A chill in the air?

After a remarkable run of fair weather for commercial real estate developers, some sectors the construction market could see the first signs of a frost.

Whoever said nothing lasts forever clearly wasn’t an American real estate developer living in the year 2000. After having experienced close to seven good years, many developers see only a continuation of the boom in their industry. And not without reason: As fast as new offices, warehouses, shopping centers and hotels are built, businesses are filling the space. That surging demand, coupled with a relatively benign cost environment, is producing record profits for most property developers. The second quarter saw a hefty 12 percent-plus gain over the same period last year in funds from operations for office and apartment real estate investment trusts, according to an August Merrill Lynch & Co. report. The corresponding figure for all equity REITs was an increase of more than 10 percent.

With the economy booming, it’s not surprising that most commercial developers remain quite bullish. Nonetheless, should the economic climate change, some sectors of the economy could catch a chill sooner than others. Much will depend on the severity of the cold snap. “What happens in the economy is obviously important, but the way in which it happens makes all the difference,” says Bernard Winograd, CEO of Parsippany, New Jersey-based Prudential Real Estate Investors, which manages about $14 billion of commercial equity real estate investments for institutional investors. Most of the commercial real estate sector would experience major problems only in a recession, Winograd argues, but certain players, such as developers of offices and large hotels, “are more vulnerable to a sudden slowdown in the economy because lead times in construction are so long that you can’t adjust supply very rapidly.”

Certain geographic areas and types of development will probably prove more resilient than others. The market should remain quite buoyant in most central business districts, contends Boston Properties chairman Mortimer Zuckerman, as supply is less likely to match demand in downtown areas, where it is harder to build. “I don’t think we’re at a top in the office markets we’re in, and I don’t foresee a downturn in development next year,” says Zuckerman, who is currently developing a 1.1 million-square-foot office building in Manhattan’s Times Square that is 100 percent preleased. “Take the Boston area, Manhattan, the Washington, D.C., area or the San Francisco area. In each case, the vacancy rate in these markets as a practical matter is 2 percent or under. There’s a net absorption in each of these markets - probably at record levels.” Indeed, in this year’s second quarter, according to Northbrook, Illinois-based commercial real estate brokerage firm Grubb & Ellis Co., a record amount - nearly 20 million square feet - of class-A office space was net absorbed in the U.S.

Samuel Zell, chairman of Equity Office Properties, shares Zuckerman’s bullishness on the prospects for central business districts. Partnering with Lehman Brothers, he acquired in August a 45 percent equity interest in New York’s 1301 Avenue of the Americas, a fully occupied 1.77 million-square-foot, 45-story midtown skyscraper. The price: about $90 million, plus the assumption of $550 million of debt. Says Zell, “In an economic slowdown the curtailment of development would be beneficial to holders of existing class-A office properties like Equity Office and Boston Properties,” enabling them to keep rents firm.

Jerrold Barag, chief investment officer at Atlanta-based Lend Lease Real Estate Investments, which invests more than $25 billion in equity real estate investments for U.S. institutions, agrees that many central business districts are capacity-restrained. In Manhattan’s financial district, rents have risen to $35 per square foot, compared with less than $30 per square foot last year. That’s why in mid-August a Lend Lease opportunity fund paid a reported $156.5 million to acquire 60 Broad Street, a 1 million-square-foot downtown Manhattan building that was once the home of now-defunct investment bank Drexel Burnham Lambert.

When the economy slows, however, conditions could deteriorate in some markets outside central business districts. In this year’s second quarter, reports Newport Beach, California-based Green Street Advisors, a real estate research firm, vacancy rates in suburban office markets fell by 100 basis points, to 8.8 percent. Nevertheless, a firm report observed that “it’s easy to become complacent and to project current market conditions well into the future.” Green Street cautions that present portfolio occupancies “are at an unsustainably high level. There is more downside risk than upside opportunity.”

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High-growth suburban office markets would be hit first, says Lend Lease’s Barag. “We don’t think there’s enough profit potential in suburban office development projects to justify the risk of investing in them. So I think the number of starts will fall off as investors become more cautious.” According to Barag, rents on many suburban office projects today fail to justify construction, because existing rents in several markets barely equal replacement cost.

