Duke Realty Corporation plans to turn the 184-acre former General Motors assembly plant in Baltimore into an industrial park with 16 buildings.

Duke Realty Embarks on National Expansion

By Allison Landa

Indianapolis-based Duke Realty Corporation (NYSE: DRE) is still thinking local, but under the stewardship of Chairman and Chief Executive Officer Dennis Oklak, the company is steadily working on an ambitious set of strategic goals to operate on a national scale.

"We're transforming this company from a Midwestern industrial office company to a national multidimensional company," says Senior Executive Vice President Bob Chapman, who heads up the company's real estate operations.

Sample properties acquired by Duke in the Mark Winkler Co. deal.

From 1999 to today, we've expanded to the Southeast and are now expanding to the Mid-Atlantic," Chapman says. "We're also expanding to Houston and Phoenix and have added additional property types. … It's an expansion of what we've been doing, prudently and systematically, of both the geography and the product."

What the company has been doing has clearly been working. Duke boasts a market cap of $8.2 billion, with 690 properties in 17 cities totaling 105.5 million square feet—hardly the size and scope of a typical regional operator. The company leased an impressive 10 million square feet during the fourth quarter of 2005, and by year's-end had more than doubled its 2004 development pipeline.

Most significant at present is Duke's push to enter more competitive markets. "Although Duke's earnings growth is limited by portfolio concentrations in slow-growth markets with high cap-ex, it is moving rapidly into better coastal locations and port-related operations," says David M. Fick, managing director at Stifel Nicolaus.

A New Era

With change afoot, Duke is looking to go national. "Eighteen months ago, Denny (Oklak) really started a detailed process, a concentrated process that involved the executive committee and many of the key associates and the overall management team," says Executive Vice President and Chief Financial Officer Matt Cohoat.

Cohoat says Oklak challenged the company's management to establish a comprehensive strategic plan that it could articulate and execute.

In October 2004, Duke announced a joint venture with Indianapolis-based health care developer Bremner Healthcare. According to the agreement, Duke will provide financing and the work of its in-house construction services, while Bremner Healthcare will provide business development, leasing, and property management.

"We really expanded our product type from just suburban office and bulk industrial into the medical office property type," Oklak says. "We're now in the process of building that business and have had about $100 million of development and construction in its first full year of operation. It's another long-term growth platform for us."

Chapman sees the health care initiative as a lucrative niche that will expand Duke's platform. "I'm well over 50, and people my age and older have money and want to live as long as they can," he says. "This will be mostly medical office buildings or expansions of hospitals, and only a year and a half in, we're going in 50 to 75 percent preleased in most cases."

We’re looking at strategic acquisitions that get us into a new market, such as the Winkler Co., but over the last few years we haven’t done a lot of acquisitions in our existing markets. We feel (development) is more profitable for us." —DENNIS OKLAK

Duke also has formed a national development group to do projects in cities other than where it has a major presence. The formation came as a response to customer requests, according to Oklak: "We had customers who said, for example, 'Could you build me a building in Massachusetts? In Cheyenne? In Iowa?' We were seeing a lot of (those kinds of requests), so we decided that that was going to be a good piece of business for us."

In 2005, the company announced plans to enter the Phoenix and Houston markets. "The way we're moving into those markets initially is that we just hired someone in Houston and have transferred one of our senior people out to Phoenix to start looking at some land acquisitions," Oklak says. "We're scouting out development prospects in those two cities. … We've got the expertise to go in and acquire land positions."

This expertise is showcased in Duke's acquisition of the Mark Winkler Co., a family-owned real estate company that has done business in the Washington, D.C. and Northern Virginia markets for the past 60 years. The $855 million acquisition, which was announced in late January, entails most of Winkler's Co.'s 32 commercial office buildings in Northern Virginia, as well as 166 acres of undeveloped land in four Northern Virginia locations.

It also signals an entry into one of the country's most notoriously competitive real estate markets.

"We knew we wanted to go to the Mid-Atlantic region, the D.C. area. It's an exceptional market, and we didn't know exactly how or when we were going to get there, so the fact that this portfolio came up for sale at this time when we were looking for that expansion opportunity was somewhat opportunistic," Cohoat says.

"The combination of great land position, very solid properties, and an exceptional management team just made it a great fit for our organization," he adds. "Every time we can get a greater market share, particularly in a market that is consistently one of the top markets in the United States, that will lead to us having more customer relationships, and that'll be an ongoing snowball effect for additional new business and opportunities."

