Why Sky-High Vacancies
Haven't Caused a Crisis

MALVERN, Pa. -- In the late 1980s, Rouse & Associates was a real-estate gunslinger. Led by its charismatic founder Willard G. Rouse III, the developer -- famous for Philadelphia's soaring Liberty Place -- threw up dozens of shiny buildings without tenants. It amassed mountains of debt and ran an organization that had no titles and no committees, and frequently conducted job interviews in bars.

Mr. Rouse's rules: "Make money, have fun." Then in the early 1990s real estate crashed, and the fun stopped for Rouse and the rest of the industry. The national vacancy rate edged toward 19%, and hundreds of developers went bust, as did more than 1,400 federally insured thrifts and banks. Rouse defaulted on $117 million in mortgages, saw its prized developments auctioned on courthouse steps and fought off lawsuits.

Now Rouse is back, and its revival shows just how much the real-estate business has changed in a decade. With little notice, vacancy rates have shot back up, almost to the red-alert levels of the crash. Yet few office developers have gone bust, thanks to sweeping shifts in the structure and culture of the industry.

On the surface, the numbers haven't looked this grim in over a decade. The office-vacancy rate is 17%, just a couple of points short of the 1992 record, according to Reis Inc., a New York real-estate research firm. And some markets are as bad or worse. San Jose was 17% vacant then and 24% today. Dallas 25% then, 25% now. Atlanta 19.5% then, 19.8% now. Boston, Austin and Chicago are all worse today. Parts of Silicon Valley are a ghost town. Denver's telecom corridor is a desert of empty parking lots.

But real estate has become an island of creditworthiness. U.S. corporations defaulted on more than $105 billion in corporate debt in 2002 alone, while real-estate companies haven't had a corporate-debt default in 10 years, according to Moody's Investors Service. Commercial mortgage delinquencies today are 0.4% -- a sliver of the 7.5% rate in 1992 that wreaked such havoc.

"Normally, you'd be seeing a tremendous amount of bankruptcies, foreclosures, delinquencies," says George Emmons, who heads commercial real-estate lending at KeyCorp's Key Bank unit, a lender to Taubman Centers Inc., Forest City Enterprises Inc. and other big developers. "We're not seeing any of that."

What changed was a transformation in how commercial real-estate gets its money. Many of the developers that survived the crash went public and paid down their debt with investor capital. The scrutiny of corporate boards, and the collapse of the free-lending savings and loans, now helps ensure that developers won't take on loads of new debt. That means they can react swiftly to downturns without dealing with layers of red tape from their bankers.

Going public also opened the developers' records to public scrutiny. In the old days, construction statistics and other important data were closely guarded secrets. Developers can now look at competitors' numbers and tell at a glance if an area is becoming overbuilt. Meanwhile years of plunging interest rates were crucial in helping developers manage their debt.

The result: In mid-2001, as vacancies lurched up, U.S. development ratcheted down to a nominal amount, 40 million square feet last year, from 115 million in 2001.

In its heyday, real estate was believed to be the one asset that would always hold its value, regardless of conventional metrics. Glitzy, marble-clad skyscrapers were believed to possess near-talismanic powers to create value. The names of their developers -- Reichmann, Trammell Crow, Rouse -- fired the public's imagination, lured tenants and lulled lenders.

That's over. Office development these days is about as glamorous as a low-rise box in the suburbs. The entrepreneurial titans have begun to leave the stage, replaced by managers with less vision -- but maybe a few more organizational skills.

Those changes are on vivid display at Rouse & Associates. Now reorganized and publicly traded under the name Liberty Property Trust, the company has a $3 billion market capitalization and property stretching from Minneapolis to the U.K. Its shares returned 19% annually during the three years ended last Friday, according to Green Street Advisors Inc., a real-estate research firm in Newport Beach, Calif. (Rouse & Associates was unrelated to Rouse Co., a mall developer founded by Willard Rouse's uncle, James Rouse.)

"It's still the same people," says Joseph P. Denny, an executive holdover from the old days. "The only difference is, things have to make sense."

Mr. Rouse, who died last May at age 60, started developing warehouses in Southern New Jersey in the 1970s. He made a prescient move in 1974, buying 650 acres in Philadelphia's northwestern suburbs that became the bustling Route 202 tech corridor. He caused an uproar in the early 1980s by challenging a Philadelphia rule against new buildings rising higher than William Penn's statue atop City Hall. After a noisy debate, he built Liberty Place -- two soaring towers that reshaped the skyline.

Like most developers then, Rouse & Associates was a collection of limited partnerships -- 200 of them around the country involving 130 partners, who controlled their own checking accounts, collected their own rents and hustled for their own loans from local banks.

The common thread was Mr. Rouse, who set the tone for the company. He wore ugly green sport coats, played pinball until all hours at roadside bars and dressed as Santa at Christmas parties, one year presenting a guest with a piglet. Operations were equally casual, with strategic decisions made on the basis of Mr. Rouse's "gut."

The unraveling began with the Tax Reform Act of 1986, which revoked commercial property's huge tax advantages. Then a recession shut down demand. Property values collapsed, lenders called in loans and developers went bust.

After laying off half his employees in the early 1990s, Mr. Rouse scrambled to raise cash, pay down debt and save the company. With banks, insurance companies and other traditional capital sources either bankrupt or fleeing commercial real estate, he turned to Wall Street, which in the early 1990s was busy reorganizing beaten-down real-estate companies and selling stakes to the public. Rouse & Associates went public as Liberty in 1994, and shareholders insisted on a normal corporate organization and financial controls. Dozens of checking accounts once controlled by regional managers were closed, and regional treasurers were fired or moved to headquarters in Malvern. The company wrote its first balance sheet.