Some local suburban developers - backed by opportunity funds - are in fact already starting to pull back from office construction. Houston-based Hines Co., one of the largest U.S. office developers, says that it expects to reduce construction by 3 million square feet - some 20 percent - this year; most of that reduction will be suburban space. In the Dallas area, where last year’s 12 million square feet of office starts led to a 19 percent vacancy rate by mid-2000, the reduction to about 4 million square feet of starts this year has been especially dramatic.

And next year is likely to be no better. Says Zell, “Development by publicly traded developers mainly targeting suburban markets could curtail growth plans.” The reason: “The industry is scheduled to develop 275 million to 300 million square feet of office space this year,” he says, “and the best guess now is there’s [only] a little more than 200 million square feet of demand.”

That excess space is coming mainly into suburban markets. Says Barag: “Tenants that are out there have been net absorbing lots of space in those buildings. [Many] are suspect credits like dot-coms and others.”

Some office REITs - and investors - agree with that assessment. When Cranford, New Jersey-based Mack-Cali Realty Corp. sought to merge with Dallas-based developer Prentiss Properties Trust, it ran into heavy flak from investors who feared substantial dilution and could see no synergies between Mack-Cali and the largely suburban Prentiss. (In late September the deal was scuttled.) Mack-Cali had previously announced its intention to sell off or reduce its presence in markets with slower growth prospects and increased supply - such as San Antonio, Sacramento and Tucson - and concentrate on key city markets like Jersey City and San Francisco.

Not that it’s exactly doom and gloom. A handful of major suburban markets, including Silicon Valley, northern Virginia, the New York metropolitan area and the Cambridge-Route 128 area in Massachusetts, easily fill sizable new space additions thanks to strong growth in technology and services.

Indeed, some industry observers fear that an economic slowdown would create greater oversupply in the hotel and retail sectors than in the office market. PricewaterhouseCoopers partner Bjorn Hansen, who heads research of the global hospitality and leisure industry, points out that although hotel room construction will fall to about 136,000 this year from its 1998 peak of 161,900, the three-year average of 152,000 is still well above the 92,300 figure that has prevailed for the past 25 years.

Even if room starts decline further, to 118,300 next year, Hansen expects that it will be insufficient to avoid a rise in supply over demand in 2001. That’s partly because he expects real GDP growth to drop, from 4.4 percent this year to 2.8 in 2001, and is concerned that overaggressive construction of upscale hotels catering to the affluent could lead to disappointing revenue gains next year. Says Hansen, “I believe there are close to 40 Ritz-Carltons either under construction or planned to be built over the next couple of years.” With seven other major chains embarking on substantial building programs, some 70,000 upscale hotel rooms are under way or planned. Unfortunately, Hansen says, few of those hotel rooms will be built in strong markets like Los Angeles, Miami or New York, which would have little trouble absorbing them. The consultant wonders how a market like Atlanta or Boston will manage a surge in new rooms in a weak economy.

While some plans could be scuttled, most of those hotels will end up being built, Hansen believes. That’s because hotel chains are using their strong balance sheets to help finance their brands and reap the benefits of long-term management contracts that allow them to receive annual fees regardless of the hotels’ performance. “In the event of an economic slowdown, the chains could find themselves stuck with some hotels, because they don’t always have takeout commitments,” says Lend Lease’s Barag. “A few losses could negate much of the benefit of obtaining numerous management contracts.” The hotel chains insist it’s not a problem, contending that they could run the hotels profitably even if they had to retain them.

Hotel chains now appear to be doing what the retail anchors have been doing for years, says PREI’s Winograd, creating a never-ending supply of anchor stores regardless of demand. As a result, he says, “over the past ten years, we’ve gone from $14 a square foot of retail space per capita to about $20, a dramatic rise. We’ve gotten more disposable income since then, but that’s still a lot of space.” F.W. Dodge, a McGraw-Hill subsidiary that tracks the construction industry, estimates that developers will construct about 290 million square feet of retail space this year, down only 6 percent from a record 309 million in 1999.

In a booming economic environment, the heavy volume of construction doesn’t hurt. Says CEO John Buchsbaum of Chicago-based General Growth Properties, a large regional mall developer with 115 million square feet of space: “Business has been incredibly strong for the past 30 months so that all three of our most recent mall projects opened 100 percent leased. Never before in our history have we had a new shopping center 100 percent leased upon opening.”