DUKE REALTY CORPORATION 600 East 96th St., Suite 100 Indianapolis, IN 46240 317-808-6000 www.dukerealty.com MANAGEMENT: Dennis Oklak, Chairman & CEO; Matthew Cohoat, EVP & CFO; Robert Chapman, SEVP, head of real estate operations; Howard Feinsand, EVP, general counsel and corporate secretary. TICKER SYMBOL: DRE, listed on the New York Stock Exchange •52-WEEK HIGH: $37.30 •52-WEEK LOW: $29.28

Senior real estate analyst Lou Taylor, who covers Duke for Deutsche Bank, sees the expansion to other markets as an opportunity to reduce leasing costs and vulnerability to earnings cycles.

"They're really trying to expand their portfolio from one that had a fairly high concentration of Midwestern office space to one that has a smaller percentage of office, and having that office exposure located in other markets," Taylor says. "The other thrust is to really increase their exposure to the industrial-distribution sector, and they've done that through acquisition. … Office is one of the more cyclical sectors, and they're reducing their cyclicality."

However, Steve Sakwa, first vice president with Merrill Lynch, notes that expected returns on the Winkler acquisition—8 percent—fall below Duke's current average yield of 9.6.

Sakwa notes that Mid-Atlantic base closures may negatively affect the portfolio. "One issue according to local brokers (although contrary to Duke management) is that the military base closures and realignment could negatively impact office fundamentals in several years within the Alexandria submarket," he wrote in a January report. "While not directly impacting Duke's Mark Center complex, the additional vacancy could put pressure on future development opportunities."

Citigroup analysts Jonathan Litt, John J. Stewart, and Krupal Raval acknowledged that base closures pose uncertainty for the area, but maintained their position that the Winkler acquisition was a savvy move. "Northern Virginia is a much higher-barrier market relative to Duke's existing Midwest portfolio, and entering this market should be a long-term positive for Duke," they wrote in January.

Differentiating Through Development

Oklak maintains that an emphasis on development, as opposed to a focus on any one particular product type, helps Duke stay competitive even in times of market adversity. "Most REITs focus on one product type," he says. "We have a different business model with our focus on development, and if you look at other publicly traded companies, a handful of them look at development, but no one has a history of development (like ours)."

		Midwestern Roots Duke was founded in 1972 originally as an industrial developer.

Duke's three types of properties—industrial, office and retail—total more than 105 million square feet. The company, Oklak says, is less concerned with concentrating on one specific kind of property than with finding newer and better opportunities for development. The company currently has 10 million square feet—a value of $780 million—in its development pipeline.

The cyclical nature of acquisitions also makes Duke more interested in development. "Acquisitions are tough," Oklak says. "We're looking at strategic acquisitions that get us into a new market, such as the Winkler Co., but over the last few years we haven't done a lot of acquisitions in our existing markets. We feel (development) is more profitable for us."

Duke's in-house construction team also makes it unique amongst the company's peers, according to Chapman. "The one thing that has always helped us is having a construction group," he says. "We build our own buildings, which gives us an edge from a pricing and from a delivery standpoint. Just having that construction capability is huge for our company, and it always has been."

Cohoat adds that Duke's development and construction capabilities mean consistency to clients.

"I think there's a fair amount of companies that speak about being development-oriented, but what they don't have is the full scope of development and construction services, beginning at the design phase and going through the estimation, the bidding process and project management, and ultimately the completion of the buildings as general contractors," he says. "We're very unique in that aspect in the REIT industry, and that allows us to deliver a complete product to the customer, and most profitably, to the shareholders."

But that doesn't mean Duke isn't on the lookout for strategic acquisitions like the Winkler portfolio and a former General Motors plant in Baltimore. In early February, the company announced that it would transform the 184-acre site into a nearly 3 million square-foot industrial park. Construction is expected to begin within the next 12 to 18 months following demolition and environmental remediation of the current site.

"All told, Duke's expected return on investment (not disclosed) could average a very respectable 10 percent," Sakwa wrote in January.

Earlier this year, the company announced its purchase of a nearly $195 million industrial portfolio near the Port of Savannah, Ga. Oklak says the 18-building, 5.1 million square foot property is the company's first entry into the Savannah market.

"We're intent on continuing our geographic expansion in 2006," Oklak says.

Grappling With Growth

For his part, Chapman sees this year as a time to focus on achieving the goals Duke has set out before itself. "The big word for us in 2006 is execution," he says. "We've set out all these new initiatives: the move into the medical office business, the national development group, doing build-to-suits for clients all around the country, geographic expansions, and a huge development pipeline. What we want to do for 2006, really, is execute."

