Editor’s Note: Periodically, Portfolio sits down with prominent real estate leaders who have helped “pave the way” for the growth of the REIT and publicly traded real estate industry. These visionaries provide their unique take on where the industry has been, where it is now and, most importantly, where it is going.

Mortimer B. Zuckerman, chairman of the board

Edward H. Linde, chief executive officer

Ed Linde and Mortimer Zuckerman of Boston Properties have steadily built the company into one of the most respected real estate companies in the world.

By Charles Keenan
Photos by Christopher Navin

Some REITs have snared class A buildings at top-dollar prices in recent years, but Boston Properties (NYSE: BXP) has been noticeably absent in the buying spree. Instead, the company has sold a few trophy buildings of its own, plowing the cash back into a growing development pipeline that at mid-year 2007 had $456 million of construction projects on the balance sheet and more on the way.

"We are not just a company that acquires buildings, or even other companies," says Mortimer B. Zuckerman, chairman of Boston Properties. "Developing buildings is the DNA of the company. The aim is to recycle these funds into development to achieve a higher yield. That's the practical focus of our activities."

Zuckerman and his long-time partner Edward H. Linde, CEO, have been applying that same formula since founding Boston Properties 37 years ago. The strategy: develop and extract value from class A office buildings in areas with high barriers-to-entry, now consisting of four main markets: Boston, New York, San Francisco and Washington, D.C.

The strategy has certainly paid off for the REIT, which had 134 properties in its portfolio as of June 30, representing 43 million square feet. Funds from operations (FFO) per share this year are expected to rise to $4.60 and to $4.65 a diluted share, up from $4.25 a share in 2006.

Additionally, Boston Properties, which had a total market capitalization of $14.1 billion in mid-September, is also expected to pay a special dividend of $810 million in January 2008, approximately $5.70 per share.

"If we can sell assets at yields of less than 4 percent and recycle those funds into developments that yield 8 percent or greater, it is pretty easy to demonstrate through the math how we are recycling our shareholders' capital in the company in a productive way," Linde says.

Times Square Tower and Five Times Square in New York

Prudential Center in Boston

Trophy Assets

The company has timed the sale of assets and redeployment of capital well. Some of the larger deals include last year's sale of 280 Park Avenue, a 31-story office tower, for $1.2 billion, a record price of $1,018 per square foot.

Recently, the REIT sold the long-term leasehold and other credits on Five Times Square, the national headquarters of Ernst & Young, for $1.3 billion. It also sold the Democracy Center, an office building with approximately 685,000 square feet of rentable space in Bethesda, Md., for approximately $281 million. The REIT also parted with the Long Wharf Marriott in Boston, which sold for $231 million in March.

The recent sales have helped maintain a healthy balance sheet, with approximately $2 billion in cash at the end of the second quarter. Approximately $800 million of the cash will go toward the special dividend, with the balance to be used for reducing debt and financing development.

Consequently, this year's tightening credit markets may give Boston Properties an opportunity to buy property from distressed sellers. "Boston Properties is particularly well-positioned," says Michael Knott, a senior analyst at Green Street Advisors. "They have a strong balance sheet to take advantage of any pricing opportunities due to the dislocation that has occurred in the financial markets."

901 New York Avenue in Washington, D.C.

Generating Returns

Meanwhile, Boston Properties' development projects have put the company in a good position to generate strong returns in the years to come, analysts say. "The development pipeline is very robust," says John Guinee, an analyst at Stifel Nicholaus. "They are aggressive at selling stabilized assets and redeploying the capital into development deals. That is perceived as a very good move in this environment."

The REIT's development portfolio offers plenty of room for growth. On the balance sheet, construction stood at $456 million at the end of June, covering six projects. Yet, when considering its land bank and other projects in the works, Boston Properties expects to add an additional $1.7 billion worth of development by early 2008.

Jonathan Litt, an analyst at Citigroup Global Markets, says the company is trading at a 20 percent discount to underlying net asset value, when it is valued at a 4.5 percent cap rate applied to its portfolio and $1.8 billion of value for land holdings.

Increasing office rents nationwide should also help the bottom line for years to come. While analysts don't expect much gain from rent rollover in its New York portfolio, expiring leases will still be a strong internal growth driver in its other regions, Guinee notes. "They have a positive mark-to-market in virtually all markets," he says.

