Archives for September 2022

Churches turned into art centers, factories into microbrew pubs, and shopping malls into medical facilities are just a few examples of adaptive reuse, the term used to describe the repurposing and transformation of an existing structure. While adaptive reuse is not new, changing business and social factors are driving renewed interest. These factors include a hybrid workforce, supply chain disruptions, increased interest in green construction and a lack of affordable housing. The result: more opportunities for commercial real estate brokers to think differently about the highest and best use of a property.

Trends in Adaptive Reuse

Housing shortages are making conversion to residential use the most popular type of change. Rent Cafe reported that 2021 was the most successful year for apartment conversions, with more than 20,000 units coming online and an additional 52,700 units expected to become available in 2022, many created from former office buildings and hotels. However, opportunities for adaptive reuse projects aren’t limited to residential. Existing commercial structures are finding new life as health care facilities, logistics warehouses and mixed-use suburban centers.

“Adaptive reuse projects have evolved to a point where they should be considered an asset class of their own,” says K.C. Conway, principal of Red Shoe Economics and chief economist for the CCIM Institute. “A variety of new projects have surfaced in secondary and tertiary markets, where investors see adaptive reuse as a driver of net operating income and yield.”

Role of the Broker

Listing properties for adaptive reuse requires envisioning the possibilities and selling that vision to a prospective investor or developer. But the broker’s role doesn’t stop there. Brokers often determine the feasibility of adaptive reuse. For example, they may work with local government officials on zoning and infrastructure issues, secure permits, engage with an economic development group to secure funding, promote the project to the community and more. There are potential pitfalls for brokers who fail to anticipate and plan for these steps or, at the very least, fail to bring together the players responsible for each element of a successful adaptive reuse project.

Meet four commercial brokers who successfully turned underperforming assets (in one case, a gigantic white elephant) into lucrative sales that benefitted their bottom line and the local community.

From Rodeo Arena to Distribution Center

You’re not alone if central Louisiana doesn’t jump to mind when you think of rodeos. But in the late 1990s, a developer tried to make it happen, pouring $11 million into a 64,000-square-foot indoor rodeo arena. The arena hosted one event, in 2000, before going belly up. Afterward, the venue sat unused for 17 years through four owners until Matt Ritchie, CCIM, president of Ritchie Real Estate, walked in. “I took one look at that clear span metal building with its 45-foot-high ceilings and thought, this is perfect for industrial.”

Ritchie’s vision was so clear that he and a partner purchased the Boyce, La., building and surrounding 26 acres of land to develop it for leasing as a logistics or distribution center site. “No one was biting, so I pitched other uses,” says Ritchie—among them, a hurricane overflow center and a potential pandemic field hospital.

In 2021, Lowe’s Home Improvement expressed interest. Ritchie negotiated a long-term lease, agreeing to develop the property for a distribution warehouse within six months. “The building contained only dirt floors and bleachers,” says Ritchie. “We donated the bleachers to a local school and brought in tons of dirt to raise the floor to accommodate truck docks. Trucks also meant upgrading the off-highway roads to heavy-haul standards.”

As part of an upgrade to the water supply system, a 50,000-gallon tank was added to the existing water supply, requiring a larger pump. “It came down to the wire,” says Ritchie. The pump was sitting in a Georgia port awaiting transport. With just three days left before Lowe’s was to take possession, Ritchie sent someone to pick it up rather than risk missing the deadline. “This project took two years off my life,” says Ritchie, “but we got it done—working seven days a week for six months.”

Despite strong local support for the project and extensive lobbying, Ritchie was unable to secure funding from the state’s economic development agency. “We could have used that money, as the project came in about 30% higher than I’d priced it,” says Ritchie. “I view it as a loss leader. Lowe’s took the building and six acres. We still have land and the heavy-haul road to support other trucking operations, and I’ve already had one inquiry.”

