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.
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.
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 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.
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.
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.