Spreading Wings

Linde and Zuckerman left the Boston real estate firm Cabot, Cabot & Forbes in 1970 to form Boston Properties. It started with two other employees and grew to 10 by the end of the year. In 1978 the company redeveloped Cambridge Center, a 3 million square foot development, next to the Massachusetts Institute of Technology. The Center was largely credited with revitalizing Boston's Kendall Square/East Cambridge into a first-class, mixed-use office district.

In the meantime, Boston Properties spread its wings to the suburbs, buying sites and developing buildings. It expanded to Washington, D.C. in 1979. Boston Properties then sunk its teeth into New York in 1987, eventually completing an office tower with 1 million square feet in 1987.

In 1997, Boston Properties went public, raising $903 million in capital. Around that time, the REIT acquired key assets like New York's 280 Park Avenue and 875 Third Avenue along with Boston's Prudential Center in 1998. Seizing the momentum, Boston Properties followed with a secondary offering in 1998, raising another $808 million. In the same year, the company entered the San Francisco market, acquiring the Embarcadero Center, a mixed-use complex downtown.

"We've done many great things from our perspective," Linde says. "They have been rewarding because we have made a difference. We always have believed that operating at the high-quality end of the market would pay off financially, but, more importantly, it would give us great satisfaction."

In their zeal for high quality assets, Linde and Zuckerman have set an example for the industry by being ahead of the curve for the assets they develop. Sites such as Cambridge Center in Massachusetts, Five Times Square and Times Square Tower in New York, and 901 New York Avenue in Washington, D.C. were all sites that were not looked upon as prime real estate areas at the time of investment. Now, buildings in those areas are in high demand.

Secondly, Linde and Zuckerman paved the way for the rest of the industry by maintaining the highest integrity in both up and down cycles. Under their leadership, the company has never defaulted on a mortgage, even if it meant dipping into their own coffers during the real estate recession of the early 1990s, when the Boston Properties was private.

Portfolio recently talked to Linde, NAREIT's 2006 Industry Leadership Award recipient, and Zuckerman about the company's strategy, the REIT market and what they have planned for the future.

Boston Properties seeks a significant premium through development of buildings in prized locations. Yet, how do you find such locations in a competitive office market?

Linde: It's both very difficult and very simple. Good locations are very hard to find. However, it's simple in that we have always believed in concentrating in certain regions that we consider to be the best for office development in the country.

Our people are at the very top of the field in both their knowledge of the regions and their respect from the brokerage community and others. We are constantly exploring several opportunities at any given time. It takes hard work.

However, we have people on the ground that have been working in this industry for a long period of time. They understand where the opportunities are and we can, therefore, take advantage of them.

It seems that experience and expertise in high barrier-to-entry markets is critical to success. Can you explain further how some of those relationships work?
Linde: We have relationships with brokers, lawyers and other types of people who are involved in the real estate industry. They spend a lot of time looking around and they know what's happening.

Zuckerman: Additionally, there are a number of property owners who look at different kinds of deals that require a joint venture. Alternatively, they may want to utilize an UPREIT structure, where they get operating partnership units and, therefore, can defer their taxes.

When they look to companies that are in this situation, Boston Properties has done very well in terms of its competitive positioning. People in the real estate community have known of us for many years. We have four decades of experience in the development business and are doing very well for our partners and for ourselves.

Some of your recent trophy sales include 280 Park Avenue and Five Times Square last year in midtown Manhattan. How do you decide it's time to sell an asset?

Zuckerman: We recognized that these assets had been repriced at much higher levels. This is a way of translating our development skills and history into a better valuation for the shareholders. The money we raise from sales can obviously be recycled.

Linde: When we went public more than 10 years ago, the conventional wisdom was that REITs were not the right fit for development, and we couldn't figure out why. We've done development throughout our term as a public company, and we have the same organization in place. For more than 10 years, we have been building successfully. It's not easy—you have to know what you're doing—but it gives you a tremendous advantage over another organization.

Turning to the acquisition market, you have made some purchases recently, such as complexes in Northern California, the remaining interest of Citicorp Center in New York, and the Four and Five Cambridge Centers in Massachusetts. What allows you to get a foothold in these deals without paying too much?

Linde: That is a question of where things are in the cycle. It's no mystery that we've not been making a lot of high-profile or large acquisitions in recent times, for the same reasons we have been selling and redeploying capital into development. The yields from acquisitions, while they may be perfectly acceptable for certain types of owners, are not attractive to us.

