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Tuesday
Mar312015

The Value of Repositioning: A Review of Critical Trends and Ideas for Enhancing Building Performance

Gensler's Los Angeles Office. Image © Gensler

Editors’ Note: In late October 2014, a council of architects and designers gathered at the National Association of Real estate Investment Manager’s (NAREIM) Architecture and Engineering Meeting in Chicago to debate new ways real estate may adapt to keep up with the functional and cultural needs of human life. Doug Tichenor, a market analyst in Gensler’s Chicago office, discussed how new function and design can add value to existing core inventory. A version of this article originally ran on NAREIM's website.

The time for repositioning and reuse is now. The era of the single purpose office building is coming to an end, and this reality is being driven by a number of societal disruptions, including technological advancement, outsourcing, increased productivity, and workforce mobility. These changes have increased economic efficiency in the United States and challenged the relevance of the single use building. They have also allowed companies to operate more efficiently with less, forcing building owners, managers and developers to rethink the role of office hierarchy, lease depths, physical presence, and the permanence of space. In order to better position real estate assets, building representatives must ensure their real estate assets can adjust to cost pressures.

This article will explore macro trends that highlight the need and the value of repositioning. It will explain a process for repositioning building assets and consider how to appropriately scale repositioning to various levels of need.

MACRO TRENDS DRIVING DEMAND

Workplace

By 2020, 80% of the global population will have access to the kind of mobile technology that facilitates remote work, mitigating the need for central office spaces. In 2012, square feet per person in the workplace stood at 180 square feet. Corenet Global predicts that this number will decline between 20 to 80% by 2017. So while the future workplace will be denser, it will require real estate solutions that can adequately support a variety of work styles, from collaborative work, to focused “present” work to virtual work. The many ways in which people work in an office suggests that flexibility is the preeminent value in contemporary workplace design. Work trends not only suggest a reduced demand for more office inventory, but the need to reshape workspaces to accommodate the needs of future work.

Economic

U.S. gross domestic product (GDP) is increasing at a rate three times faster than the rate of office employment growth, whereas from 2005 to 2014, current GDP increased at an annualized rate of 3.3% while office employment increased by 1.3%. Second, a review of Engineering News-Record (ENR) Construction Cost Index, a proxy for commercial construction costs, revealed that in the past decade, construction costs increased at an annualized rate of 3.1% compared to average office lease rates increasing at an annualized rate of 0.9%, indicating declining construction yields for office development and indicating increased risk in the office asset class. Finally, from 2005 to 2014, new office development outpaced office absorption by an average of 20 million square feet annually in the top 142 metropolitan areas throughout the U.S., suggesting that the average metropolitan area added more than one million square feet of office space that was not supported by market demand in the past decade. Ultimately these are trends pointing to near-term volatility and a real estate market that may be out of balance with real estate needs.

Demographic

Attraction and retention of talent are among the most important issues facing companies today. The next generation of talent is widely referred to as the millennial generation (those born between 1980 and 2000).

Millennials are the largest, most diverse, and most educated generation in the United States, and they represent approximately 29% of the US population. In many ways, Millennials exhibit different values than the Baby Boomers. But as highlighted in a an article written for the Financial Times, some experts anticipate Millennials will regress to the mean of American values and, like those before them, effectively trade cities for suburbs in an intergenerational housing swap.

For the time being, however, Millennials continue to exhibit a distinct preference for dense, mixed use communities within proximity to a variety of amenities and employment centers and featuring multiple housing typologies and a variety of transit options. These characteristics play heavily in a company’s decision on where to locate their facilities, and how to accommodate their workforce through their real estate facilities. What’s equally compelling is the rise of population locating in downtown areas across the U.S. A 2012 Census report indicates that city centers in some of the largest regions are becoming not just places for work, but places to live. For example, between 200 and 2010, metro areas with five million or more people experienced double-digit population growth rates within their city centers, more than double the rate of growth of their respective regions. This trend indicates potential demand for a variety of new urban residential building inventory.

Image © Gensler

THE PROCESS OF REPOSITIONING & REUSE

The time for repositioning office assets may be more relevant now than at any other time in American history. Gensler Analytics has determined that throughout the U.S. there is approximately 185 million square feet of office space that may be considered functionally obsolete and ready for “reuse,” as well as roughly 300 million square feet of office space that may not be competitive in the market without building upgrades.* In total, this equates to 485 million square feet of space that qualifies as ready for repositionable. This represents about 6% of the total office inventory in existence within the U.S. Additionally, the total amount of repositionable space is 22% greater than the total amount of office space that has been absorbed in the past decade. So as the U. S. office market has added almost 550 million square feet of new office inventory in the past decade, it is now teetering on the brink of over-supply, rendering the lower class of space functionally obsolete and potentially speeding up the repositioning cycle for younger buildings.

