Adapting CRE to COVID-19
Considering the volatility across CRE sectors, adaptive reuse holds promise for repurposing shuttered businesses, despite some common roadblocks.
Distress moving through the commercial real estate sector in the wake of the coronavirus pandemic is creating both opportunities and challenges for the adaptive reuse sector. On one side is a rapidly growing pipeline of struggling assets that run the gamut from retail stores, restaurants, and bank branches to regional malls, hotels, and even some office buildings. Yet some formidable obstacles remain, chief among them being a still-shaky economy and the ability to secure the necessary financing and city approvals to move projects forward.
What to do with underutilized, obsolete, and sometimes blighted buildings has been an ongoing issue that gained even more attention following the Great Recession. Developers and investors have risen to that challenge with creative solutions that have produced everything from trendy new urban lofts and boutique hotels to creative office buildings. Retail has been ground zero for adaptive reuse projects, and COVID-19 has only accelerated secular changes already in motion in that sector. Although forecasts vary, most experts expect retail store closures to hit a record high in 2020, perhaps surpassing 8,000, including big name brands such as Sears, JCPenney, Macy’s, Gordmans, Stein Mart, and Bed Bath & Beyond.
These closures are creating buying opportunities for firms such as Home Star Storage, a developer of self-storage adaptive reuse projects across the East Coast. The company is actively pursuing empty big-box retail stores for conversion to self-storage facilities. “A lot of big-box stores are coming to the market already, and we’re expecting a tidal wave over the next two years,” says Isaac Rothermel, CCIM, acquisition director at Home Star Storage. Ideal conversion candidates for climate-controlled storage are big-box formats upward of 40,000 square feet. “The challenge for us, besides zoning, is pricing expectations,” he says. Finding retail, even empty retail, where the numbers pencil out for a storage use is no easy task.
Growing Pipeline of Opportunities
Prior to the pandemic, adaptive reuse was an active and growing sector of the commercial real estate market. The aging building stock coupled with a surplus of empty space left by the last recession had created an ample supply of redevelopment opportunities. The size and scope of the adaptive reuse sector are tough to quantify because projects are often commingled in the broader universe of commercial real estate, which spans some 32 billion sf of office, retail, and industrial warehouse space in the U.S. Adaptive Reuse: Turning Blight into Bright, a 2018 report published by the CCIM Institute and the University of Alabama Culverhouse College of Business, identified more than 33 million sf of adaptive reuse projects valued at approximately $4.4 billion that had been either recently completed or were in progress. The report also projected that adaptive reuse projects could very well increase twofold by 2023.
The COVID-19 crisis could unleash a bigger wave of adaptive reuse projects due to distress emerging across sectors such as hospitality and retail. Additionally, expectations for increased work-from-home policies may shift demand for office space. However, that surge isn’t likely to come right away, cautions K.C. Conway, CCIM, MAI, CRE, chief economist for CCIM Institute and principal of Red Shoe Economics. “I think everyone is going to pause and try to fix what they have first,” he says. However, once the economy gets back on track, potentially in 2022 or 2023, adaptive reuse could regain momentum and potentially even double or triple the original forecast from 2018, Conway says. He estimates the volume of assets that need to be repurposed falls somewhere between 50 million and 100 million sf.
Adaptive reuse is going to be more in focus as a solution, primarily because there are so many businesses and property types affected by COVID-19, whether it is restaurants, retail, and now hotel,” says Conway. One of the differences in 2018 is that the industry was focused on large, urban adaptive reuse projects, such as repurposing a closed factory or a regional mall. The bigger focus will now be on smaller scale projects, which will create opportunities for many CRE professionals in their local markets, notes Conway. For example, some investors have taken advantage of opportunities to buy vacant Dave & Buster’s and Havertys furniture stores at below-replacement-cost prices of $25 to $50 per sf. They are converting those big boxes to last-mile distribution centers — not for large semitrailers, but for smaller cargo vans that can deliver goods to the surrounding dense population, he says. Due to some of the disruption in urban centers, COVID-19 also could shift the focus from urban to suburban adaptive reuse opportunities, Conway adds.
