Redlands Commerce Center Redlands, CA Distribution Center 1,313,105 square feet · AMB Property Corporation

Focusing on development brings risks and rewards

By Michael Fickes

Two years ago, declining capitalization rates and high demand for industrial, multifamily, office and retail real estate ignited a round of development. That's not unusual in a real estate cycle. "The lower cap rates go, the more attractive development looks on a risk-adjusted basis," says Dan Fasulo, director of market analysis at Real Capital Analytics.

However, while development produces higher returns than acquisitions, it is also riskier than acquiring properties. "It now seems the industry was at the top of the real estate cycle in early February," says David Harris, a REIT analyst with Lehman Brothers. "So, we may get an over-commitment of capital. People will have either overpaid for stabilized assets or have over-committed to development. That's standard."

If buyers overpay for stabilized assets, their returns won't justify the price they paid. "This is true for REITs," Fasulo says. "Due to their structure, they have to pass through income. But if you accept a 3 percent cap rate for a prime Manhattan office building, there won't be much cash flow to share with investors, at least not in the first or second year, until you can raise rents."

Instead of buying, some REITs turned in recent years to development. However, construction has its risks too. For example, declining demand may hurt individual developers trying to stabilize finished projects. Other risks include the time it takes to move from land acquisition to leased property, the costs of construction, including materials, funding and the constantly shifting market values of property.

Despite the added risks, development offers what property companies and many investors want: a way to boost returns on a risk-adjusted basis.

How Development Adds Value

Property development generally yields higher returns than acquisition, compensating the developer for uncertainty regarding future demand for space and the accompanying level of rents. "If you want to create value in commercial real estate today, you have to look at development," says Ralph Block, long-term REIT investor and former portfolio manager at Phocas Financial. "By developing, you can build a property that yields 6 percent or 7 percent and sell at a 4.5 percent cap rate."

In the retail category, Regency Centers, Inc. (NYSE: REG), a REIT that focuses more on development than acquisition, develops to a pro forma return of 9 percent, while retail assets today are selling for 6 percent cap rates.

"Spreads have widened today," says Brian Smith, CIO of Regency. "When we started developing in 1997, the spread between development return and the exit cap rate was about 150 basis points (1.5 percent). That gave us a 25 percent profit margin over acquisition returns. Today, our returns on a development have fallen from 10.5 percent to 9 percent, but the spreads have widened to 300 basis points."

Including Regency, there are a few REITs that are primarily developers, such as AMB Property Corporation (NYSE: AMB), AvalonBay Communities, Inc. (NYSE: AVB) and Cousins Properties (NYSE: CUZ).

"Only 5 percent of REITs are mostly development companies to the extent that we undertake," says Dan DuPree, president and COO of Cousins Properties, a REIT with interests in industrial, multifamily, office and retail properties.

Falcon Ridge Town Center Fontana, CA 299,474 square feet · Regency Centers, Inc.

Potential Oversupply

In January, Lehman Brothers issued a report entitled "REIT Development Monitor" that identified oversupply as a key risk for property developers. The report stated that the continued pressure of capital flows into the real estate sector is providing liquidity for developers, and some metropolitan statistical areas (MSAs) risk oversupply. Oversupply already has impacted owner-occupied residential markets, and some office markets remain at risk.

"There is no question that more capital is flowing into new development today, more than earlier in the cycle," Fasulo says.

According to Real Capital Analytics research, money flowing into the purchase of commercial land—presumably for development—grew from $8.6 billion in 2005 to $11.3 billion in 2006. During the first six months of 2007, $9.5 billion went toward the purchase of commercial land, suggesting that this year will see another high percentage increase as well.

Companies such as Regency Centers have seen their development pipelines grow dramatically as well. In 2004, for example, Regency's pipeline stood at approximately $750 million. A year later, it had grown to $1.1 billion. In 2006, it rose again to $1.8 billion, according to Smith.

However, despite full pipelines and booming construction activity, the industry does not seem particularly worried about overbuilding right now. "Overbuilding is certainly a concern, but it's not an issue at this point," says Janice Svec, director, REIT ratings group, of Fitch Ratings. "However, there are some local markets where it is a concern."

Timing Risks

According to Lehman Brothers, development activities such as entitlement, construction, design and site preparation are timing activities, since these components of development can take years to complete and variables can change. Underlying pro forma assumptions about supply conditions, as well as macro-and micro-economic environments, can prove to be incorrect. However, for companies that complete substantial pre-leasing, timing risk can be substantially reduced.

"You have to remember that the company is not making money today on the development started today," DuPree says. "Today, I'm selling a project we built five years ago to an 11 percent cap rate. We can sell that same project at a 6 percent cap rate today, but that's a windfall. It all depends on what the cap rates will be five years from now. We believe they will revert to historical norms, around 7.5 percent for office. That means we can build to a 9.5 percent cap rate today and earn 200 basis points then."

Despite recent spreads between development and acquisition cap rates up to 5 percent, the historical spread has usually been 2 to 3 percentage points, he adds.

The problem for developers is to preserve the historical spread by managing the timing issues of construction, design, entitlement and site preparation. "Obtaining entitlements is more difficult," says Gene Reilly, president of North America for AMB. "A complex mixed-use entitlement process can take years. In our business, industrial entitlements are more straightforward, but it is getting difficult to entitle industrial space."

Cost Risks

Interest rates and project costs are the two basic development risks. According to Lehman Brothers, many developers finance projects with construction loans carrying floating rates. A spike in interest rates during construction can drive down returns, as can rising costs of construction.

In the recent past, construction material costs spurred by demand from China and India were rising at a rate of 20 percent per year. "It costs almost twice as much to build a multifamily project today as it did five years ago," says Jonathan Cox, senior vice president of development for the Mid-Atlantic region and Chicago with AvalonBay.

He says that the cost spikes have moderated, but costs continue to rise in some areas. For example, demand remains high in New York City, where concrete costs remain higher than in other markets. "Overall, we project increases in construction costs that are higher than inflation, in the range of 5 percent to 7 percent a year," Cox says.

Chasing Yield

Investors typically award a premium for REITs with a proven, successful development track record. "If I were an investor looking at a REIT's development capability, I would want to know how deep and experienced the team is," Smith says. "If you are trying to create development programs right now in a competitive market and you haven't done it before, you have to think about the possibility that you don't have the best site or the necessary sophistication for getting entitlements or the required experience to underwrite a project."

REITs that lack in-house development expertise often form joint ventures with experienced developers. According to Svec, a typical joint venture will leverage 50 percent to 90 percent of the venture. "For example, if you choose to leverage 50 percent, you and the joint venture partner will put in the other 50 percent as equity, with the REIT contributing 15 percent to 35 percent of that total," she says.

The REIT will earn fees for managing the property. When the property is sold, the REIT will receive a promoted interest based on the value created over development cost. Of course, the profits are split with a partner, but they will probably be higher than what an acquisition would provide.

"Today, we're looking at a REIT market where stock prices are discounting lower net asset values (NAVs), which is a manifestation of lower pricing going forward," Harris says. As a result, REITs committing funds to development now may find that projects won't yield as much as original projections suggested.