buys property, and manages it. "When we put a dollar to work in this kind of structure, we earn more than if we put that dollar to work wholly owning an asset," Goff says. "The premium is 300 to 600 basis points in return on equity."

Boston Properties: Ever the Developer
A traditional developer, Boston Properties, Inc. (NYSE: BXP) has developed 10 million square feet of office space since going public in 1997. Currently, the company has $385 million worth of properties in its development pipeline. As for acquisitions, Boston Properties hasn't bought any property for at least a year.

"We want to create value the way we always have—through development," says Douglas Linde, executive vice president and chief financial officer of the Boston-based company. "Our development projects are for the most part fully-leased, in central business districts (CBDs) and 24-7 markets like Washington, D.C. and the Boston area."

Boston Properties owns 122 office buildings, 75 percent of which are located in CBDs. The company's revenue reached $1.4 billion in 2004, up 2.8 percent from the year before. Net income for 2004 totaled $284 million, down 22.3 percent from $365 million in 2003.

Linde says that company developments typically yield over 10 percent, substantially higher than the 4 percent to 6 percent returns expected from current office acquisitions. Moreover, Linde notes that the returns calculated for a fully leased development property show cash flow returns that will not be diluted by necessary capital infusions. On the other hand, continues Linde, yields for acquisitions, stated as cap rates, are generally based on estimates of net operating income before deducting capital costs for tenant improvements, broker's commissions, and other costs that always arise in connection with existing properties. In other words, a cap rate can be a high estimate of the actual returns an acquisition will generate.

Might Boston Properties consider an acquisition strategy similar to Crescent's, forming and managing a fund or joint venture? "We have considered joint ventures," Linde says. "And we've done some tests. By and large, though, our board's view is that shareholders would rather have 100 percent of one building than a 25 percent share of lots of buildings."

New Plan: A Sale Is a Gain
With a complex transaction announced in July, New Plan (NYSE: NXL) hopes to generate new cash flows to fund joint venture acquisitions and development, according to Glenn J. Rufrano, the company's CEO.

At the end of 2004, New Plan owned nearly 400 community and neighborhood shopping centers valued at $3.6 billion. For the year, the company generated rental revenues totaling $493 million and net operating income of $335 million.

New Plan's best development returns have come from re-developing existing property. According to Glenn Rufrano, the return on re-development investments can approach between 10 percent and 12 percent.

In July, New Plan agreed to sell 69 of its nearly 400 community and neighborhood shopping centers to Galileo America LLC, which is a joint venture between CBL & Associates Properties, Inc. (NYSE: CBL) and Galileo America, Inc. Galileo America is a U.S. REIT owned by Galileo Shopping America Trust, an Australian property trust.

Galileo will pay New Plan $928 million in cash and $40 million in equity for the properties. In the transaction New Plan also purchased property management contracts held by CBL, effectively replacing CBL in the joint venture.

So the transaction will generate cash for New Plan, boost income from management fees from 52 properties already held in Galileo's portfolio as well as from the 69 properties transferred from New Plan to Galileo. New Plan will use some of the cash to pay down debt of about $450 million, adding that much in purchasing power to the company's balance sheet.

Finally, New Plan will use $300 million of the proceeds to make a one-time distribution to shareholders of $3 per share. The company will then reduce its dividend from $1.65 to $1.25 per share, bring it more in line with industry standards and increase free cash flow for investments.

According to Rufrano, the complex plan will generate cash flows making it possible to invest in 20 percent shares of joint ventures with institutional investors. Rufrano says that the property management fees and equity promotions generated by deals like this can push overall returns up to the level of a new development—without the risk associated with development.

"The reason people in our business are doing this is because there are funds available out there that have a lower cost than ours," Rufrano says. "It works because institutions require returns that are lower than what we require. So they will pay fees that enable us to reach our hurdle rates."

Rufrano says New Plan is also developing and redeveloping properties. New developments generate returns in the range of 10 percent to 11 percent, he says. But New Plan's best development returns have come from re-developing existing property. According to Rufrano, the return on re-development investments can approach between 10 percent and 12 percent.

Regency: A Developer First
Development is the primary source of growth at Regency Centers Corporation (NYSE: REG), according to Martin E. Stein, Jr., the company's chairman and CEO. Stein estimates that returns from new retail developments are running slightly more than 10 percent, compared to returns of 6 percent to 7 percent for acquired centers.

