Investors Look to Development for Higher Yields
By: Lydia Tan and Martin Standiford, senior vice presidents for development in the Western and Eastern U.S., respectively, at Bentall Kennedy (U.S.)
Bentall Kennedy and Leggat McCall Properties acquired a portfolio near Boston Medical Center that included two existing medical office buildings, three properties intended for redevelopment and two acres for potential multifamily development.
Today’s positive economic outlook and capital-rich environment are leading investors to explore new development opportunities.
AS ECONOMIC GROWTH has emboldened users of commercial real estate to make new space commitments, the apartment, office, retail and industrial markets have experienced declining vacancy rates and rising rental rates. Forward momentum is strongest in the still-recovering office and industrial sectors, while the apartment market continues to see healthy gains after several years of growth. Retail trends remain mixed, based on asset quality and location.
With a promising economic outlook and plenty of debt and equity capital in play, investors seeking higher returns are looking at new development opportunities. Construction levels have increased as a result, but the apartment market is the only property type where supply growth had risen above its 10-year average by the end of 2014. In 2015, industrial construction may modestly exceed historical average levels, and office construction completions are approaching the 10-year average. However, the growth in demand for office and industrial space is also greater than average.
Fundamentals are expected to continue to improve in every property sector this year, even with the faster pace of development, as the tailwind of healthy economic growth bodes well for net operating income (NOI) growth and investment performance. The pace of growth will vary by geography, but in most primary and secondary markets commercial development is still catching up with demand. Virtually nothing was built in the office and industrial sectors between 2008 and 2012, and in recent years almost all development has consisted of build-to-suit projects, with very little speculative development.
Even with rising construction activity, conditions will continue to improve in the office, retail and industrial markets, and the apartment market is unlikely to weaken materially. Although the development forecast is positive across the board, every property type is unique in the pace and shape of demand for new space.
Development volume in key office markets is far below average volume over the past 20 or 30 years, but absorption of existing space has also been slow. In many cities, vacancy rates have been slow to come down even as job growth has ramped up in recent years. One reason is that companies are making more efficient use of space, requiring less square footage per employee than in the past. Another factor is that tech firms and other growing companies are choosing “live, work, play” neighborhoods with convenient access to public transit, near and beyond the central urban core. Many are converting empty warehouses to loft offices. Development and redevelopment opportunities exist in these markets, but demand for high-rise office towers is not what it was in past cycles.
Office market dynamics vary from city to city. In downtown San Francisco, large companies anticipating future growth are leasing much more space than they currently need, creating the potential for a sizable “shadow market” of sublease space. Washington, D.C., which has a history of stable growth even during recessionary periods, has been in a slump for several years because of government cutbacks and space consolidation among law firms. Thus, national trends in office development don’t extend uniformly to all markets — or even all gateway markets.
Industrial development opportunities are driven in part by changes in the supply chain and logistics business. Many large distribution center tenants are looking for high ceiling clearance, modern early suppression fast response (ESFR) sprinkler systems and wide truck courts — features that don’t exist in older inventory and are difficult to retrofit. With very little speculative construction in recent years, the industrial market is ripe for new product that meets the needs of e-commerce users as well as traditional distribution users. The challenge for developers is to find vacant sites in established markets where tenants want to locate. In many cases, the choice is between demolishing obsolete buildings on a well-located infill site to make room for new inventory and developing on a greenfield site in a less desirable location.
Multifamily investors are turning to development to get yields higher than they can achieve through acquisition. Development opportunities are greatest around urban innovation markets, where growth in science, technology, engineering and math (STEM) jobs continues to create demand for well-located apartments with the right amenities. In cities like Boston, San Francisco and New York, apartment inventory has yet to catch up with demand, despite a wave of construction completions in the past few years.
Retail has been slower to recover than other property types, as shown by demand among investors. Office, industrial and apartment properties saw values increase an average of 15 percent in 2014, while retail gained just 5.3 percent. However, retail also enjoyed the highest total return of any property type in 2014, at about 13 percent. It also saw less growth in supply than other property types. Development and redevelopment will play an important role in the sector’s growth, as retailers deal with the challenge of combining e-commerce and brick-and-mortar strategies.
Good Sites Matter
In all property sectors, gaining control of good sites is the key to successful development. Traditionally, investors have favored “shovel-ready” development opportunities to avoid entitlement risks, even though this can limit the upside of a successful project. In the current environment, the competition to invest in designed and entitled development sometimes drives up cost and reduces back-end yields. Investors are still pursuing entitled deals, but are also seeking well-located sites with good development partners where they can add value during the entitlement phase.
Development inherently contains risks beyond investment in existing property. The question investors ask every day is whether the additional yield is worth the risk. The answer depends on the overall economy, supply and demand in the area, the quality of the site and the track record of development partners. In the current market environment, opportunities exist for investors with development experience and strong analytical capabilities to achieve high yields in development.