Reflecting on the project, Ritchie says he should have hired a broker to negotiate on his behalf. “Self-representation saves you on the front end but could cost dearly on the back end of the deal,” he says. “In this instance, I believe I negotiated the best available deal, but I will never know.” He recommends involving a business or real estate attorney at every step. “Many small brokers don’t want that expense, but in the grand scheme, it’s worth it.” He also recommends including escalation clauses in the contract. “In this environment of inflation, supply chain and labor shortage issues, I would never agree to a lease rate without escalation clauses if the cost of construction increases.”

Next up: In December, Ritchie expects to start leasing up an 88-unit facility that he and a partner converted from a motel to a senior residential facility. Not every hotel-to-residential conversion works, he says, but the property was in a unique location—close to a hospital and restaurants, and perfect for the 55-and-over crowd.

Source: “What Could You Create?“

When the official consumer price index (CPI) came out last week, it was an unpleasant surprise to many economists. One, in fact, that signaled the Fed would likely raise its benchmark interest rate by at least a 75-basis point—if not more.

“It’s becoming more apparent to market participants that the amount of tightening from the Fed thus far has not been enough to cool the economy and bring down inflation,” said Charlie Ripley, senior investment strategist for Allianz Investment Management, in an emailed note.

Marcus & Millchap concurs. “In August, the headline Consumer Price Index recorded a year-over-year increase of 8.3 percent, slightly below the 8.5 percent rise recorded the month prior,” the firm writes, as fuel prices have seen a sharp decline. “The core CPI measure, excluding food and energy, advanced at a faster pace, however, ascending 6.3 percent year-over-year in August compared to 5.9 percent in July.”

The virtually certain rate increase later this week when the Fed has its scheduled meeting “will coincide with an acceleration to the Federal Reserve’s monthly balance sheet reductions to apply renewed upward pressure on both short-term and long-term interest rates,” the Marcus & Millichap post noted. Increased financing costs “are complicating the financing process for both balance sheet and non-balance sheet lenders,” they added. There will be “more hurdles in closing transactions moving forward.”

Those are the direct implications. But the firm also noted some other effects through the impacts that particular aspects of inflation could induce on the businesses that must pay rent. “One area where consumers’ wallets have taken a large hit is in groceries and dining,” they wrote, because even though inflation in food prices “slowed by nearly a third last month,” they are still up 11.4% year over year.

Value options are big in dining, whether in grocery stores or restaurants. And yet, consumers are once again spending more in restaurants than buying groceries. “While food costs are going up, dining out provides a convenience and social experience that may offset the higher checks in consumers’ minds,” according to Marcus & Millichap.

But lower gas prices were a potential gift to retail, offices, and hotels. “While fuel costs have jumped over the past year, the 10.6 percent drop in the gas price index last month lets out some of the pressure on inflation,” they wrote. “Less pain at the pump will allow consumers to allocate discretionary funds elsewhere and may prove fruitful for leisure travel demand, aiding hotels and tourist-oriented retailers.” Cheaper gases could also mean less expensive commuting, possibly making a return to the office more attractive to many.

Source: “Consumer Necessities Inflation Have Implications for CRE“

Apartment rent growth hit a staggering 18 percent nationally in 2021, and while prices have tempered a bit this year, rents are continuing to rise at paces exceeding pre-pandemic norms in many parts of the country. And according to a new analysis from Apartment List, prices are rising faster in cities previously deemed “low-cost.”

In Washington, for example, rent growth has been slowest in Seattle and its closest suburbs, “but it accelerates as you move outward into other, more-affordable parts of the state,” Apartment List’s Rob Warnock says. “Near the eastern border with Idaho, pandemic rent growth has reached up to 40 percent in the cities of Spokane and Spokane Valley.”

And in the Sun Belt, “a rapid influx of new residents has burdened virtually every city with high rent inflation, regardless of how expensive they were before the pandemic,” Warnock notes. In Arizona, every city but Scottsdale has posted upticks of more than 30 percent. Tucson rents are up by 41 percent over pre-pandemic norms, and rents in the suburb of Gilbert are up 36 percent.

