Publications

- November 1, 2018: Vol. 5, Number 10

Rethinking adaptive reuse: Obsolete properties may become the next big institutional-grade product category

by K.C. Conway

Adaptive reuse has been garnering headlines for more than a decade, but it is no longer only about repurposing beautiful, historic properties in primary markets to entice millennials. Many less-attractive but equally newsworthy projects are starting to appear in lower-priced secondary and tertiary markets, where investors see adaptive reuse as a driver of net operating income and yield.

For institutional and private commercial real estate investors, adaptive-reuse projects offer a compelling way to countervail soaring construction costs and move up the risk curve to generate higher yields.

We predict adaptive-reuse projects will make up a greater percentage of investment activity than self-storage and other established noncore property types by 2023. But the commercial real estate industry’s understanding of this property segment is not keeping up with this growth, and capital will not flow to what it cannot measure, monitor and manage. The absence of a clear definition, metrics for analysis, and local collaboration for adaptive reuse real estate impedes investment and development.

(RE)DEFINING ADAPTIVE REUSE

To develop a recommended industry definition for adaptive reuse, Alabama Center for Real Estate and CCIM Institute interviewed a broad cross section of industry participants, including developers, brokers, municipal government leaders, CCIM instructors, Counselors of Real Estate, lenders and investors. Using their input, we determined the following elements are necessary for a project to qualify as adaptive reuse:

  • Existing structure: While adaptive-reuse projects may involve some level of new construction or an expansion/addition of space, they always start with an existing structure.
  • Functional and/or economic obsolescence: All adaptive-reuse projects begin with a property in a state of disrepair, high rate of vacancy, or with highest and best use in transition. In essence, the old use is no longer productive or economically viable, and the tenants have left.
  • Change of use: The project/property must involve a repurposing of a prior structure and use, not a mere re-tenanting with tenant improvements. This key point distinguishes our methodology from other industry research on adaptive reuse.
  • Economic viability: The new project/property must pass the ultimate test of highest and best use. Not only does the reuse need to be physically possible and legally permissible, but it also has to be economically viable. Local government incentives are sometimes necessary to make a project economically viable because of the cost of assemblage, higher repurposing costs with a greater cost-overrun risk factor than new construction, and speculative lease-up risks.

Other elements are common among adaptive-reuse projects but are not prerequisites for classification. Many involve costly rezoning, for example, or local ordinance variances. Communities such as Tucson, Ariz., have incentivized adaptive reuse by officially addressing some of these impediments, thus saving developers time and money.

Also, local community support and a local developer or project team are front and center in every large-scale, successful adaptive-reuse project that we studied. In addition, most adaptive-reuse projects involve multiple uses, which requires project participants to be skilled in more than one property type, as well as market analysis.

With an official definition for adaptive reuse, we can begin to quantify investment activity and further encourage the transformation of cities across the country.

QUANTIFYING ADAPTIVE-REUSE ACTIVITY

We estimate the United States has an existing inventory of nearly 32 billion square feet of commercial office, retail and industrial warehouse space. (This was calculated by triangulating available information from national commercial real estate brokerages, leading data-aggregating companies, and government data sources. It does not include MSAs with a population of less than 50,000 people, buildings associated with academic institutions, or government-owned and -occupied space.) In addition, the United States has an estimated 11 million multifamily units and 2.5 million hotel rooms. All together, that amounts to an estimated 32.3 billion square feet of core commercial real estate space. Adaptive-reuse activity is commingled with, and thus hidden among, those billions of square feet.

As a result of this data void, developers, lenders and equity investors have no source to turn to today that can translate how much of this existing multifamily, hospitality, office, retail and industrial space has been or is currently undergoing adaptive reuse. (Among the major data-aggregating and reporting enterprises, only one is currently capable of segregating adaptive-reuse activity in a useful way: Dodge Pipeline, the nation’s oldest construction database. But this assumes that adaptive-reuse projects can be uniformly defined, coded and segregated.) Developers, lenders and investors are unable to discover the impact adaptive reuse is having on existing inventory — and the market implications for absorption, vacancy and rents — without engaging in an expensive and time-consuming custom market and feasibility study.

To put the significance of this data void in perspective, we identified and studied recently completed or in-process adaptive-reuse projects totaling more than 33 million square feet with a value of approximately $4.4 billion. The sample included projects across all U.S. regions (Northeast, Mid-Atlantic, Southeast, Midwest and West) and encompassed more than 20 major MSAs, such as Tampa, Fla.; Washington, D.C.; Atlanta; Austin; Boston; Memphis; and Chicago.

