NEW YORK -- Office buildings in top U.S. markets are getting so expensive that landlords are choosing to build rather than buy, spurring the most development by real estate investment trusts in at least a decade.
Office REITs -- led by Boston Properties Inc., Vornado Realty Trust and Kilroy Realty Corp. -- are planning to plow almost $11 billion into new projects, triple the amount just two years ago and the most in data going back to 2004, according to research firm Green Street Advisors Inc.
Much of that is focused on the coasts, including San Francisco and New York, the areas with the most demand from both tenants and investors.
Prices for office buildings in major markets have surged past peak levels, lifted in part by sovereign-wealth funds and pensions willing to accept lower yields than other investors because they are seeking safe investments.
For REITs, which have to answer to shareholders seeking higher returns, building is often a better option than competing with institutional buyers.
“They’re selling assets and they’re developing,” Michael Knott, a managing director at Green Street in Newport Beach, Calif., said. “They’re going out the risk-reward spectrum by starting more developments rather than buying.”
Projects in the works include Boston Properties’ $1.13 billion tower in San Francisco that will be the headquarters of Salesforce.com Inc. (NYSE: CRM) and the city’s tallest building. SL Green Realty Corp. (NYSE: SLG) plans on constructing a 1,200-foot skyscraper in midtown Manhattan.
Cousins Properties Inc. (NYSE: CUZ) and Brandywine Realty Trust (NYSE: BDN) are developing offices in Austin, Texas.
For Boston Properties, the biggest office-focused REIT by market value, the “vast majority” of new investments are in development, Chief Executive Officer Owen Thomas said on April 30.
The Boston-based company has about $3.2 billion in projects, according to Green Street.
“In our core markets, we are at that point in the real estate cycle where new properties can be delivered at lower cost per square foot and higher yields than where existing older properties are trading,” Thomas said.
Prices for central business district office properties in six major markets -- Boston, New York, San Francisco, Chicago, Los Angeles and Washington -- were 16 percent above the 2007 peak as of April, according to data from Moody’s Investors Service and Real Capital Analytics Inc.
Capitalization rates, a measure of returns derived by dividing a property’s net operating income by its purchase price, have tumbled as a result.
The average cap rate for Manhattan office buildings was 4.5 percent in the first three months of the year, close to the low of 4.4 percent in the second quarter of 2008, according to Real Capital. It reached as high as 6.6 percent as the property market cratered in 2010.
In San Francisco, cap rates were 5.4 percent in the first quarter, down from 7.8 percent in the second quarter of 2010. They hit a low of 5 percent in 2009.
Institutional investors such as sovereign wealth funds and pensions are buying properties in major markets in part because they view those areas as being less risky, Ryan Severino, senior economist at Reis Inc. (Nasdaq: REIS), said.
The yields they get from those buildings are still above 10-year Treasury securities, which yielded about 2.61 percent Monday.
Norway’s $890 billion sovereign wealth fund, the world’s biggest, is trying to fill a 5 percent real estate allocation and is looking to invest in Washington, San Francisco, New York and Boston, Karsten Kallevig, the head of real estate, said in May.
Canada’s two biggest pension funds last month announced separate purchases of stakes in Manhattan office towers.
“A lot of these private equity funds and some of these sovereign wealth funds are going to do things differently than the public REITs would,” Ian Goltra, a money manager overseeing real estate funds at Forward Management LLC in San Francisco, said. “They’re just going to capitalize the acquisition differently and they’re going to out- compete the public REITs for the same building.”
Goltra -- who manages funds that own shares in REITs including Boston Properties, Vornado and SL Green -- said he’d rather see publicly traded office owners construct new properties than buy a building for a cap rate under 5 percent.
“That’s why the public REITs are left to build buildings,” said Goltra, whose firm manages about $5 billion.
There is a “big disconnect” on how Boston Properties (NYSE: BXP) is evaluating acquisitions compared with institutional investors, President Douglas Linde said at a conference last month.
“They’ve got a lower overall total return objective than we do,” he said at the conference, sponsored by the National Association of Real Estate Investment Trusts. “We have the alternative of investing capital in development and being able to find a place that we think we can better allocate our dollars.”
While returns vary depending on the development, they’re generally averaging around 7 percent for Boston Properties projects under way, Linde said.
In addition to the Salesforce tower, Boston Properties is developing 601 Massachusetts Ave., a 478,000-square-foot building in Washington, and 535 Mission St. in San Francisco. Arista Joyner, a spokeswoman for the REIT, didn’t return voice messages seeking comment on the development plans.
