When Equity Office Properties unloaded $2.7 billion worth of property in non-core markets such as Cleveland, Houston and Philadelphia last year, executives with the Chicago-based giant thought it would take three to five years to complete the disposition strategy. Thanks to soaring demand for office assets, however, it took just one.

But the REIT still managed to make $1.4 billion in acquisitions, including 1095 Avenue of the Americas for $505 million in New York. Equity office also has some 2.3 million sq. ft. under construction in a development pipeline valued at $1 billion. Included in that total is a 600,000 sq. ft. speculative office building in Bellevue, Wash., that Equity Office will begin building later this year.

Equity Office isn't the only REIT pursuing growth. Amid signs of flattening appreciation and improving fundamentals — year-over-year increases in absorption and rental rates — many office landlords are placing more focus on beefing up net operating income (NOI) in their core portfolios via development, acquisition and management.

The bottom line: REITs are less likely to be the net sellers they've been during the last few years when high demand for commercial real estate allowed office landlords to dump non-core assets or buildings in unfavorable markets.

“It's been a great market in which to sell,” says Jeffrey Johnson, chief investment officer at Equity Office, which cut its dividend per share by 34% to $1.32 late last year. “Some of the properties would have taken a lot longer time to sell [in a different economic environment].”

Core focus

In large part, REITs have fulfilled plans to concentrate their portfolios in large markets that promise more job growth. Chicago-based Trizec Properties, for example, sold more than $1.4 billion in primarily non-core assets over the last two years and reinvested the proceeds in seven markets — coastal areas such as Washington, D.C., New York, Northern California and Southern California.

But in 2005, Trizec acquired about $200 million more assets than it sold, marking the first year since 1999 that the REIT was a net buyer. And late last year, Trizec announced it would buy 13 properties comprising 4.1 million sq. ft. in Southern California from Los Angeles-based Arden Realty for $1.6 billion.

GE Real Estate, a division of Stamford, Conn.-based General Electric, is buying the balance — some 180 properties totaling 14.5 million sq. ft. — for about $3.2 billion in a deal that will effectively fold Arden into GE (see related story on page 16).

“We feel like we're very well positioned to continue to see significant net investment growth,” says Brian Lipson, chief investment officer for Trizec, which owns and operates a 36 million sq. ft. office portfolio. Capital continues to flow into the market, he adds, providing the REIT with joint venture opportunities.

Trizec, in fact, partnered with Principal Real Estate Investors of Des Moines to pay $157.5 million for the 343,000 sq. ft. Victor Building in Washington, D.C., last November. The nine-story, Class-A building located at the city's East End submarket was built in 2000.

Equity Office also has sharpened the focus of its portfolio by “buying back” buildings from shareholders. The REIT considers its stock price undervalued, and last year it used about $1 billion of its sales proceeds to purchase 41.3 million shares for an average share price of $30.87.

“Effectively, we're buying our own buildings cheaper than we'd be able to buy them on the market,” Johnson says. “We've been selling the bad stuff and buying more of our good stuff. So, our prospects for growth have gone up because the quality of our assets is higher.”

Under pressure?

Office owners are hardly shutting the disposition spigot — REIT executives say they'll continue to strategically sell assets. But investment strategies will likely determine how aggressively office owners will market their buildings, says Charles Baughn, executive vice president of capital markets for Houston-based Hines, a privately held development firm with $11 billion in assets.

Traditional real estate funds have recently reached their targeted returns sooner than expected due to the appreciation of real estate, which encourages them to cash out.

Hines sponsors funds that employ several different strategies, from buying value-added properties for a three-year period to owning core properties for seven to 10 years. In early February, a core fund organized by Hines and Japan's Sumitomo Life Insurance Co. acquired the 20-story 720 Olive Way in Seattle from Irving, Texas-based Archon Group.

REITs, on the other hand, generally face less pressure to sell, particularly if the properties are providing decent cash flow and keeping Wall Street happy, Baughn says. In the case of Equity Office, generating what Wall Street considers healthy cash flow might not happen for another year, say analysts. Many REIT analysts want the landlord to take advantage of historically high prices and slim down more. Despite its slew of sales last year, the company still dwarfs other office REITs with some 111 million sq. ft. in about 660 buildings.

But based on comments by Equity Office CEO Richard Kincaid during the company's earnings call in February, the REIT will focus on tax-efficient sales this year, such as Rule 1031 exchanges, rather than pursuing a more ambitious disposition strategy. Why the shift? The REIT has largely met its goals to strengthen its portfolio: year-end 2005 occupancy was 90.4% — the highest level since 2001 — and markets such as Boston, San Francisco, Los Angeles, Seattle and Washington, D.C., now generate 85% of NOI.

Indeed, like Equity Office, several REITs have plowed money into the same cities or other large markets, wagering that their dynamic economies will provide more jobs over the long term than other areas of the country. Ultimately, the thinking goes, that should translate into fuller buildings, growing NOI and steep appreciation.

In Washington, D.C., for example, 11,700 jobs were created in 2005 while unemployment fell 2.8 percentage points to 6% during the year, according to Washington, D.C.'s Department of Employment Services. In San Francisco, meanwhile, jobs grew by 23,000 in 2005, and the unemployment rate dropped 1.2 percentage points to 3.8% over the course of the year, according to California's Employment Development Department.