Formerly an estate with an Embassy Suites hotel, the Park Terrace is an all-inclusive senior living community on 17 acres in Phoenix.
COVID Will Create Shakeout in Hospitality
Distress in the hospitality sector is attracting attention to potential adaptive reuse for hotels and resorts. According to Trepp, which tracks data specific to the CMBS universe, nearly half of all CMBS loans backed by lodging properties were either delinquent (19.4 percent) or in special servicing (25.2 percent). However, the business case for converting hotels to residential is one that developers have recognized for years, notes Marcus Threats, CCIM, JD, LLM, a hotel investment specialist in the National Hospitality Group at Marcus & Millichap in Las Vegas. Recent examples include:
- 2577 West Greenway Road in Phoenix: The former Embassy Suites was purchased in 2016 and converted to Park Terrace at Greenway, a 227-unit community with assisted and independent living units.
- 5858 West Chandler Boulevard in Chandler, Ariz.: The former Hawthorne Suites by Wyndham was purchased three years ago and converted to apartments.
- 8242 North Black Canyon Highway in Phoenix: Originally built in the late 1980s, the Residence Inn is currently in the process of being converted to an apartment community.
In these three cases, the hotel operator was not in distress — it was a situation of an opportunistic sale. “These examples show that adaptive reuse is not just happening because of COVID, it was happening before,” says Threats. The conversion of hotel and resort properties to residential could be further fueled by the negative effects of the pandemic on business and leisure travel. “However, in doing the analysis, I don’t think you can only look at distressed deals, because you will miss the mark on that opportunity,” he says.
For example, investors were looking for a similar wave of distress following the 2008-2009 recession. “It didn’t come in the form that most people thought, and I think the same thing will be the case here,” Threats says. “The banks are going to get very creative next year, because they don’t want to take back 20 or 30 hotels on their books.” In addition, those distressed hotel opportunities may not lend themselves to adaptive reuse, he adds.
Irvine, Calif.-based Shopoff Realty Investments is focusing on opportunities in both hotels and retail. In particular, the firm is looking at extended stay hotels with an exterior walk-up and slightly larger room sizes that would be a good fit for conversion to workforce housing. “That is not to say that we wouldn’t buy something with interior hallways, but we think an exterior, two- to three-story walk-up is the better building option for us,” says Bill Shopoff, CCIM, president and CEO of Shopoff Realty Investments. “I think we will find those, but candidly, it is taking us a little more time than we thought it would,” he says.
Repurposing retail remains an ongoing focus in a market where — even after thousands of store closures over the past decade — many still see the U.S. market as over-retailed. “Retail has been evolving for many years, and COVID-19 really accelerated that process,” says Tom J. Lagos, CCIM, executive director of Institutional Property Advisors in Los Angeles. Lagos has been approached by several multifamily developers who are looking to acquire obsolete or underutilized shopping centers in the Los Angeles market that can be used as development sites for apartments.
Often, the land underneath the vacant or underutilized retail is worth more than the buildings, especially in urban areas where building sites are scarce. At the same time, retail properties are being converted into new uses, adds Lagos. For example, a Costco in Torrance, Calif., was recently converted to a fulfillment center that ended up trading at a head-turning price per foot, he says. “That sale really signaled that retail big-box may be looking more at fulfillment, warehouse, or cold storage in the future than it is more retail,” Lagos says.
Even for retail properties that are not in distress, owners must start thinking how these properties might be impacted in the future, advises Lagos. “One thing that I like to ask my clients is, ‘What do you think your property will look like in 10 years?’ Owners need to start thinking about that now, and they need to start getting ready for that now,” he says. Online retailing and the distribution of goods direct to consumers is only growing in popularity. As a result, the demand and the amount of rent people are willing to pay for last-mile distribution and fulfillment centers will grow. “That’s where it crosses over into the opportunity of adaptive reuse or mixed use,” says Lagos.
