Is This the Only Option?

Alternatives for Class B and C Office Buildings

The U.S. office market is gaining strength, prompting both private and public real estate investors to focus on acquisitions in this segment. The recovery, however, has not touched all levels of office product with equal intensity. While trophy buildings are trading at a record pace, sluggishness persists in secondary product.
However, in central business district (CBD) markets throughout the country, opportunities in class B and class C office buildings are emerging. After a flight away from such properties not long ago, today's market is ripe with possibilities for getting the most from investment in these older office buildings, including repositioning, alternative use, government intervention, and demolition.

Market Dynamics
In 1996, nationwide office vacancies in cities and suburbs dropped to their lowest level in a decade-13.6 percent and 11.2 percent, respectively. The economy's continued expansion and developers' discipline to consider economic factors before breaking ground have helped stabilize the supply and demand of office space.

Technology, the perceived life-threatening force of the office sector, has not affected real estate the way doomsday protagonists predicted. While the number of telecommuters is increasing, new business technology is supplementing, not replacing, traditional office structures. Traditional high-technology corridors are not the only benefactors from this growth; information technology has created high-tech office demand in older industrial cities including Minneapolis, Chicago, New York, Pittsburgh, and Philadelphia, bolstering the use and investment in office product.

From Suburbs to the City
In the early stages of the office market recovery, suburban activity led the charge in investment. But as pension-fund and real estate investment trust purchase activity reduce the going-in yields for suburban product, investors are seeking alternative investments with more attractive returns. The result is a renewed interest in CBD real estate. Newsworthy deals in 1996 include New York's Rockefeller Center, Detroit's Renaissance Center, and Chicago's AT&T Corporate Center.

But what about older assets that do not offer the location and amenity features to compete with class A? A resurgence of interest in downtown assets, once the white elephant of real estate, should make 1997 the year of the CBD. An examination of the recovery cycle occurring in major cities including New York, Chicago, Denver, Philadelphia, and Cleveland offers a glimpse of the trends developing in class B and class C markets throughout many U.S. cities.

Boom, Bust-Boom Again?
Most major cities experienced a fundamental shift in the 1980s from an industrial-based economy to a service-based economy. As industry moved to suburbia and beyond to take advantage of cheaper labor and production costs, the void was filled by the expansion of the white-collar workforce. The subsequent office development explosion in the 1980s doubled the aggregate amount of office space in a decade. Rents reached record levels in all asset classes and it appeared no end was in sight.

The early 1990s recession exposed the overbuilding and fundamental weakness of ill-conceived class A product and rehabilitation of class B and class C buildings. As the market moved from a landlord to a tenant market, the race was on to attract the diminishing supply of tenants with reduced rental rates, concessions, and buyouts.

Flight to Quality
As rental rates dipped, the value gap between class A and class B buildings narrowed, in some cases, to $2 to $3 per square foot. The minimal cost difference for tenants to relocate to new class A properties accelerated a flight to higher-quality buildings. Vacancies in noncompetitive class B and class C buildings hit record levels, and lenders became the new owners of underperforming downtown office buildings.

The combination of tenants relocating to class A and the lack of new construction helped stabilize the occupancy in well-located class A buildings at the expense of older buildings. The improving supply and demand fundamentals of the past 24 months have bolstered a fragmented recovery. In Chicago, as in other major cities, first-quarter 1997 vacancies decreased and rental rates increased at a much faster rate than older buildings.

Class B Rebounds
Current vacancies in downtown Chicago are about 9.0 percent for class A, 12.7 percent for class B, and 20.6 percent for class C. The spike in class A rents widened the value gap to $4.50 per square foot between class A and class B and $3 per square foot between class B and class C. As tenant leases expire and companies search for economical deals, the rising tide of class A rent prohibits them from moving up a building class. Tenants either renegotiate with their current landlords or search for alternative locations within the same product class.

The strength of class A rents has had a trickle-down effect on class B rents. By stemming the flight of tenants to class A buildings, class B rents have stabilized and are poised for a rebound. In some markets, a bullishness for class B is causing landlords to dust off their old renovation plans to position themselves against class A. In Chicago, developers have submitted four proposals to reposition older buildings to compete with newer product-unheard of just three years ago.