Changing market conditions in combination with macro trends that drive demand for alternative uses is creating a need for repositioning. This process is predicated on aligning market conditions with building viability, structural/mechanical integrity, and smart design. Specifically, transitioning troubled assets into buildings that accommodate flexibility and a variety use types will ultimately enhance the durability of those building assets, and performance of the initial investment.

Knowing that the time is now to think differently about building assets, building owners, managers, and developers may approach this opportunity in the following ways:

  • Determine the right approach for the asset
  • Implement the appropriate process for the client
  • Understand how to bring value to the building

Repositioning approaches should begin by understanding the appropriate tolerance for risk. This can be done by applying a cost-benefit analysis in a preliminary framework for a building or portfolio strategy. In addition, evaluating what the building needs in order to be competitive in the marketplace, and determining if a building has become no longer profitable operating as it was originally intended. Evaluating a building asset can best be understood on a risk/reward scale of refresh, revitalize, and reuse. Understanding what level of capital investment determines what level of reward may be generated from a repositioning effort.

Building Refresh

This is lowest risk approach. Depending on scale, this approach requires the lowest capital investment, and generates revenue similar to the initial value (i.e., office revenue remains office revenue). Simply put, this approach is not a change of use, but it does include design and engineering solutions to improve building operations and performance. Energy retrofits, daylighting, and tenant strategies are key parts of this improvement strategy.

Building Revitalization

Similar to the building refresh, the approach would not be considered a far departure from the intended use. This approach leverages synergistic opportunities through place-making, ground plane activation, landscaping, and adding, as well as enriching amenities on-site. A pillar of this approach generates value by integrating the building asset with surrounding neighborhood.

Building Reuse

As the highest risk approach, building reuse attempts to optimize financial returns by capitalizing on reduced development costs (as opposed to ground up construction costs), aligning the building use with in-demand market opportunities, and ultimately benefitting from greater yields generated from new building uses.

The repositioning of any building is a strategic step undertaken to add significant value to the property’s current value. Whether the intention is to retain tenants, attract new tenants, and attract new users, implementing the right approach for a building depends on the following formula.

  • Market Analysis:Identification of market opportunities by evaluating regional socioeconomic trends, real estate conditions and development patterns, and developing baseline values from competitive property comparisons.
  • Building Assessment: Determine capital obligations and risks associated with building improvements and reuse by conducting structural, mechanical, and electric facility assessments. The assessment will determine the viability and scale of building reform.
  • Visioning & Conceptual Design: Employ an iterative design process that optimizes building functionality and integrates design strategy with conceptual and schematic design scenarios. This process may include parametric design, discounted cash-flow modeling, and real-time massing/blocking schemes that are influenced by user experience, capital obligation, revenue potential, and physical constraints. This element of the repositioning process is especially important because financial performance and structural fit of conceptual designs can be measured simultaneously, increasing the ability to quickly deliver the right product to the market.
  • Delivery Development: Align construction phasing and building improvements with market demand opportunities, while limiting disruption of existing building operations.

Image © Gensler

HOW REPOSITIONING CAN ADD VALUE

The value of repositioning can be realized in many ways, including:

  • Leveraging opportunistic costs to optimize development yields, and enhance the aggregate square foot value of the building
  • Aligning phasing and parcelization of building improvements with market demand to increase agility of the building asset in volatile market conditions
  • Enhancing building flexibility supporting a variety of tenants and use types, allowing buildings to respond better to market conditions and be more investable in the long-run
  • Integrating sustainability to reduce long-term operating costs

Image © Gensler

In the end, it is important to remember that real estate investments are often characterized as irreversible investments. However, regardless the redevelopment effort, incorporating options into building assets can help hone the highest and best use for functionally obsolete buildings. Flexibility allows a building to have option value. Implementing real options into building assets is optimal when the present value cost to make changes at a later date is greater than the additional cost of including flexibility at the onset. Not only is this true from a ground up development standpoint, it is especially true for repositioning. Evaluating buildings using this process is a healthy exercise to understand how buildings can perform better in the long-run.

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