Obsolescence pt II - Getting Creative
If you haven’t read our previous piece on the tipping point of real estate obsolescence, read here. If you’re up-to-date, go forth.
Real estate obsolescence is not new but fundamental market shifts that accelerate obsolescence are rare. Unfortunately, we’re in a period where the factors that push an asset toward obsolescence are piling up (rising interest rates, inflation, increased regulatory burdens, and looming recessionary worries, on top of traditional economic, functional and physical pressures). Once they hit a tipping point (when customers have atrophied to the point that an owner can no longer afford to spend on updates and bring customers back), there’s no turning back.
Another strong study echoing these points can be found here.
So, GroundBreak, I hear you say, what can be done!?
Well, firstly, one can simply acknowledge that these risks are real and that “at risk” assets may be stranded with little or no residual value. Once acknowledged, an owner can look for an exit, or, perhaps more pragmatically, invest in bringing the asset up to par to attract new customers and/or increase rents. This has traditionally been done by:
Updating finishes, appliances, etc.
Updating technology and services to improve comfort, productivity, and health
Automating to lower operating expenses
Updating amenities
Unfortunately, these types of adjustments are increasingly insufficient.
Recently it has been very popular to talk about ESG strategies as a way to fend off obsolescence. A few options include the following:
Building electrification - replacing the building’s operational equipment and infrastructure with that which transitions from lower efficiency methods. This process can be expensive, but can be done in stages (ie. hybrid electrification strategies, replacing the boiler at the end of its 15-20 year life instead of right after you’ve just purchased it), but stands up a whole host of benefits - higher energy efficiency, lower maintenance, better building performance, better analytics and insights, a foundation for any digitization efforts, etc.
Tracking and striving to minimize utility usage and allow tenants to submeter to do the same (install a building monitoring system like Enertiv)
Tracking and striving to minimize waste
These strategies are all incredibly valuable as they relate to asset optimization/compliance and are worth pursuing on a case-by-case basis, but are unlikely to be enough to fend off the types of obsolescence risks (complete shift in consumer preference) we are most worried about, particularly for Class B & C structures.
In these cases, owners may need to find ways to attract entirely new types of customers. Gensler hypothesizes that the traditional office will need to be redesigned to suit a hybrid workforce. This could mean a preference among tenants for smaller footprints (fewer people in the office at any given time) and more team-centric, collaborative spaces (versus doored offices and cubicle jungles). Deep work will get done at home and meetings, collaboration, and teamwork will get done at the office.
Another strategy is retrofitting underwhelming commercial space into multi-family, condos, hotels, life sciences, or anything else. While commercial-to-residential retrofits have typically been incredibly expensive and only feasible with government assistance (as written about here), these types of makeovers may be necessary and funding pools have been made available in a variety of regions. For example, Calgary drove this change in their struggling downtown commercial sector with a $1B support plan to the tune of $54/sqft up to $7.2M without needing further approval from the city council.
Commercial-to-residential isn’t the only option, either. More creative plays are catching on in categories that are clamouring for more mixed-use-capable square footage, such as ghost kitchens (Reef), self-storage (Stuf), last mile fulfilment centres (Fillogic, Fabric), short-term lease structures for “pop-up”s (xNomad), and vertical farms or agriculture. Even tennis courts.
If the tipping point we are concerned about is in the offing, tweaking around the edges will not be sufficient and bold rethinking (and investment) may be necessary to PRESERVE (rather than GROW) net asset value. That may be difficult to digest, but also realistic. Really, this is all about fitting out to serve changing groups of customers. Moreover, retrofitting instead of tearing down and building anew is less costly and less carbon-intensive, so it’s a double-win. It’ll be a steep learning curve for stakeholders, but there are many options on the table whose payouts are aligned with the level of effort required to achieve them.
From your friends at GroundBreak Ventures