“If people were convinced that values were going to go down, it would make you a seller,” says Baughn. “But I'm not convinced they're going to go down.”

Sizzling investment sales market

Real Capital Analytics, a New York-based commercial real estate research and consulting firm, reports that 2,810 office properties traded hands for about $101 billion in 2006, compared with 2,184 properties for $75 billion in 2005.

Meanwhile, capitalization rates, a measure of an asset's current cash yield based on the purchase price, fell to 7.4% from 7.9% over the same period. Such a decline reflects rising demand.

Experts anticipate that investors who have targeted other products will set their sights on offices, particularly amid growing concerns that residential values have peaked. Apartment cap rates fell 600 basis points to 6.2% in 2005, for example, while condo conversion cap rates dropped 500 basis points to 5.2%, according to Real Capital Analytics.

“Office has been on the back burner for a while — investment activity has languished since there wasn't a lot of leasing activity,” says Dale Anne Reiss, global director of real estate, hospitality and construction services for Ernst & Young in New York. “What we're seeing now is a lot of leasing activity, and there hasn't been that much new construction.”

Building has indeed remained in check. Office developers completed about 104 million sq. ft. between the beginning of 2003 and the end of 2005, which was about a third of the 315 million sq. ft. built in the three years prior to that period, according to Reis Inc., a commercial real estate data research firm in New York that tracks nearly 70 major metro markets in the U.S. Condo converters have also been removing existing office space from the market, Reiss and other experts note, which has constrained supply even further.

Fundamentals are cause for optimism

Office landlords are noting improvement in real estate fundamentals. Tenants absorbed 61.8 million sq. ft. nationwide in 2005, a 62% increase over absorption in 2004, while vacancy dropped to 14.7% from 16.3% over the same period, according to Reis. Meanwhile, effective gross rents grew 3.3% to $20.65 per sq. ft. in 2005. While not every market is enjoying rent hikes, last year marked the first annual increase nationally since 2000.

Plus, the office sector generated a total return — meaning cash flow and appreciation — of about 19.5% in 2005, compared with 12% in 2004, reports the National Council of Real Estate Investment Fiduciaries, which collects and disseminates commercial real estate performance information from member organizations in the pension fund community.

By comparison, over the same period total returns of retail assets declined about three percentage points to some 20%, according to NCREIF. Apartment total returns grew by eight points to 21.2%.

Still, the stubbornly slow upswing in fundamentals is putting some investors at risk. Many buyers have been underwriting acquisitions assuming rent spikes in the first year of ownership to support aggressive pricing, says Woody Heller, executive managing director for the capital transactions group in the New York office of Studley, a commercial real estate services firm. The spikes have yet to materialize, so bullish office buyers likely will fail to achieve anticipated returns in the initial projected time periods, which have shortened in response to rapid price appreciation.

REITs, meanwhile, are generally renewing leases at rents below the old rates. Equity Office, for example, experienced rent declines, or so-called “rent roll downs,” of 14.5% in 2005 compared with a drop of 16.3% in 2004.

But REIT executives are quick to point out that the old rents date back to the late 1990s or 2000 when rents were peaking — at sometimes absurd numbers. Case in point: Equity Office's 1.4 million sq. ft. One Market in San Francisco hit gross lease rates of $110 a sq. ft. at the height of the dot-com boom.

“We never thought that was sustainable, and we don't think it will happen again,” says Equity Office's Johnson. “But two years ago gross rents were averaging $35 per sq. ft. in that building, and this year they're up about 19%.”

Staking out claims

Many investors anticipate better days ahead for the office sector, and are positioning themselves accordingly. Atlanta-based real estate consulting firm Kingsley & Associates projects that U.S. pension funds will invest nearly $60 billion in commercial real estate in 2006. About $22 billion of that could go toward office product, assuming office continues to account for 37% of pension funds' real estate portfolios, which was the allocation in 2005, according to NCREIF.

Other funds geared toward office assets are attracting billions of dollars, as well. New York-based Tishman Speyer closed a $1.1 billion office fund in January, for example, and Boston-based Beacon Capital Partners is assembling its fourth office fund, which will total $1.75 billion.

Even REITs that have ambitious disposition plans still are intent on growing. Washington, D.C.-based CarrAmerica, which owns and operates some 27 million sq. ft. in 12 markets, plans to sell 1.8 million sq. ft. in Denver and Chicago — all of its holdings in the cities except for One Parkway North in Chicago — and redeploy the proceeds into core markets such as Washington, D.C., New York, Southern California, Northern California and Seattle. For the last several quarters CarrAmerica, too, has pursued a strategy to drill down into fewer markets, and last year it exited Phoenix.

Still, CarrAmerica is focusing more on development to reap cash yields of 8% to 9%, or 100 to 200 basis points higher than acquisitions would provide, says Karen Dorigan, CarrAmerica's chief investment officer. The REIT plans to spend some $200 million to $300 million on new construction this year, including development of a 120,000 sq. ft. building in the South Lake Union area of Seattle.

“We see the development window opening in some markets,” Dorigan adds. “So, we intend to get fairly aggressive on the development side pretty quickly.”

Joe Gose is a Kansas City-based writer.