And, as happened throughout the industry, old ways of doing business dried up. Liberty can't load up on debt now that the freewheeling savings and loans are gone, tougher lending regulations are in place and shareholders are watching every move. Liberty's debt today is slightly lower than average, about 45% of the value of its assets, compared with 127% in 1991, when interest expense ate up two-thirds of revenue and led to default.

Risk-averse stock and bond holders also second-guess capital spending. Fear of a shareholder backlash is making Liberty proceed cautiously on its only trophy project: One Pennsylvania Plaza, a $370 million, 55-story tower planned for downtown Philadelphia. With so much capital at risk in a single deal, "it's not my favorite thing," grumbles David Oakes, a senior research associate at Cohen & Steers Capital Management Inc., New York, one of Liberty's biggest shareholders.

A rival REIT, Brandywine Realty Trust, is developing the 28-story Cira Centre tower, a few blocks away. Most brokers agree the market can handle -- at most -- only a single new tower, and the first out of the ground has the best shot.

But instead of racing to be first to build, the developers are locked in a fierce struggle to lock in tenants. Brandywine, based in Plymouth Meeting, Pa., scored a big victory last month when it signed two law firms to take up about half of its project's planned 690,000 square feet of office space. Brandywine broke ground within days.

Liberty, meanwhile, is left to reassure investors that its project won't leave the ground until it signs its own anchor tenants. "First of all, Liberty management wouldn't do it," says Stephen B. Siegel, a Liberty director. "Secondly, the board wouldn't allow it."

Spending controls have downsized and reshaped office buildings, which in the 1990s were typified by the hundreds of squat suburban buildings that sprang up from Silicon Valley to Route 202. Nothing in the decade matched the glitter -- and risk -- of a typical '80s trophy, such as the soaring Momentum Place, now Bank One Center, in Dallas. Smaller, cheaper buildings mean lower margins, but lower risk.

Style has been a victim of tight budgets. On a recent Tuesday, Robert Fenza, Liberty's chief operating officer, and a dozen designers, engineers and executives sat in a windowless room amid stacks of notebooks and drawings, parsing details of an assembly line of suburban rectangles. The discussion centered on utilitarian issues such as the number of steps from the farthest parking space to the door and where a sign goes.

The design for one building was so bland that Mr. Fenza suggested adding lights on window ledges to add "night drama." And the back of the building looked so much like the front that Mr. Fenza suggested a flagpole and landscaping -- something that said, " 'This has to be the entrance.' "

At one point, Ward Fitzgerald, a Liberty leasing executive, jokingly suggested ordering the same interior finishes for all four buildings under review. "Nobody's going to notice," he said, to laughter.

All the caution paid off in the past three years, as the bottom dropped out of the U.S. office market. The speed and ferocity of the downturn -- an eight-percentage-point rise in vacancy in 2001 and 2002 -- shocked brokers and developers. Developers had gotten in trouble by overbuilding before, but for the first time in generations the nation's office-space needs actually tumbled, as big tech, telecom and financial companies put entire buildings on the sublease market.

But unlike last time, when landlords were stuck paying for empty buildings they had built speculatively, tenants this time are holding a big chunk of the space. In a typical deal, software provider Siebel Systems Inc. three years ago signed a lease at about $784,000 a year to expand operations on a floor of a Liberty building in Wayne, Pa. It never moved in and still can't find a subtenant, even after slashing rents 35% from what it is paying, about $28 a foot. On a walk through the space, plastic sheets still cover fluorescent lights and rows of new wood-and-glass workstations sit empty.

In a statement, Siebel, San Mateo, Calif., says many companies made big real-estate commitments during the late '90s growth and that it has since "restructured these commitments to reflect the current economic environment."

Moreover, this time around, developers have much greater latitude to cut deals with faltering tenants. In the past, banks -- which supplied developers with most of their capital and had a say in any deals with tenants -- often blocked such moves. Last year, Liberty cancelled leases valued at $16 million and took $1.6 million cash from VerticalNet Inc., a supply-chain software provider in Malvern that had ballooned from three employees in 1995 to 1,700 before its stock collapsed. VerticalNet's CFO, Gene S. Godick, says Liberty's alternative would have been to line up as a creditor in a bankruptcy proceeding and perhaps get nothing.

For all of developers' new strengths, they're still looking at a grim 2004 with only tepid job growth expected. And rising interest rates could add more pain. But apart from a few real-estate companies' cutting dividends, the sector isn't expected to cause widespread problems for the economy, as it did last time.

"The stability in this business is astonishing," says Daniel P. Garton, an executive vice president of AMR Corp., American Airlines' parent, and a Liberty director. "Heck, my company lost $3 billion" in 2002.

In January 2002, Mr. Rouse announced he had lung cancer and stepped down as CEO. With Mr. Rouse's support, the board promoted Executive Vice President William P. Hankowsky to president, then CEO. Mr. Hankowsky, Philadelphia's former economic-development chief, concedes he isn't another Bill Rouse but adds Liberty may not need one. One of Mr. Hankowsky's first big investments wasn't even in a building, but in a $7 million computer system. Mr. Rouse rarely even used a computer.

"We're at another stage in the company's life," he says. "It's not five loud and crazy guys trying to do real estate anymore."

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