Class C Strategies
Class C buildings offer a different challenge. The value gap between class B and class C is still low, only $3 per square foot in Chicago, and tenants' flight from older product has not stopped. In fact, class C vacancies in Chicago rose to 27.9 percent in 1996. Deep pockets and/or alternative strategies have become necessities.
Four options are available to class C landlords: repositioning, alternative use, government intervention, or demolition. To pinpoint the proper strategy, an analysis of five interrelated investment issues is important for each asset.

Stabilization of Rents. The pace of new tenant signings and rate volatility is a barometer of rent stabilization. Are tenants shopping for price or are they attracted to location and amenity factors?

Rollover Risk. Class C buildings generally attract small-space users demanding short-term leases. As leases expire, renewal rates may be substantially below previous rental rates. If heavy tenant rollover occurs in a short time period, a substantial decrease in cash flow may occur. A lease expiration grid helps highlight future rollover trends. The preferred scenario is a steady rollover of tenancy over time.

Tenant Improvements and Deferred Maintenance. Tenant rollover and new lease-up activity determine the tenant improvement requirements of a building. Heavy tenant rollover and lease-up significantly impact the bottom line. Deferred maintenance items such as facade repair, mechanical upgrades, and aesthetic improvements often blindside inexperienced landlords. The long-term costs of maintaining an aging asset should be calculated to determine its impact.

Lease-Up Timeframe. How bullish is the market? Tracking the pace of new tenant inquiries and the building's leasing momentum sets realistic expectations.

Credit Loss. An aging report highlighting delinquencies and other tenant disputes should be reviewed to determine the severity of potential credit loss. Maintaining good tenant relations is the most efficient way to limit tenant issues.

Repositioning
After reviewing investment fundamentals, owners can map strategies for success. When leasing fundamentals show strength, continued use of the structure as an office building may be the appropriate option. Repositioning a building may differentiate the asset from competing product.

For example, 55 Broad Street in Manhattan's Wall Street district symbolizes the early 1990s market crash. After losing anchor tenant Drexel, Burnham & Lambert, owner Rudin Management, Inc., shifted the focus of the asset away from Wall Street and toward the high-growth industry of the 1990s-information technology. The birth of the New YorkTechnology Center signifies the viability of repositioning to attract the fastest-growing job market in the economy. The building is 60 percent occupied with an expected lease-up by year-end 1997.

The Jewelers Buildings at 5 N. Wabash Avenue and 5 S. Wabash Avenue in Chicago are niche office buildings that outperform the market by catering to a specific trade. The buildings are occupied predominantly by jewelers whose customers benefit from the critical mass. Tenants benefit from a crossover of customers and an immediate reading of industry demand. The result is 98 percent occupancy and rental rates higher than comparable buildings in the State Street corridor.

In Westchester County, New York, W&M Properties repositioned a vacant 120,000-square-foot office building at 711 Westchester Ave., along the "platinum mile" where vacancies average more than 18 percent due to a rash of corporate downsizings. However, W&M Properties recognized a shortage of space for multitenant users and shifted its strategy away from a single-user scenario to a focus on multitenant use.

Other repositioning efforts concentrate on expanding economic sectors. Medical-related buildings can be found in most major markets. The critical mass of medical professionals in one location offers a strong calling card to customers and, more importantly, an attraction to tenants looking to expand their practices.

Alternative Uses
Alternative use of real estate also is a proven strategy. Industrial-based economies have experienced a wave of alternative uses as aging industrial assets have become functionally and physically obsolete. Office owners should closely scrutinize the successes and failures of alternative-use strategies implemented during industrial downsizing.

Most mature major markets face the dilemma of a deteriorating and aging building stock. In Chicago, nearly one-third of the 110 million-square-foot downtown office market is located in pre-World War II buildings. The economics of many of these buildings may not warrant continued use as offices, but alternative uses-such as residential with retail or hotel-could increase demand.

Office to Residential.The rebirth of downtown markets has heightened the demand for residential development. So-called "24-hour" cities including New York, Chicago, Boston, and San Francisco have capitalized on the synergy created by retail, residential, office, and entertainment destinations in a downtown area.

