It seems you can’t go a day without seeing headlines about the creative ways in which an obsolete space is getting a new life, whether it be a retail location turned into a warehouse, an old schoolhouse into multifamily rental units, or a former train station into a shopping destination. These transformations are examples of adaptive reuse (AdRu)—a term that has gained recognition in recent years.
The growth of AdRu has been driven by many factors:
- Declines in developable and entitled land within urban metropolitan statistical areas (MSAs)
- Increased demand for affordable housing alternatives in contrast to cost-prohibitive new construction
- The retail “e-volution” resulting in thousands of closed retail stores that need a new purpose
- Creation of Opportunity Zones from the 2017 Tax Act
- The evolution of the environmental, social, and governance (ESG) movement bringing capital to vacant buildings or blighted urban areas via “impact investing”
Regardless of the influences that have brought AdRu to the forefront of the commercial real estate industry, it’s becoming another core property type, much like multifamily, retail, office, industrial, or self-storage. In fact, according to research I published in a 2018 paper with the CCIM Institute, there are more completed and underway adaptive reuse projects nationwide than all of self-storage inventory or construction. So why doesn’t AdRu have its own category and ongoing research coverage like other CRE property types?
Adaptive reuse challenges
The challenges to adaptive reuse development and investing are well recognized by those who have ventured to dip their toes into these waters. Among the most common challenges in AdRu are:
- Costs due to the unknown of what might be involved in successfully repurposing a building
- Local government opposition—few cities and counties understand adaptive reuse or maintain a segregated zoning ordinance to address the unique issues in repurposing a building, which run the gamut from site utilization/density and setbacks, to parking and life safety
- The absence of data to quantify key metrics needed for financing, such as income and expense ratios, comparable sales to derive capitalization rates, typical absorption, tenant retention and vacancy rates, and allocation of common-area expenses when multiple uses are involved
- Lack of established appraisal methodologies—every adaptive reuse project is unique, and there are few seminars and courses on AdRu to educate appraisers and lenders on how to value or underwrite an adaptive reuse project
- General fear of the unknown by all project participants, from the developer to lenders
The result has been that most adaptive reuse projects are undertaken by local, high-net-worth entities that can devote 50% or more of the needed capital as equity and who are motivated more out of philanthropy or civic-minded goals to address a local blight. These individuals have been the pioneers of AdRu, but now we need AdRu activity to expand to traditional CRE investment and institutional capital channels to truly expand and become mainstream in every MSA. One current project that epitomizes this statement is the adaptive reuse of the legacy Greyhound Bus Terminal in downtown Birmingham, Alabama, by Michael Mouron, chairman of Capstone Real Estate Investments.
In conjunction with my legacy role as the director of research for the Alabama Center for Real Estate (ACRE), I was fortunate to speak with Mouron about not just the story of this unique project, but also his own history with adaptive reuse, in a podcast at ACRE. (This conversation is in Episode 71.) These kinds of projects can vary tremendously, and every case must be treated appropriately to reflect the unique qualities of the existing building and the goals of the redevelopment. The good news is that, as expressed in my conversation with Mouron, we can begin to outline a general framework for how to view AdRu projects and maximize a project’s chances of achieving long-term operational success.
Adaptive reuse explored
The best starting point is to establish a good understanding of what constitutes an AdRu building, and then examine the issues and challenges confronted by the property managers who eventually will undertake management of these types of assets for owners.
The main distinction in this definition is that to qualify specifically as an adaptive reuse, the property must undergo a change of use. Merely updating or restoring a legacy office building to a more modern office use or a retail store to another retail use—such as a department store to a sporting goods store—are not changes of use. The change of use is key. The following elements are collectively 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 commence with a property in a state of disrepair, high rate of vacancy, or with its highest and best use in transition. In essence, the old use is no longer productive or economically viable, and the relevant tenants have left.
- Change of use
The project must involve a repurposing of a property’s prior structure and use, not a mere re-tenanting with tenant improvements. This key point distinguishes our methodology from other industry research on AdRu.
- Economic viability
The new project must pass the ultimate test of highest and best use for the property. 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 due to the cost of assemblage, higher repurposing costs with a greater cost-overrun risk factor than new construction, and speculative lease-up risks.
Managing an AdRu property
With an established understanding of adaptive reuse and its challenges, let’s focus on the property management perspectives of this type of asset—after all, it’s a CPM that is likely to be entrusted with the management of such a complex asset. There are essentially three aspects of property management unique to adaptive reuse that are not always fully appreciated.
- Use combinations and points of friction
Most adaptive reuse properties involve more than one use. Not all uses play well together, and management can be challenging. For example, multifamily and hotel uses, generally speaking, are not complementary. Multifamily residences tend not to be able to absorb their pro rata share of common area and concierge services from an adjoining hotel use. Friction and litigation are common between the HOA and the hotel operating entity and its agreement. However, office and hotel uses are accretive. Before one undertakes the property management of a mixed-use AdRu, understand the friction points that can result between uses. Parking and allocation of common-area expenses are typically the two most contested areas of property management in an adaptive reuse property.
- Tenant leasing and retention
Tenants that opt to occupy an AdRu property generally have two common characteristics. First, they tend to be younger companies that want something different than a generic office building, but they lack the credit worthiness and time in business to satisfy permanent lending requirements. Large credit tenants tend to stay in traditional and institutionally owned buildings for a variety of liability and security reasons; your leasing success will come from a smaller and less credit-worthy tenant. Second, AdRu tenants tend not to move at lease expiration, as they invest more in tenant improvements. The AdRu building itself is as much a part of their business identity as their name. That translates to higher tenant retention ratios. In my experience analyzing adaptive reuse projects across 40 states and over many years, the average tenant-retention ratio in adaptive reuse projects tends to exceed 85%, regardless of use—office, retail, or residential.
- Added complexity
Make sure you get paid properly to manage a more complex property. Despite the fact that most adaptive reuse projects’ mechanical systems have been recently updated, they are hybrid in nature and are often made bespoke to specifically fit a particular reuse. Maintaining systems requires knowing who designed them and where parts can be sourced, but perhaps it’s more important to know what your Plan B is for restoring a system if it goes down and takes days to repair. Allocation of common- area expense among users will be a perennial challenge, requiring more time to explain and document the fairness of the allocations. Leasing approvals will take longer, as you will likely be dealing with a startup company or smaller business with less credit.
Mouron’s bottom line is, “Do your homework and make sure that you get paid to manage an asset to the owner’s expectations.” From my experience, the traditional 3.5%–5% management fee is inadequate. AdRu owners tend to pay at least a 100-basis-point premium when they hire their second management team to replace the original one that couldn’t manage to expectations due to a low management fee. These assets are more complex and require an experienced management team. The message to owners/investors is to budget more for their property management expense—it will pay dividends in tenant retention and overall operations.
Adaptive reuse projects have evolved to a point where they should be considered an asset class of their own, just as we have seen take place with self-storage. The trend is moving toward more AdRu projects as cities struggle to repurpose vacant buildings since the COVID-19 pandemic began. Look beyond retail for adaptive reuse. Think about uses like car dealerships that are going online, along with everything else. Understand the definition of adaptive reuse and that critical change-in-use distinction. ESG and impact investing are finally bringing much needed capital to adaptive reuse opportunities.
Finally, managing adaptive reuse properties is more complex than managing most other properties. Don’t underestimate the cost of doing the job right. AdRu profitability is most influenced by property management after cost overruns in repurposing the building. To property owners and investors, my advice is to not go cheap when hiring property management firms any more than you would when working with engineering firms in the upfront decision to undertake an AdRu project.