Collectively, this sample set of projects represents the equivalent of 1 percent of the aggregate commercial real estate space for all property types in five of the largest U.S. metropolitan areas: Los Angeles, Chicago, Dallas-Fort Worth, Atlanta, and Charlotte, N.C. That 1 percent can materially alter supply-and-demand metrics. In other words, the current level of adaptive-reuse activity is enough to impact absorption, vacancy and rental rates for any property type in almost any primary or secondary U.S. metro.

Using this sample, we estimate adaptive-reuse projects constitute between 1 percent and 2 percent of all commercial real estate space in the United States today. That figure will likely increase by twofold over the next five years, to up to 4 percent, largely thanks to store and mall closings, as well as the impact of e-commerce and artificial intelligence, which will render many properties obsolete. This means, as a property-segment percentage of total commercial space, adaptive reuse will likely surpass other recognized noncore property types, such as self-storage.

Adaptive reuse is in the early stages of its development lifecycle. It will be a key source of both redevelopment and investment opportunity in the coming years, in much the same way as historic structures became investment-worthy in the 1980s until their demise with the Tax Reform Act of 1986. ACRE and CCIM Institute will continue to track and report on this progress.

LOCAL COLLABORATION

The expected acceleration of adaptive-reuse investment also requires collaboration from local governments. Vacant structures are creating blight in markets across the United States, and local governments are losing revenue from both declining sales and property taxes as retail stores close and prior growth industries, such as financial services, contract. How can cities replace lost sales- and property-tax revenues from closed stores and branch banks? Ironically, the solution is what local communities least understand and most resist: reusing a structure or property. It is a fear of the unknown and a lack of example that most often keep local cities from permitting an adaptive-reuse project. In the coming years, local governments will invest more economic seed capital to germinate the bright that will eradicate the blight.

In December 2016, Tucson Mayor Jonathan Rothschild and the Tucson city council voted to implement a 24-month pilot program to encourage adaptive reuse, modeled after similar programs used in Phoenix and Los Angeles. The program incentivizes developers and business owners to repurpose existing buildings within the city limits while maintaining and enhancing the current structure.

Adaptive-reuse projects typically involve controversial and costly rezoning and local ordinance variances for items related to density, parking and compliance with any number of modern building codes unrelated to life-safety. Communities such as Tucson are starting to address zoning codes and other unique adaptive-reuse challenges to accelerate the reuse of empty buildings, which can restore the property-tax base and attract new businesses.

The Tucson program primarily focuses on buildings that are 50 or more years old, or that have been vacant for 30 years or more, but it also makes allowances for buildings that are at least 30 years old. Projects are also required to provide community benefits and ensure consistency with the plans of the surrounding area and neighborhoods. The incentives for developers and investors include relaxed parking, permit fee waivers, and flexible density and zoning requirements.

“This program will make it easier to get new businesses into old buildings. … [It] will save developers time and money while boosting the economy through job creation and a proliferation of construction projects,” Jonathan Mabry, the city’s historic preservation officer, told Inside Tucson Business in 2017. “The collateral effects of adaptive reuse include increased density in our urban core by putting vacant buildings back into use. Historic preservation is achieved by giving new lives to our vintage and historic buildings, and sustainability is created by recycling entire buildings.”

The city of Tucson is on the forefront of adopting policies to encourage adaptive reuse, particularly among smaller markets. It is a model for other cities looking to pave the way for more adaptive-reuse activity to stimulate the local economy and put empty buildings back to productive use. But until we see widespread collaboration from local governments, legal and ordinance/zoning challenges will prevent adaptive reuse from making a positive impact in many markets. According to industry participants, in cities that do not have a support structure like Tucson’s, adaptive-
reuse projects are not for the “faint of heart” or undercapitalized.

K.C. Conway is CCIM Institute’s chief economist, and the director of research and corporate engagement at the Alabama Center for Real Estate housed within the University of Alabama’s Culverhouse College of Business. This article is an excerpt from the 3Q18 Commercial Real Estate Insights report from CCIM Institute and the Alabama Center for Real Estate, which redefines, quantifies and provides best-practice examples of adaptive reuse. To read the full report, visit https://www.ccim.com/insights.

 

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