Florida has seen a reversal of the trend, with prices rising slightly faster in the more-expensive parts of the Sunshine State.  Tampa has seen the biggest uptick with rents up 43 percent in the city limits, 44 percent in Clearwater and St. Petersburg, 46 percent in Largo, 51 percent in Bradenton, and 56 percent in Town ‘n’ Country.

Just nine cities are posting median rents below its pre-pandemic level, including five in the Bay Area: Oakland (-9.8 percent), San Francisco (-9.2 percent), San Bruno (-3.1 percent), South San Francisco (-2.2 percent), and Redwood City (-0.4 percent). Two more are in Minnesota: Minneapolis (-2.6 percent) and its nearby suburb of Richfield (-3 percent).  The other two are oil towns in West Texas that have been hit hard by turbulence in the energy sector: Midland (-16.9 percent) and Odessa (-17.9 percent).

However, some analysts say the staggering rent growth of the last two years is showing signs of slowing, with a recent report from Apartments.com saying the market is “deteriorating.” Overall, rent growth was negative from July to August, with rents down 0.15% in July.

Jay Lybik, National Director of Multifamily Analytics, CoStar Group, said in prepared remarks, “We’re seeing a complete reversal of market conditions in just 12 months, going from demand significantly outstripping available units to now new deliveries outpacing lackluster demand.”

And another report from Yardi Matrix revealed that the average apartment asking rents recently decreased for the first time in 2022, dropping by $1 to $1,718.

“Rent growth tends to slow in the fall, but this year comes at the tail end of the unprecedented increases. The deceleration in August was strongest in many of the markets that have had the most growth over the past two years, a sign that affordability is becoming an issue,” the report states.

Source: “Apartment Rents Are Growing Faster in Low-Cost Cities“

Have you be watching the wrong kind of inflation, and missing the implication for real estate values?

Transitory inflation has grabbed the headlines. This kind is caused by sudden supply constraints and the price spikes they produce. Once the supply constraint eases, prices come down. This kind of inflation comes and goes; the danger is short and sharp.

Embedded inflation is more chronic than acute, and it is harder to escape. In this scenario consumer and business expectations about inflation begin to harden. The result is that spending patterns change, and wage claims go up, as economic players adjust to ever-increasing costs, in the process creating a self-sustaining spiral of rising prices.

Until the summer many central banks, and property market in-house economists, assumed inflation was the transitory kind, inspired by pandemic lockdown shortages. It would wash through the system by early next year. However, the balance is now tilting to the assumption that it could be embedded inflation.

There is already evidence that embedded inflation is a risk. UK households are raising their long-term expectations about price growth, with the latest data suggesting the expectation is above 4%, at least twice the expectation norm in recent years, according to a YouGov/Citi analysis.

Analysis by Oxford Economics has now revealed the substantial potential downside risks that embedded inflation poses to property returns up to 2024.

Its baseline analysis suggested total real estate returns averaging 5.2% in 2022-24, a figure already down from 7.4% since the energy price shock began to bite in June. But embedded inflation would scale returns of 5.2% back to 2.1%. If inflation remains high, and central banks can’t control it, then embedded inflation could damage all property sectors, even the highly favoured industrial sector, Oxford said.

Property values would be severely eroded, falling some 11% below the baseline forecast by year-end 2025. Low-yielding sectors like industrial and residential are hit the hardest, with U.S. industrial values falling nearly 25%, Canadian residential 20%, French residential 19% and UK industrial 16%.

Some economies would fall further, and harder. Returns could fall by 6.1 percentage points for the UK and 5.5 percentage points for the U.S. Gas rationing — now looking likely, according to Oxford Economics — would hit European economies even further.

“As headwinds mount, the global economy is teetering on the brink of a late 2022/early 2023 recession,” Oxford Economics Associate Director Christopher Babatope said. “These downside risks pose a significant threat to the near-term outlook for real estate.

“Adjusting for the current round of associated risks, the weighted average of global real estate returns is 4.4% a year. While much weaker than returns over the past five years, we still believe that real estate will outperform other asset classes over the five-year forecast horizon.”

Source: “Here Comes The Wrong Kind Of Inflation, And It Could Destroy Real Estate Values“