Regency owns almost 300 grocery-anchored neighborhood and community shopping centers valued at approximately $3.3 billion. The company generated $443 million in revenue during 2004, up about $20 million from the year before. Net income for 2004 reached $128 million, up slightly from 2003.

The City of Lake Mary, Fla. municipal services complex was developed by Duke Realty.

Stein estimates that 50 percent of the company's annual growth in income and shareholder value comes from development. In 2004, Regency completed 17 new developments representing a $264.2 million investment. The company also began new developments valued at $269.6 million.

To fund new developments, Regency sells underperforming or non-core properties. Last year, for instance, the company sold $526.7 million in developments, operating properties, and periphery property in a total of 75 transactions.

"By culling our portfolio, we generate attractive returns and get brand new shopping centers," Stein says. "And we're financing the net growth of our portfolio through joint ventures."

About 20 percent of the company's annual growth in shareholder value comes from acquisitions made through joint ventures with institutions, Stein says. Regency has joint venture partnerships with Macquarie CountryWide Trust (ASX: MCW) and the Oregon Public Employees Retirement Fund. All told, these joint ventures own 69 properties valued at $1.2 billion.

Regency also manages existing properties with an eye toward internal growth in the form of rental and occupancy rate increases. Stein says that about 30 percent of the company's income growth comes from revenue increases achieved by existing properties.

BRE: Taps Multiple Sources For Multifamily Growth
BRE Properties, Inc. (NYSE: BRE) owns and operates 84 multifamily apartment communities in California, Arizona, Washington and Colorado, regions where barriers to entry, high prices and low cap rates have generally hampered returns available to property developers and acquirers.

BRE's growth strategy aims to balance revenue growth with portfolio growth from developments and acquisitions, says Constance B. Moore, BRE's president and CEO.

Moore says BRE aims for revenue growth two to three times the consumer price index. In 2004, BRE's rental revenue totaled $268 million, up 9.39 percent from $245 million in 2003. Net operating income from rentals rose 7.28 percent to $180 million in 2004.

On the investment side, BRE targets $250 million per year in new development and $100 million per year in acquisitions to the company's portfolio. Once a development has stabilized, Moore says the company wants the property to yield at least 7.5 percent.

Returns from acquisitions are more problematic, however, especially in light of the low cap rates characteristic of west coast real estate markets. Currently, the cap rate problem is worse than ever, Moore says.

"Today, with the [amount of] liquidity chasing properties, going-in yields are so low it is difficult to grow revenue enough to cover our cost of capital," Moore says. "And we hold firm to the premise that [an acquired] property's NOI must grow enough to cover our cost of capital in a reasonable period of time."

Duke: Development Still King
Development has been the primary engine of growth for Duke Realty Corporation (NYSE: DRE) since the company was founded in 1972, says Thomas Peck, senior vice president of investor relations.

"People generally seem to think that development is extraordinarily risky—that you hit a home run or lose your shirt," Peck says. "That has never been the case for us."

According to Peck, from 1993 through the first quarter of 2005, Duke developed 436 projects averaging $8 million each and produced an average unleveraged return of 11.2 percent once the projects stabilized.

"Of all those projects, the best produced a 21 percent return and the worst came in at 6.1 percent, which is close to some cap rates people are paying for acquisitions today," Peck says.

Currently, Duke owns interests in 114 million square feet of office, industrial, and retail properties valued at $5.9 billion. Revenue for 2004 stood at $836 million, up from $772 million in 2003.

When the economy gets tough and cap rates rise, Duke resists the temptation to acquire. Instead, the company simply cuts back on its development work. As a developer, however, Duke covers the entire development playing field. The company develops properties for its own portfolio, develops merchant properties that are then sold to the highest bidder, and develops under fee arrangements for owners.

"When the market won't support as much development as we would normally do for ourselves, we shift resources into the third party construction area and build projects for fees," Peck says.

Should a REIT buy or build growth in today's economy? Acquisition-minded REITs are increasingly open to and engaged in joint ventures and co-investment funds. Development-oriented REITs are looking at doing less development or spreading risk through joint ventures. REITs that both acquire and develop have rebalanced their initiatives, placing a little more emphasis on development than acquisition. In the end, the activities of the companies featured suggest the answer is yes, both can work—buy and build. While today's economic realities have led REITs to re-think their growth strategies, no one is changing horses completely.