Investors have so far rewarded the company’s strategy, with shares up 13 percent in the past year, compared with an 8.3 percent gain in the Bloomberg REIT Index. Vornado has jumped 25 percent, while Kilroy (NYSE: KRC) is up 16 percent.
Vornado, which has been selling assets and is spinning off its shopping center division to focus on its core office and retail projects, has $3.1 billion in developments planned, according to Green Street.
Those are mainly retail and residential projects, including a condominium building on Central Park South in Manhattan that Green Street estimates will cost $1.35 billion.
Mark Semer, a spokesman for New York-based Vornado, declined to comment.
New office development in the United States has been concentrated in 10 markets -- including San Francisco, New York and Houston -- with 70 percent of new construction in these areas, according to Arthur Jones, senior managing economist at CBRE Econometrics Advisors in Boston.
Kilroy, based in Los Angeles, is making big bets on San Francisco, with five projects in the area.
The city is the best- performing U.S. office market after four years of record leasing, led by technology companies, pushed occupancies to an all-time high of 70 million square feet in the first quarter, according to CBRE (NYSE: CBG).
After 15 years of buying and developing office properties in suburban San Diego County, Los Angeles-based REIT Kilroy Realty Corp has reduced its presence here.
At the same time, however, it has been laying the groundwork for 1.4 million square-foot One Paseo, its most ambitious project yet in the county.
Kilroy, which up until the end of 2013 owned more than 5 million square feet of mostly office space in San Diego County, has sold about 1.1 million square feet of that space in the past 7 months to focus on projects it is planning in Los Angeles, San Francisco and Seattle.
The $327 million, 13-property two-part transaction that was concluded in January, included the sale of 13 buildings located on Pacific Mesa Boulevard,
Kilroy said the properties were 93 percent leased. A Starwood Capital Group entity was the buyer.
Kilroy retains more than 1 million square feet in its Kilroy Centre Del Mar property in the Carmel Valley among its other assets.
The firm has worked to get its 23-acre, 1.4 million-square-foot mixed-use One Paseo development at the corner of Del Mar Heights Road and El Camino Real in Carmel Valley built.
One Paseo -- which would feature housing, retail and office uses -- has been controversial with area residents due to traffic concerns.
Kilroy has pledged millions of dollars in major road improvements to both Del Mar Heights Road and El Camino Real to mitigate the impacts.
In the meantime, the Los Angeles-based REIT still owns about 4 million square feet of mostly suburban office properties in San Diego County.
Along with its Kilroy Centre del Mar, Kilroy developed more than 400,000 square feet for Intuit (Nasdaq: INTU) along the state Route 56 Corridor between Carmel Valley and Rancho Penasquitos, just as SR-56 was constructed early in the last decade.
The REIT also owns about 400,000 square feet in the Kilroy Sabre Springs development on Evening Canyon Road.
Most of the Evening Canyon buildings are fully leased, according to CoStar Group (Nasdaq: CSGP).
In April, the REIT sold the 303,000-square-foot 10850 Via Frontera building that Petco Animal Supplies plans to redevelop for its corporate headquarters. Petco, which paid more than $33 million, is slated to move into the space in June 2015.
Even with divestitures, Kilroy claims it will still be the largest suburban office player in the San Diego region.
Kilroy will have an estimated cash return of 7.5 percent on its $1.5 billion of developments, Chairman and CEO John Kilroy said on a February earnings call.
New projects carry risks, including signing up enough tenants and construction costs, said Bob Bach, director of research at commercial real estate brokerage Newmark Grubb Knight Frank in Chicago.
Office REITs try to have tenant commitments for half the space before starting construction, Goltra said.
Kilroy bought a site at 350 Mission St. in San Francisco in October 2012 and started construction without a tenant.
By December, it signed Salesforce to take the entire 27-story building. It is scheduled to open next year.
Kilroy reduced the risks that are inherit in development by pre-signing tenants for its projects, said Michelle Ngo, senior vice president and treasurer. More than 62 percent of its projects under development preleased, she said.
The REIT is increasing its bets on San Francisco, spending $95 million last month for a 3.1-acre piece of land in the Mission Bay area. It plans to spend an additional $355 million to build a 680,000-square-foot office campus.
Office rents are expected to climb 6.4 percent this year in San Francisco, the most in 30 U.S. markets, followed by San Jose, Calif., and New York, according to Reis.
“There are very few public REIT acquisitions of ‘A’ quality office buildings going on,” said Goltra, of Forward Management. “The fact that they kind of step out and take some development risk in a market like San Francisco is OK to me.”