By Chris Zarpas
Commercial real estate, long a haven for investors, must evolve or die.
Threats to the once unstoppable growth in the value of commercial real estate are mounting, depriving the ailing market of the air it needs. Inflation, now running at 8.6% a year, is reducing consumers’ purchasing power, making existing retail tenants weaker and potential tenants jittery, threatening higher vacancy and yields lower for investors. Online competitors are also taking an increasing share of retail sales. Meanwhile, employers are struggling to get remote workers back into the office. Some, particularly in IT, quit when ordered to return. Commuter foot traffic has dropped dramatically, crushing retailers even on Madison Avenue in midtown Manhattan and Chicago’s Magnificent Mile.
Cinemas will never fully recover from the threats of streaming, 4K displays and home surround sound. Regal Cinemas, whose parent company has filed for bankruptcy, operates more than 500 movie theaters in 42 states, which often anchor large suburban malls. Many of these theaters will shut down, as will nearby stores.
Almost all variables look unfavorable to commercial real estate investors, especially higher interest rates.
Many veteran real estate professionals point to a phrase from Charles Darwin’s 1859 book, About the origin of species: “It’s not the strongest species that survive, nor the smartest, but those that respond the most to change.” The upheaval in commercial real estate has arrived; investors will have to be inventive to survive.
This is where Darwin and real estate come together: “adaptive reuse”. In Darwin’s writing, adaptive reuse applies to genetic traits that suddenly become useful in new competitive environments. In real estate, adaptive reuse involves reinventing old, obsolete or abandoned properties. Office buildings or closed factories have become apartments. Enclosed malls become community colleges. Movie theaters become medical offices or video game centers.
Demand for apartments has risen sharply over the past decade as soaring home prices have driven many first-time home buyers out of the market. As baby boomers sense home values may fall, they delay selling their homes, which reduces inventory, driving up prices despite higher interest rates. So why aren’t new homes more in demand? Prices. Building new houses is more expensive than two years ago. With inflation, builders demand higher wages. Add to that supply chain disruptions and higher prices for everything from roof shingles to basement concrete.
Developers are looking for a solution for higher housing demand and higher construction costs and they have found it by converting office buildings into apartments.
Adaptive reuse projects cost 16% less than new construction and reduce delivery times by 18%. Rehabilitating commercial buildings into apartments often qualifies for tax benefits and alternative financing, according to data from national real estate consultant Geneva Analytics. It is therefore cheaper, faster and often more financeable.
An example of this trend: In 2020, Highland Square Holdings redeveloped an aging suburban office building into Mission Lofts, an innovative workspace in Fairfax, Virginia. Hybrid zoning allows for residential and office uses, and Mission Lofts has more parking than apartments to accommodate business clients. The original construction of the offices offers very thick walls between units, full fiber, backup generators and computer cabinets with sufficient electrical capacity to run servers and copiers. Toilets in common areas are available for tenants and guests. “We couldn’t understand why, every year since 2010, the DC area has seen positive job growth, but an increase in office vacancy,” said Highland Square CEO Rob Seldin. “For decades before, office buildings were machines with two essential functions; temporarily store individuals and permanently store information for processing by those individuals. With the introduction of the iPhone, information and office buildings were separated, and that changed everything.
New laws have contributed to this change. The federal telecommuting law, passed in 2010, increased the number of federal employees allowed to work from home. COVID has done the same in the private sector, gutting office buildings – turning adaptive reuse from a niche activity into a mainstream business development category. As a result, office property values have suffered a total net loss of $6.9 billion across 460 properties in CMBS loan portfolios since August 2021, according to a recent Business Journals report. Experts expect the trend to continue.
The “adaptive reuse” crowd is also profitably heading into healthcare. The demand is there: the number of older people is expected to double by 2040. Older people consume health services at a higher per capita rate than their younger counterparts. Combining these two trends, the demand for healthcare real estate will continue to rise. At the same time, inflation has pushed healthcare facility construction costs past $600 per square foot in major markets, and healthcare developers, like their multifamily counterparts, are reporting lengthy delays. Delivery. “Healthcare construction begins in 2022 and totals nearly 53 million square feet, but we are seeing the lowest levels of deliveries since 2015,” said Hilda Martin, director of Revista, the leading research and healthcare real estate data.
Data from Revista shows that healthcare providers have increasingly moved away from sprawling hospital campuses, preferring locations closer to homes and offices. Sites with accessibility, visibility and generous parking are essential. “Health care providers want to go where patients are, making it easier for them to access services. The sooner the better, so adaptive reuse is a good strategy,” Martin said.
PMB, a San Diego-based healthcare real estate developer, capitalized on this trend when it converted a 50,000-square-foot 1980s multiplex movie theater in suburban Phoenix into high-end medical practices. The property is across from an acute care hospital and within walking distance of Target, Barnes & Noble, Total Wine and Chipotle.
Darwin’s thesis – survival of the fittest – predicts the loss of many of these small businesses. Forty percent of small business owners said they couldn’t pay their rent in full in July, up 6 percentage points from June – setting a 2022 record, according to a recent report from Alignable. Research Center. Landlords, under pressure from their mortgage lenders, are demanding full rent from tenants (those who survived COVID) who are now hammered by 9% inflation. Many will close. This is bad news for their investors and lenders, but good news for developers adopting “adaptive reuse” strategies.