By Chris Zarpas
Commercial real-estate, long a safe harbor for investors, must evolve or die.
Threats to the once irrepressible growth in the value of commercial real estate are crowding in, denying the fainting market the air it needs. Inflation, now galloping at 8.6 percent per year, shrinks the buying power of consumers—making existing retail tenants weaker and prospective tenants skittish—threatening higher vacancy and lower returns for investors. Online rivals are taking a growing share of retail sales, too. Meanwhile, employers are having a hard time getting remote workers back to the office. Some, especially in IT, quit when ordered to return. Commuter foot traffic has declined dramatically, crushing storefront retailers even on midtown Manhattan’s Madison Avenue and Chicago’s Magnificent Mile.
Movie theaters will never fully recover from the threats of streaming, 4K screens, and surround sound at home. Regal Cinemas, whose parent company has filed for bankruptcy, operates more than 500 theaters in 42 states, which often anchor large suburban malls. Many of those theaters will go dark, as will the stores nearby.
A Regal Cinemas remains closed on March 17, 2020 in New York City. (Photo by Victor J. Blue/Getty ... [+]
Nearly every variable seems tilted against commercial real-estate investors, especially higher interest rates.
Many veteran real-estate professionals are pointing to a phrase from Charles Darwin’s 1859 book, On the Origin of Species: “It is not the strongest species that survive, nor the most intelligent, but the ones most responsive to change.” The shakeout in commercial real-estate has arrived; investors will have to be inventive to survive.
Here’s 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 means reinventing old, obsolete, or abandoned properties. Office buildings or shuttered factories became apartments. Enclosed malls become community colleges. Movie theaters become medical offices or video gaming centers.
The demand for apartments grew sharply over the last decade as skyrocketing home values priced many first-time homebuyers out of the market. Since baby boomers sense home values may fall, they are putting off selling their homes — thus lowering inventory, which props up prices despite higher interest rates. So why aren’t new homes in higher demand? Prices. Building new homes is more costly that it was just two years ago. With inflation, builders are demanding higher wages. Add to that, supply chain disruptions and higher prices for everything from roof shingles to basement concrete.
Developers are searching for a solution for higher housing demand and higher construction costs and they found it in rehabbing office buildings into apartments.
Adaptive reuse projects cost 16 percent less than new construction and shrink delivery times by 18 percent. Rehabilitating commercial buildings as apartments often qualifies for tax benefits and alternative financing, according to data from national real estate consultant Geneva Analytics. So it’s cheaper, faster, and often more fundable.
One example of this trend: In 2020, Highland Square Holdings redeveloped an aging suburban office building into Mission Lofts, an innovative live-work building in Fairfax, Virginia. Hybrid zoning allows residential and office uses, and Mission Lofts has more parking than apartments to accommodate business clients. The original office construction offers extra-thick walls between units, full fiber, backup generators, and IT closets with enough electric capacity to run servers and copiers. Restrooms in the common areas are available for both tenants and guests. “We couldn’t understand why, in every year since 2010, the D.C. area saw 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 storing people, and permanently storing information for processing by those people. With the introduction of the iPhone, information and office buildings were delinked, and that changed everything.”
The exterior of the Mission Lofts hybrid apartments in Falls Church, Virginia.
New laws helped drive this change. The Federal Telework Act, passed in 2010, ballooned the number of federal employees allowed to work from home. COVID did the same in the private sector, emptying office buildings — transforming adaptive reuse from a niche business to a mainstream commercial development category. As a result, office property values have suffered a net total loss of $6.9 billion value 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 moving profitably into healthcare. The demand is there: The number of senior citizens is forecast to double by 2040. Older people consume health services at a higher per-capita rate than their younger counterparts. Put these two trends together and demand for real estate for healthcare will continue to climb. At the same time, inflation has sent healthcare construction costs past $600 per square foot in major markets, and healthcare developers, like their multifamily counterparts are reporting long delays in delivery. “Healthcare construction starts in 2022 total almost 53 million square feet, but we’re seeing the lowest levels of deliveries since 2015,” said Hilda Martin, a principal at Revista, the leading healthcare real estate research and data service.
Revista’s data shows healthcare providers have increasingly moved away from sprawling hospital campuses, preferring places that are closer to homes and offices. Sites offering accessibility, visibility, and generous parking are essential. “Healthcare providers want to go where the patients are, making it easier to for them to get services. The sooner the better, so adaptive reuse is a good strategy,” said Martin.
PMB, a San Diego-based healthcare real estate developer, capitalized on that trend when it converted a 50,000-square-foot 1980s-era multiplex movie theatre in suburban Phoenix into high-end medical offices. The property is across the street from an acute-care hospital and in walking distance to Target, Barnes & Noble, Total Wine and Chipotle.
Darwin’s thesis –survival of the fittest - foretells the loss of many of those small businesses. Forty percent of small business owners said they could not pay their rent in full in July, up 6 percentage points from June — setting a record for 2022, according to a recent report by the Alignable Research Center. Landlords, pressured by their mortgage lenders, are demanding full rent from tenants (the ones who survived COVID) who are now hammered by 9% inflation. Many will close. That’s bad news for their investors and lenders, but good news for developers shifting to “adaptive reuse” strategies.
Chris Zarpas is a commercial real estate broker at SL Nusbaum Realty Co. in Norfolk, Virginia.