Important components of office conversion to residential use include parking availability, architectural detailing, and small floor plates, which increase the perimeter area per square foot and allow more windows. Community support and zoning also affect conversion feasibility.

The most pronounced market for office-to-residential conversions is New York's Wall Street corridor. The devastating 1980s tumble of the financial district left many distressed class C office towers. Mayor Rudolph Giuliani's Lower Manhattan Task Force offered incentives to redevelop the downtown market into what Donald Trump coined "South Beach of the future." Rockrose Development Corporation in conjunction with Goldman, Sachs & Company's Whitehall Fund are most active with the 530,000-square-foot 45 Wall Street, which is slated for conversion to 440 units, and are considering other conversions.

In Chicago, developer Markwell Properties renamed the former Chicago Motor Club building Wacker Tower, and the 68-year old landmark at 68 E. Wacker Place is being converted from office use to 15 luxury condominiums priced from $1 million to $4 million. The small floor plates of 4,000 square feet coupled with a soft East Loop office market provide substandard economic reward for an architecturally significant office building. Conversely, Chicago River views and proximity to Michigan Avenue may prove to be great selling points for residential use.

The pace of these types of conversions highlights the appetite for in-city living and the improved market fundamentals for office-to-residential conversion.

Office to Hotel. Another trend in major markets is the conversion of office to hotel. The hotel building boom of the mid-1980s finally has been absorbed, and hotel transactions are on a fast pace. The demand for additional rooms has the major flags pursuing downtown property locations. The lack of available land for development, coupled with rising average daily rates and occupancies, make converting improved real estate a viable option.

Philadelphia's Center City district soon may have four office buildings converting to hotel use, including the half-full Packard Building at 111 15th Street. The market is experiencing negative net absorption and the prospects of negative net effective renewal rates.

In Chicago, where hotel occupancy rates are reaching 80 percent, three office buildings are converting to hotels, including the landmark Marina City complex on the north bank of the Chicago River.

Government Intervention
The extent of government incentives may make or break the relocation decision of tenants and the revitalization of downtown areas. New York and Chicago are initiating incentive programs that the rest of the country is watching closely.

In New York, Giuliani implemented tax concessions and other benefits for pre-1970 buildings located south of Murray Street to revitalize lower Manhattan and the Wall Street area. Although the incentives amount to only a few dollars per square foot, they have changed perceptions about the downtown market; developers sense that the city will work with them rather than against them.

In Chicago, community leaders are concerned with the proliferation of outdated class C buildings in the downtown Loop market. Like lower Manhattan, assessed values continue to decline, and the city is developing ways to recoup the declining tax base. In late 1996, the city announced a fourfold expansion of the North Loop Tax Increment Financing District to expand the affected property base. The hope is that subsidies given to developers and public works projects will alleviate the stigma of unoccupied assets and improve real estate values.

Conversely, the lack of government incentives can act as a deterrent to retaining tenants or revitalizing an area. Washington, D.C.'s downtown lost a significant tenant, in part, due to its lack of an incentive program. When the 200-employee Watson Wyatt Worldwide relocated to Bethesda, Maryland, it noted an $800,000 incentive program from the state and county as the determining factor.

Government intervention can work to protect key assets from incompatible uses. In a significant step by a municipality, the city of Chicago purchased the 16-story Reliance Building at 32 N. State Street, one of the last remaining pioneering skyscrapers from the late 1800s. A $6.5 million, three-phase restoration plan began in 1994 to restore the landmark facade and to pursue new uses for the building.

Demolition
A final strategy is to demolish functionally and economically obsolete buildings. Reasons for implementing demolition include reducing operating expenses and real estate taxes in preparation of a long-term hold, and redeveloping to the highest and best use. The keys to any demolition strategy include a low-cost basis and a clear exit strategy on the redevelopment.

Remnants of demolitions dot most downtown markets. As the economy faltered in the early 1990s, owners razed less competitive office assets to reduce their costs of carry. Short-term alternative uses include parking lots or low-density retail use. The hope is that a stronger future market creates development opportunities for a well-located site.