The idea of repurposing empty big-box retail stores or even obsolete malls into fulfillment centers or last-mile distribution centers has been a hot topic amid rapidly rising e-commerce sales. The challenge for developers has been acquiring retail properties at a price point that makes sense for an industrial use, while also getting the city to approve the necessary zoning changes that a change of use would require. Although the pandemic is not likely to remove those obstacles entirely, it may at least lower the hurdles. Some malls have already seen steep write-downs in values following the pandemic. For example, a $63 million loan secured by half of the 1 million-sf Burnsville Center in Burnsville, Minn., sold at auction in late October for $17 million. The collateral backing the loan formerly held by CBL Properties was reportedly valued at $137 million in 2010.
The Ashton Woods development in the Atlanta area aims to redevelop a former quarry into a mixed-use project.
Adaptive reuse projects have traditionally required heavy lifting to overcome a variety of challenges, including cost overruns, local government opposition, and securing financing. Financing for adaptive reuse projects could very well be a bigger challenge in the current climate with lenders — especially banks — that are risk-averse in the current economic crisis. Most lenders are highly focused on financing stable, cash-flowing projects.
One factor that could draw more interest and capital to adaptive reuse in the future is a growing focus on impact and ESG (environmental, social, and corporate governance) investing, notes Conway. Institutional investors, private equity real estate funds, and REITs may be willing to accept lower returns if they can have a positive social impact that fits within their ESG mission. For example, Brookfield Properties announced a new partnership with homebuilder Ashton Woods in October on the redevelopment of a former quarry on Atlanta’s Beltline trail. The firm plans to create a mixed-use project that will include green space, affordable and market-priced housing, and retail.
Another common frustration for developers is getting the necessary city cooperation on approvals and a change of use, especially when the rezoning requires moving from retail to industrial. Many municipalities depend on retail for the sales taxes and jobs they generate. “The last thing a city wants to champion is the elimination of retail and that tax base,” says Lagos.
“The cities don’t want to get rid of their retail and hospitality stock, particularly here in California, because they generate strong sales tax revenue or hotel occupancy tax,” agrees Shopoff. Shopoff Realty has worked with financial analysts to develop analyses to show that perceived losses may not be as big as they think. For example, if a city has three retail centers that are 50 percent occupied — and they take out one — those remaining tenants will move somewhere else, likely strengthening occupancy at the remaining centers. “People usually don’t leave the market. They just go somewhere else within the market,” Shopoff says. The same is true of hotel guests. “Convincing the city that they are not losing anything is not easy, but empirically and mathematically, we can show that to them,” he adds.
Cities are facing revenue pressure due to COVID-19 that could encourage some to be more flexible in working with adaptive reuse developers. From April through December 2020, many cities and states saw a roughly 30 percent decline in revenue collections due to business disruption from the pandemic. That situation could look even more bleak in 1Q2021, notes Conway. “Local governments know they have a huge revenue collection problem coming. They know that more properties are empty, and they know that more people are going to come in for property tax appeals,” he says.
Heading into 2021, considerable uncertainty surrounds which businesses will survive and what properties will become candidates for adaptive reuse. For industry professionals, the anticipated surge in distressed real estate ahead could create some interesting exercises in highest and best use property analysis. “Finding the highest and best use can be challenging, and it really requires all the skills that CCIMs are taught in market analysis classes, as well as professional experience,” says Rothermel. CRE professionals need to help clients and employers find creative solutions, while at the same time balancing the risk and return profiles of those adaptive reuse investments. It is important to look at how the cost to convert a building to another use compares with alternatives such as a tear-down or ground-up development on a greenfield site, he adds.
For more on this topic, check out CCIM Institute's 3Q2018 Commercial Real Estate Insights Report, "Adaptive Reuse: Turning Blight into Bright."