On the other hand, we have people in each of our main regions who can find what we describe as "off-market" transactions, where there are other motivations the seller might have for disposing of a property. Those are instances where we are the best acquirer of those assets.

Private equity firms have been able to outbid REITs for properties by using more leverage. How do you see this disconnect playing out?

Zuckerman: There is a different kind of disconnect. By and large, there has been a different valuation of the assets than NAV per share. Usually, the stock has been considerably below that, trading at a discount—without giving any valuation to the ability of the company to generate new projects or higher earnings. That, too, has been a part of the REIT industry. In one sense, it is an attraction for people to invest in REITs.

Linde: You can say that was the good news: REITs were not able to leverage the way some of the other acquirers have done. There is a certain safety margin that is very reassuring, especially for the shareholder. REITs have had conservative balance sheets, and, from a shareholder perspective, that is not a bad thing.

Boston Properties has done very well in terms of its competitive positioning.... We have four decades of experience in the development business and are doing very well for our partners and for ourselves. —MORT ZUCKERMAN

Senior officers at Boston Properties have an average of 14 years of experience with the company. How important is that to your company's success?

Zuckerman: It is critical. In terms of our experience and the talent we have, there is a culture in the company—a certain commitment to the quality of the development and design. It is the nature of how we deal with the towns and the communities we are in, the construction people we work with, the tenants we work with and the brokerage community. These are matters we have worked through for a long time, and we have a particular view of handling them.

This is the first time in the last eight years that REITs may not outperform the broader markets. How would you characterize the nature of the industry this year?

Zuckerman: The fundamentals of the office sector are very strong. Occupancies are high, rental rates are going up and development deals are quite profitable. However, the issue of stock valuations is another matter because they are affected by considerations that are outside of the industry.

There is a broad brush. People think that valuations of real estate are going down if interest rates go up and will change the pricing of real estate. There may be some truth to that. However, we own and develop assets only at the highest level in the value chain. We believe we are in the best markets in the country with high barriers-to-entry. Therefore, the new supply is always constrained. That means we do better in good markets and much better in bad markets.

Linde: The decline in REIT stocks is also about capital flows. Some people may think that even though real estate valuations may not be overvalued, maybe there were some bargains in other parts of the equity markets where people can shift their capital to receive a greater appreciation over a shorter period of time.

However, it's a market. As capital shifts, stock prices are impacted. Just because of the inherent values in real estate, you are going to see a shift back in the other direction.

The future for REITs is very strong and rosy. If the REIT is well managed and delivers on what it says it is going to do, it is going to be rewarded by its shareholders. —ED LINDE

In the office market, particularly in class A properties, do you see breathing room for cap rates to compress?

Zuckerman: To some extent, they are responsive to the overall interest rate environment. However, they are going to be responsive to the perceived market conditions and the ability to increase rents over time.

Today, when you calculate a real estate investment, it's not the current return that is important. The increasingly more important thing is the residual value in the building in five or 10 years, which will bring in future rents. That's a much larger proportion of the valuation of real estate.

The real estate assets—particularly the good ones—were underpriced for a very long time. People now recognize that there are huge residual values that you can count on the same as in the stock market, where you buy the stock not necessarily for the dividend yield but for its ultimate value.

Since you went public 10 years ago, the model of sticking to a few specific geographies has worked very well for you, whereas companies with a national model didn't fare as well. What is the method behind that?

Zuckerman: There were companies that had significant real estate holdings in 20 to 25 markets, and we don't think there are that many good markets in the country. Also, it's a very difficult thing to understand markets with different conditions. Some are more management intensive.

However, we know our concentrated markets well, and we perform the best in terms of investing our management time and capital. So far, it has worked dramatically.

How has the industry changed since you entered it in the early 1960s?

Linde: It has gotten more professional. There is a lot more sophistication in terms of systems such as management and control systems. There's also a concentration in the amount of property held by fewer hands. However, there are still lots of small players out there.

REITs have matured over time into a widely accepted investment class. What do see as the next phase for REITs?

Linde: Investors noticed that several REITs are going private, and they think that means the industry has gone through a cycle. That is not the case at all. The future for REITs is very strong and rosy. If the REIT is well managed and delivers on what it says it is going to do, it is going to be rewarded by its shareholders.