For First Time Since Global Financial Crisis, Major Public Equity REITs Willing to Increase Leverage to Fund Construction Pipelines
Encouraged by low vacancy rates and steady demand for space across nearly all property types, public equity REITs have recently changed their tune and began reporting plans to ramp up development activity in their pipelines for the first time since the global financial crisis plunged the U.S. economy into recesssion.
It's a discussion that CRE analysts are tracking closely this month as REITs discuss their year-end 2013 results and business plans for this year. As rents edge higher across more markets to the point where new development begins to pencil out, big real estate players finally appear to be willing to increase their leverage ratios to fund new speculative projects.
According to Fitch Ratings, third-quarter 2013 saw a slight increase in overall REIT leverage, the first rise since the 2008-2009 global financial crisis. Should it continue another such quarter it would become an emerging trend, since many REITs have taken on additional borrowings to expand development, the rating agency noted.
REITs raised record amounts of cash last year and were the largest net acquirers of office properties in fourth-quarter 2013, exceeding private buyers, institutional investors and owner users -- all of which were net zero or slight net sellers.
But that elevated level of "buying versus building" activity isn't likely to continue in 2014 in light of the performance of REIT prices since last spring, said Hans Nordby, managing director and corporate officer of CoStar's Property and Portfolio Research subsidiary.
"Based on current trade values in the market, and because most REITs are developers at heart, and generally hold for the long term, I think they will move more into developing buildings rather than buying them," Nordby said during CoStar's recent office market review and forecast. "Development will be more accretive to their growth strategies."
While private equity and institutional investors were also very active on both the buying and selling front in 2013, the lure of rising rents should persuade them to step up this year to place the large amount of acquisition capital raised in recent quarters, Nordby said.
While apartment REITs have been in new-supply mode for a few quarters, office and warehouse REITs are just beginning to see the sweet spot in the development cycle come into view. Net office completions, which totaled 18.2 million square feet last year -- up 45% from 2012 -- are expected to double in 2014 from last year.
Despite declines in their stock values, REITs still wield considerable access to the capital markets at attractive and historically low all-in costs. That allows companies to groom balance sheets and grow the business through their development and redevelopment pipelines as well as via acquisitions.
On balance, Fitch said it views development favorably at this point in the cycle, given balanced supply and demand dynamics for most property types in most markets. Moreover, REITs have generally been conservative in their development activities in the recovery up to this point by limiting pipeline sizes to less than 10% of gross assets while limiting their levels of spec development.
Several REITs, including Duke Realty (NYSE: DRE
) and Kilroy Realty (NYSE), have pointedly embraced development in their respective markets.
For Duke Realty, new construction starts and asset repositioning resulted in an outstanding year for the mixed-property REIT, according to Chairman and CEO Denny Oklak.
The company launched $666 million in new development projects last year, including $362 million in the fourth quarter, the strongest-ever for the company. About 27% of the new projects were medical office and other health care developments, funded chiefly by $669 million in equity raised during the year.
In addition to heightened development spending, Duke logged $540 million in industrial property acquisitions and completed nearly $930 million in dispositions during 2013.
"Our premium MOB development franchise has a strong backlog of potential projects we are working on now; overall, the [MOB] business has tremendous growth prospects," Oklak said.
Duke has had "outstanding success" monetizing office land positions, winning corporate build-to-suit deals and starting substantially pre-leased or speculative developments in such markets as Houston and Raleigh, NC.
"These opportunistic office developments have produced very strong 9% to 10% stabilized yields, representing excellent value creation," Oklak said.
The development program for West Coast powerhouse Kilroy Realty, the most active developer among pure-play office REITs, is "running at all cylinders," said Chairman, President and CEO John Kilroy, who provided color on the company's West Coast developments.
Kilroy recently obtained full entitlements for an additional three stories at the 350 Mission St. office tower in San Francisco, raising the square footage from 400,000 to 450,000 square feet. Salesforce.com will occupy all of the added space, which will cost $25 million.
The company began construction of three other projects during the fourth quarter: 333 Brannan Street in San Francisco's South of Market area, which has been fully leased to Dropbox; Crossing/900 in Redwood City, CA; and Columbia Square in Hollywood.
Kilroy's total under-construction development projects now encompass more than 2.5 million square feet and represent a total estimated investment of $1.5 billion, John Kilroy said. At an average forecasted cash return of about 7.5% and assuming Kilroy could sell the assets at a 5% cap rate, which he said is probably conservative, "that’s over $8 a share, or $700 million, of value creation," Kilroy added.
Kilroy projects 2014 development spending on current construction projects to be about $400 million, with delivery of the campus for business social networker LinkedIn during the fourth quarter and 360 Third Street in San Francisco to be fully occupied late in the third quarter.
Despite the improved climate for new supply and financial stability of REITs, some investors remain concerned over the potential leverage trend, chiefly the possibility that some REITs may take on too much debt for acquisitions and development. Borrowing costs for the sector have increased following the spike in interest rates surrounding the Federal Reserve's tapering comments in June 2013.
On the plus side, acquisition capitalization rates have been relatively stable, partly reflecting strong demand for core CRE assets by institutional investors who are traditionally less sensitive to interest rate changes. Moreover, REITs that are trading below NAV are less likely to fund external investments with new equity, Fitch said.