Not all the indicators are so rosy, though. Same-store sales growth started to weaken around midyear, according to a monthly report of 59 retailers’ sales by Merrill Lynch’s REIT research group. This July same-store sales were up 2.8 percent year-over-year, compared with 4.7 percent last July. Meanwhile, there are potential signs of overbuilding. General Growth’s new 1.6 million-square-foot mall - the Stonebriar Centre, which has 152 shops anchored by five department stores - opened in August in the Frisco area of north Dallas at a total cost of $210 million. However, next August Stonebriar will face competition from Shops at Willow Bend, a 1.4 million-square-foot mall being developed by Taubman Centers a mere four and a half miles down the road in Plano.

If head-to-head competition is infrequent these days among regional mall developers, it’s not so rare among so-called power centers, malls that are anchored by three or four category killers like Home Depot, Best Buy, Target and other big-box specialty retailers.

About two and a half years ago, developers and movie theater chain operators figured it would be mutually beneficial to build expensive, state-of-the art movie megaplexes in their shopping centers in an effort to attract customers. According to Winograd and Barag, it’s becoming a headache for movie chains and mall owners alike. “Recent severe financial stress among several theater operators because of overbuilding is likely to lead to a round of competitive problems for shopping centers that have been relying on movies as a traffic generator,” says Winograd.

Adds Barag: “There’s a significant overcapacity problem. Attendance is way off.” Theater owners rushed to build 15-to-30-screen complexes. One of the most extreme examples, Barag says, is in Ontario, California, where there’s a 24-screen-plex across the way from a 30-plex. Winograd advises investors to avoid power centers in favor of grocery-anchored strip centers and financially solid department store chains in large regional malls. “They have less risk of obsolescence,” he says.

Already, some fallout has hit mall operators, following this summer’s bankruptcy filings of Carmike Cinemas, Edwards Theatres Circuit and United Artists Theatre Co. Newhall Land & Farming Co. says that Edwards Theatres’ bankruptcy was the reason a buyer canceled the purchase of its Valencia Town Center Mall in the Santa Clarita Valley in California. Edwards has two theater complexes totaling 21 screens and an IMAX 3D theater in the mall and at a neighboring entertainment center.

Investors are starting to feel the pain. Entertainment Properties Trust, a Kansas City, Missouri-based REIT that leases many of its shopping center properties to big movie theater chains, has seen its shares tumble some 40 percent from their May 1999 high of 17.

One sector that looks pretty solid, even in a slower-growth environment, is multifamily apartments. According to Richard Michaux, chairman and CEO of Alexandria, Virginia-based Avalonbay Communities, which has some 40,000 apartments mostly in high-barrier-to-entry markets like Boston and Washington, D.C.: “Even if there were to be a moderating economy next year, it would have little impact because so little supply is available. Instead of an increase of 10 percent in rents - which we have been getting - you might get only 5 to 6 percent rent increases.” He’s less sanguine about the possibility of similar rent increases in a slowing economy in easy-to-enter markets like Atlanta, Charlotte, Dallas, Houston, Las Vegas, Orlando, Phoenix, Raleigh and San Antonio.

On the other hand, several large harder-to-enter markets will remain strong in a weaker environment - including Chicago, Minneapolis and Boston, down through Washington, D.C. “There it’s a great time to be developing apartments,” says Michaux. “We’re in a sweet spot the business hasn’t seen for decades. You can develop a property today, get an 11 percent return on cost and turn around tomorrow and sell that property at an 8 percent capitalization rate.”

Michaux says many private builders are profitably developing apartments to meet today’s strong demand. They include Donald Bren’s Newport Beach, California-based Irvine Co. Bren shrewdly took REIT Irvine Apartment Communities private in mid-1999 (Institutional Investor, January 2000) because REIT shares had been depressed. He paid roughly net asset value - $569 million. Since then rents in Orange County, where most of the developer’s 22,000 apartments are located, have increased by about 8 percent. And while Bren is making hay, publicly traded apartment owners like Avalonbay, Post Properties and Archstone Communities have seen their stockholdings rack up total returns of 20 percent or better since the start of the year.

Certainly, some sectors and regions of the commercial real estate market are more susceptible to economic slowdown than others. As things stand at the moment, however, many developers’ bullishness appears justified. Overall, says Dennis Yeskey, a Deloitte & Touche regional managing director and editor of the Global Real Estate Capital Markets Outlook, “the commercial real estate market next year looks like it will be fairly healthy. In 2001 there will be no excess space odyssey.”

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