A hold and redevelop strategy may not be the only reason to consider the demolition of an asset. If the location and demographics of a particular market warrant a higher density use, then an immediate redevelopment plan becomes practical. In downtown office markets across the country, improving retail, residential, and hospitality segments add legitimacy to redevelopment in their respective uses.

Recognize the Proper Strategy
The U.S. real estate recovery of the mid-1990s fragmented the office market into the "haves" and "have-nots." As class A office rebounds with gusto, concer n over the future of aging assets builds. However, opportunities for aging office buildings can result in significant long-term gains and wealth development. Repositioning, alternative use, government intervention, and demolition are viable ownership strategies. The keys are recognizing these options and executing the proper strategies.

Jeffrey L. Jacobson and Marc A. Boorstein, CCIM

Jeffrey L. Jacobson and Marc A. Boorstein, CCIM, are principals with MJ Partners Real Estate Services in Chicago who specialize in the disposition of commercial real estate for institutional and private owners. They can be reached at (111) 879-9800.Building ClassificationsClass A Building has an excellent location and access to attract the highest-quality tenants. Meets or exceeds building code. Building is of superior construction and finish, relative to new or competitive with new buildings, and provides professional on-site management. Rents are competitive with new construction. Class B Building has a good location, management, construction, and tenancy. Construction and physical condition are good and meet building code. May suffer some physical deterioration or functional obsolescence. Rents are below those for class A buildings and new construction, but may be able to compete at the low end of the class A market. Class C An older building (typically at least 20 years old) with growing functional and/or economic obsolescence. May not meet building code. The building typically requires renovation to attract tenancy. Reasonable rents generally are lower than class B buildings. Office Building Facelift Fools The EyeIt\'s amazing what some paint can do for an old building-especially when the paint is in the hands of a renowned artist. In my case, a 100-year-old class C office building was transformed into a local attraction that has drawn tourists, the media, and awards-and has kept our tenants happy. In January 1993, my wife, Sally, and I knew something needed to be done to fix up the four-story brick building called the Midtown that we own in Owensboro, Kentucky. It was built in 1892 as a high school, and served as a junior high school before being converted into 50 office suites in the 1950s. In the past 17 years, the building has undergone patchwork renovations including painting, awnings, lighting, and signage, with nothing following a smooth renovation pattern. Because of the building\'s prominent downtown location, we knew we wanted to do something more than your typical paint job. We wanted the project to be a gift to our tenants and to the community. After being impressed by an architectural mural we saw on a St. Louis building, we decided to bring that style to Owensboro. But don\'t let the word "mural" mislead you. The style that governs this type of mural is called trompe l\'oeil, French for "to fool the eye." Trompe l\'oeil relies on paint and illusion to transform an otherwise flat-walled building into a classic example of Greek Revival or other architecture, complete with pillars and adornments that look as if they\'ve been carved from limestone. To tackle this 90,000-square-foot "canvas," we contacted St. Louis artist Pat Schuchard, who painted two trompe l\'oeil murals in downtown St. Louis. In spring of 1993, Schuchard began to study our building and the style of others in town, so that he could draw a plan to fit the community. Inspired by the style of the neighboring Carnegie Library Building, which was built in 1909 and is now the Owensboro Museum of Fine Art, Schuchard settled on an American Greek Revival motif. After five months of research and revisions to the drawings, Schuchard and a team of sign painters made precise, life-size patterns that could be transformed onto the building\'s walls with chalk. This process is thousands of years old, dating back to the Greeks, according to Schuchard. A similar technique was used for the Sistine Chapel and for other ancient frescos in Europe. In July 1993, scaffolds were set up at the Midtown building and the team began painting, using a special mineral-based paint that bonds with the surface of the prepared wall. The project was completed in about three weeks on site and our class C building began its transformation into a class B through the new facade, the higher quality, longer-term tenants it was capable of attracting, and the awards it later received. The metamorphasis continues with about $50,000 in ongoing interior improvements, including new wall and floor coverings, ceilings, and lighting. The results astound passersby, even those who have seen the mural before and know that what looks like carved stone is actually just paint. Some of the windows, which are bordered in "stone" trim, look as if they are recessed, and "pillars" were painted near the roof line. The word "Midtown" looks as if it\'s been etched into the building\'s surface. The painters even added the shadows that would exist if the detail actually was three-dimensional stone. The project revives a style of architecture and limestone construction that today is cost-prohibitive. With paint, it\'s a viable option. The total cost of the project was $35,000, including design, supervision, and paint. We recovered these costs in 36 months through longer-term tenants who don\'t require as much interior remodeling as new tenants, gradual rent increases that did not surpass inflation rates, and higher occupancy rates with little turnover. When someone does move, it is usually to a larger space within the building. The tenants are very proud of their space and have taken ownership in the painting. Our run-of-the-mill building was elevated into a conversation piece and a landmark. An editorial in our local newspaper said the whole building "appears to have been replaced," and a half-hour public television documentary about our project was shown nearly 20 times across the state. Renovating the Midtown building has been a win-win-win situation-we increased the class and value of our property, the tenants work in a building they can be proud of, and the community has been given something unique. It\'s like hanging an incredible, enormous piece of art where everyone can see and enjoy it every day. —by Malcolm Bryant, CCIM, of the Malcolm Bryant Corp. in Owensboro, Kentucky, a developer, property manager, and broker of commercial and industrial property in Kentucky and Indiana. He can be reached at (502) 926-1103. A Tenant\'s Second Look at B SpaceFlorida has seen tremendous growth in new business development during the 1990s. South Florida, encompassing Miami, Fort Lauderdale, and West Palm Beach, has reaped the benefits and been a strong contributor to this trend. With the influx of new businesses from domestic and international markets and the expansion of established industries, office space in Miami is a hot commodity. A lack of significant new construction, the continuing decline in vacancy rates, and increasing rental rates have caused tenants to more closely consider class B and some C properties. Last year, my team represented ProSource Distribution Services in assessing and negotiating the best solution for its U.S. headquarters\' consolidation to South Florida. ProSource\'s current leasehold in Coral Gables could not accommodate the requirement, so the company wanted to relocate to another class A building in the Miami area. The challenge was to identify a suitable office building, immediately available, that would accommodate 84,000 square feet of contiguous space, meeting the tenant\'s economic, operational, contractual, and timing objectives. With careful consideration and after many discussions including governmental incentives, we narrowed the move to two submarkets: Coral Gables and Airport West. Where to MoveAside from class A undertakings such as 220 Alhambra and ReBank Tower, which would not be completed until spring 1997, new class A construction had been nearly nonexistent in Coral Gables. At the time, none of the existing class A buildings could accommodate the company\'s requirements. Time constraints made relocation to new construction in Coral Gables infeasible. ProSource needed to scrutinize existing properties in its desired areas. We leveraged negotiations between two buildings: a class A and a class B. The operational criteria could be met at either building, but ProSource was seeking the best overall transaction, highlighted by economic advantages, contractual flexibility, and a tenant-friendly lease document. The company found it in 1500 San Remo in Coral Gables, a class B facility that could accommodate its long-term space needs on only three floors. What compels a client who is looking at the latest in class A facilities to lease a class B space? An Offer They Can\'t RefuseThe owners of 1500 San Remo, Associated Capital Properties, agreed to undergo base-building renovations of more than $3.1 million, upgrading the building\'s systems and amenities to improve efficiency and comfort. This, coupled with the reduced cost of the property ($5 to $6 per square foot cheaper than class As in the area), simplified ProSource\'s choice. The company was satisfied with a Coral Gables address, a refurbished building, and economic benefits. The bottom line is that class B property has become more attractive amid tightening markets. Tenants in class A buildings faced with renewal rates approaching $30 per square foot are reconsidering the types of buildings that they "have to be in." In markets like Miami, subleases with term and class B and C properties become more viable options. Due to market demand, class C property in the Airport West area has risen from the $10 full-service range to the mid-teens. The renovation and refurbishment of B and some C properties has become a sensible and cost-effective alternative. Owners and landlords who recognize this trend are ahead of the game.—by David B. Voell, an associate director for Cushman & Wakefield of Florida, who specializes in representing Fortune 500 companies in the procurement and disposition of office facilities. He can be reached at (305) 371-4411.