Pandemic Causes Large Office, Industrial Developers to Hit Pause on Speculative Construction

West Coast Developer Kilroy Realty Among Latest Companies to Halt New Development Projects

Kilroy Realty Corp., one of the most active developers in the top office districts along the West Coast, said it won't start any new speculative projects and may not begin any new construction for at least a year.

The company is the latest of office and industrial developers from Los Angeles to Washington, D.C., that have announced plans to halt most new construction, especially projects built without signed tenants, as landlords wait to see if they will receive their next rent checks from companies paralyzed by the coronavirus pandemic shutdown.

"Clearly, the bias now versus two or three months ago is to be far more conservative," Kilroy Chief Executive John B. Kilroy told investors last week. "I see no potential for us starting any spec development within the next 12 months, and I don't know that we'll have started any development within the next 12 months." 

Office construction had been booming across the country as part of a record national economic expansion and speculative construction rose as recently as the first quarter of this year, according to brokerage JLL's latest office outlook. Speculative development had been common for years in San Francisco, New York and other large cities as developers bet on the growth of tech, media, coworking and other hot industries. 

But speculative projects have been taking off in secondary cities such as Minneapolis, Minnesota; Atlanta, Georgia; Pittsburgh, Pennsylvania; and Portland, Oregon, all of which had have launched their own first large-scale efforts in speculative office development in the past year. 

Roughly 160 million square feet of office space is under construction totaling about 2% of the nation's total office stock, with tech hubs such as Austin, Texas; San Jose and San Francisco, California; and Seattle, Washington, seeing the most activity, according to CoStar's first-quarter national office report. Slightly more than half of that construction was begun without a tenant signed on to the project, according to brokerage JLL's "First Quarter 2020 Office Outlook." 

Now, the coronavirus pandemic has brought the economy to a screeching halt, and it seems unlikely many firms will be scouting for more space soon, with most workers at home and a potential economic recession on its way. Even Google, the most ambitious real estate user of the big tech companies, said it is pulling back. The delivery of spec projects already under construction is expected to lead to faster vacancy increases and fewer prospects for owners to generate lease income once market activity resumes following the pandemic, according to JLL's first-quarter outlook. 

Office owners ranging from Kilroy to industrial giant Prologis are waiting and hoping that tenants will be able to make rent payment this month. Though Kilroy collected 96% of its April rent from tenants, the company said only one of its three coworking and flexible office space tenants, which make up about 1.8% of annual revenue, paid rent last month. 

"I'm old-fashioned," Kilroy told analysts. "I like companies to make money and can pay rent. I'm just glad we don't have a lot of the coworking space in our portfolio."

Corporate Office Properties Trust, a Maryland-based investor in offices leased to the federal government and the defense and aerospace industry in greater Washington, D.C., said only two 100,000-square-foot buildings in its 2.2 million-square-foot construction pipeline are speculative projects. 

"We would not proceed with another spec building unless we had tenants to fill it," Corporate Office Properties Chief Executive Steve Budorick told investors May 1.

Even fast-building industrial developers such as San Francisco-based Prologis has said it will halt all new speculative projects. Prologis said it will continue to build projects for warehouse users that sign a lease.

Gauging Future Demand

Many office landlords, tenants and analysts are waiting to see whether workers sent home to work after social-distancing and shelter-in-place policies closed their office buildings will return to the office when the pandemic wanes, and what effect it will have on demand for office space, said Paul Leonard, managing consultant with CoStar Advisory Services in Boston.

Even before travel restrictions and shutdowns began in mid-March, CoStar analysts projected the softening global economy could make it difficult to attract tenants to speculative office projects in such cities such as Portland, Oregon; Phoenix, Arizona; and Charlotte, North Carolina. Roughly 160 million square feet of office space is under construction across the country, equaling about 2% of the nation's total office stock, including projects in tech hubs such as Austin, San Jose, San Francisco and Seattle. The new supply is putting pressure on landlords' ability to increase rents, according to CoStar's latest national office report.

Stifel analyst John Guinee doesn't expect office developers to start very many construction projects this year, including Kilroy Realty, which he said has been the most aggressive real estate investment trust in launching large-scale developments. Kilroy's $1.2 billion project pipeline includes the 2.5 million-square-foot Oyster Point development in South San Francisco, Netflix's Academy On Vine facility in L.A.'s Hollywood and the 640,000-square-foot 333 Dexter in Seattle's Lake Union district, set to be finished for Apple this year.

Kilroy also has development land valued at $1 billion, including rights to build its largest project in San Francisco, the roughly 2.3 million-square-foot Flower Mart redevelopment in the city's South of Market district, which isn't scheduled to break ground until next year, Guinee said. 

Corporate Office Properties Trust's Budorick said work continues uninterrupted by shutdowns or quarantines at its construction sites.

"We have experienced some minor delivery delays or disruptions, but we've either resolved them or substituted vendors to maintain our schedules," Budorick said.

Brandywine Realty Trust, one of the largest office landlords in the Texas capital, told investors last month it is expecting to receive an estimated $5 million less in revenue this year from speculative projects in Austin, as well as the Philadelphia area, because of construction stoppages and lower leasing volume. Office and industrial developer Duke Realty Corp. has also halted new speculative construction.

"We think there will probably be some pauses on speculative office development, and frankly, we're in markets where there has not been a lot of that anyway," Brandywine Chief Executive Gerard Sweeney told investors.

Duke Chief Executive James Connor told investors on April 30 that "we have decided to temporarily halt any new speculative development starts, acquisitions or dispositions until we have more clarity around the timing and impact of the post-COVID world."

By Randyl Drummer  |  CoStar News  |  May 6, 2020 | 8:57 A.M.

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