That means shoring up the Houston and Phoenix offices, which currently have just opened with the purpose of establishing a development beachhead. It also means keeping an eye on markets such as Las Vegas and Los Angeles's Inland Empire, two of the major markets that Duke hopes to penetrate within the next few years.

Cohoat says that Duke management is looking into West Coast opportunities that resemble the Winkler portfolio—acquisitions that will help land the company in some of the country's most hotly contested markets. In particular, Duke will be eyeing the Inland Empire for good deals. However, Oklak says that goal is for the future.

"We've got our hands full right now with these new markets, but I would say that the Southwest markets look attractive to us," he says. "Obviously, California is a great market, but I think it's going to take us some time to get there, because it's a very competitive market. Also, other (attractive) markets when you look at distribution are Pennsylvania and New Jersey."

When it comes to expanding Duke's presence in current markets as well as establishing itself in newer territory, Chapman says the company's strong credit rating and high debt rating will counter rising interest rates and higher post-Hurricane Katrina construction costs. He also credits Duke's in-house construction company with helping lower development costs: "We can build things less expensively, as long as we can get the good people and the strongest local leasing team, then we feel like we have the right ingredients."

He points to its 1,100 employees as the company's strongest single asset. "Our staff cuts across all disciplines," Chapman says. "We are fully vertically integrated in terms of leasing and property management. We have an in-house construction team, an in-house legal team. It's soup to nuts."

Chapman also credits high tenant-retention rates—with renewals in the 80-percent range—and the company's stock of newer products will continue to keep Duke competitive as it continues checking off items on its ambitious to-do list.

"We've developed almost everything we have now, and our properties have an average age of 10.5 years," he says. "The flex portfolio (that we sold) was older property. Everybody likes the shiny new stuff. Also, we're aggressive in terms of trying to keep the property leased. We're in a huge pickup. Just in the last quarter in 2005, we leased 10 million square feet."

Duke's total portfolio is currently 92.6 percent leased, Chapman says.

UPSIDE-DOWNSIDE Samplings of what analysts are saying about Duke Realty Corporation Prudential Equity Group, LLC RATING: NEUTRAL WEIGHT (1/26/06) TARGET PRICE: $29 "As an active developer, Duke continues to face a period of declines in development yields during the current downturn from a combination of rising construction costs, market competition and low interest rates. However, if the Midwestern and Southeastern office markets recover more quickly than we anticipate, results may exceed our estimates, allowing the shares to trade above our target price." Stifel Nicolaus RATING: HOLD (1/27/06) TARGET PRICE: NA "Duke is aggressively moving out of the Midwest toward stronger markets such as Washington, D.C. and Savannah in an effort to recharge a portfolio characterized by high cap-ex costs and sluggish growth." Citigroup Investment Research RATING: HOLD (1/25/06) TARGET PRICE: $34 "If the continued weakness in demand for office and industrial real estate in Duke’s Midwest and Southeast markets, along with increased supply were to reverse course—particularly in the industrial sector—this could cause Duke Realty to outperform our earnings estimates, and our target price could therefore prove to be too conservative." Banc of America Securities RATING: NEUTRAL (1/27/06) TARGET PRICE: $34 "Duke presumably paid top dollar for the Winkler assets, with a low going-in yield, and its JV partner has not yet been secured. In addition, tearing down and rebuilding the Baltimore site will be time consuming in a market with lackluster fundamentals."

Local Company, National Scale

The long-term intent behind going national isn't merely a grab for territory. Chapman says the company is looking to be number one on local as well as national levels. "We're trying to be the best local company in each of our markets," he says. "Real estate is a local business, very local, and our biggest competition in every city are the local developers. We want to be the best in the local market and then bring all the market power of being a national company to a local platform."

That means staying the current course: continuing to build up current markets, more fully establishing newer territory, and keeping an eye on likely investments for the future. "In our view, Duke is making strides toward becoming a first-tier player among U.S. industrial REITs," Stifel Nicolaus' Fick says.

Taylor agrees. "Duke is taking the right steps to reposition its portfolio for market and long-term performance," he says. "You don't turn around an $8 billion balance sheet overnight, but certainly the steps they've been taking, the sale of the flex portfolio, bulking up their industrial developments, making industrial acquisitions, getting into the medical-office business, these are the steps that they need to take to effect the portfolio, and they're doing it."