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Why Office REITs Are Building Again

Reckson Associates Realty has ambitious plans for the Class-A office building that it is developing in Melville, N.Y., 35 miles east of Manhattan. The 277,000 sq. ft. project will feature a 140-seat auditorium and concierge parking. About 100 acres of parkland will surround the $60 million project. Construction is scheduled to be completed in the fall of 2005, but so far no prospects have signed leases.

Despite a lack of tenants, Scott Rechler, chief executive of the Melville, N.Y.-based REIT, is optimistic about filling the speculative project. “Our other buildings on Long Island are 96% occupied, and there is good tenant demand,” he says.

After several years of hard economic times, some REITs are accelerating development activities in strong markets. Increased hiring by corporate tenants is encouraging new building. REITs that are stepping up development include Boston Properties, Kilroy Realty, and Brandywine Realty. The emphasis on development reflects a shift from recent times when many REITs focused on buying existing properties. But now REITs that want to grow have a big incentive to build from scratch. With investors from around the world bidding on prime office properties, prices of existing buildings have reached record levels, says Reckson's Rechler. Prices have moved well past replacement costs in strong markets.

Cap rates — the initial yield to buyers based on purchase prices — for existing buildings in Washington, D.C. range between 6% and 8%, says David Aubuchon, a security analyst with A.G. Edwards & Sons. But a developer who builds from scratch can receive a cap rate of 10%. “It makes no sense to pay $500 a sq. ft. for a building in Washington when you can develop a comparable property for $400,” says Aubuchon.

Still, developing a new property comes with an element of risk. To avoid vacancy problems, Brandywine Realty Trust is focusing on submarkets where occupancy rates are at least 95%. Even then, the Pennsylvania-based REIT does not begin construction until the project is 50% preleased. The company currently has 75% of space pre-leased in its Cira Centre project, a $180 million development with 727,000 sq. ft. located next to the 30th Street train station in Philadelphia. “We feel confident in building now because we cannot meet the space requirements of our existing tenants,” says Gerard H. Sweeney, chief executive of the REIT, which owns 292 properties in the MidAtlantic region.

Only a few REITs are aggressively pushing into development, says Aubuchon. For most companies, construction of new office buildings seems like a risky bet at a time when many markets still face substantial vacancy rates. Development ties up considerable capital, which can make conservative REIT investors nervous.

To limit leasing risk, some REITs are focusing on build-to-suit work. CarrAmerica Realty, a Washington, D.C.-based REIT, recently completed a 124,000 sq. ft office in Dallas that cost $16 million and was taken entirely by Washington Mutual. Still, REITs are reluctant to develop in weaker markets. “This is probably not a good time to develop in Denver,” says Jamie Williams, president of CarrAmerica Development Inc.

Williams notes that the climate for development shifts with real estate cycles. When the economy grew in the late 1990s, there was pent-up demand for office space and a healthy environment for developers. Then after 2000, the economy slowed, and demand for new space slipped. In 2004, the atmosphere changed in many markets. Now, Williams expects that the stronger economy will absorb new office space. “For the next year or two, conditions should be very favorable for development.”

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