Opportunity through obsolescence

• Consider all aspects of obsolescence. When planning capital outlays, investors and authorities alike should consider the multiple dimensions of obsolescence – age and design, regulatory and location – in order to maximize return on investment.
• Anticipate changes in real estate demand. Within cities, the fluidity of office demand is contrasting with acute shortfalls in residential, experience-based retail and urban logistics supply to reshape spatial development and regeneration patterns.
• Identify locations to prioritize. Upwards of US$1.2 trillion in capital expenditure globally could be needed to bring office assets at the end of their life cycle up to current standards. Additionally, 78% of office product and 83% of necessary capex is found in the U.S. and Europe. 
• Plan for the long term. On the other hand, data centers, student accommodation and other emerging and alternative classes are only beginning their life-cycle journeys, with implications for strategic asset management into the 2030s.

Heading into the second half of the 2020s, commercial real estate continues to exist in a rapidly evolving environment. Shifting preferences for how space is used to where development takes place are converging with tightening sustainability requirements and severe shortages of housing, quality office and retail product and spiking climate mitigation costs, all under the umbrella of strained national and local finances and infrastructure.

As a result, heightened attention is being placed on the scale of potentially obsolete assets across the real estate spectrum. The current discussion around obsolescence, however, does not reflect the multifaceted opportunities found in turning challenges into value and returns. Importantly, the decision tree and investment journey for a given asset will vary depending on the type of product, spatial considerations, changing market preferences and viability constraints, amongst other factors.

A more holistic perspective shows that there are three overlapping factors – age and design, regulatory pressure and locational effects – whose convergence points inform the strategic direction for both owners and cities. Creative and proactive engagement between owners, developers, capital partners and public entities will enable necessary investments to take place not only faster, but also in a manner where the result is greater than the sum of its parts.

Although there is no one measurement to calculate near-term obsolescence or stranding risk, building age tends to correlate best with respect to the ability to meet tenant, investor and sustainability requirements along with the rate of occupancy and rent growth. Age aligns strongly with existing engineering, technological and climate adaptation capabilities as well as the ability to retrofit them at pace. In parallel, the presence of social value- and wellbeing-oriented design through the presence of private outdoor spaces, biophilic architecture, retention of some or all of the substructure to better manage embodied carbon, and floorplates that maximize light penetration all have a greater presence in new construction, meeting newer standards for users of all forms of commercial real estate.

The scale of these impending capital needs should not be underestimated, particularly for highly differentiated sectors. Of the 776 million square meters of existing office space in 66 key markets globally, anywhere from 322 to 425 million square meters is likely to require substantial capital expenditure to remain viable in the near term. In practice, this equates to roughly US$933 billion to US$1.2 trillion in spending, roughly 2.2 to 3.1 years’ worth of dry powder in the entire United States.

At the same time, this is unevenly distributed: 44% of projected obsolescence is likely to arise in the U.S. given higher levels of structural vacancy, with a further 34% in Europe as flight to quality in select segments leads to a smaller but still significant amount of vacant product with little demand chasing it. Such divergence also exists at the market level, where New York, Washington DC, Paris, Chicago and London alone will account for US$242 to US$320 billion of necessary global capital expenditures. These discrepancies underscore the distinctions that owners will need to make when assessing the gradient and distribution of super-prime, core, value-add and distressed investment opportunities and strategies.

Pressure on owners to extensively retrofit their buildings is also coming from both private and public forces with respect to sustainability and decarbonization. Although the share of emissions sourced directly from buildings is beginning to flatline, they still comprise upwards of 39% to 42% of global emissions on an annual basis. In order to reach impending net-zero targets, the scale of retrofitting will need to accelerate markedly. The top eight markets for regulatory stranding risk have more than 86 million square meters of office product in need of near-term capex due to tightening compliance standards alone.

The upfront expense of necessary capital expenditures, however, comes with longer-term benefits to operating costs over the life cycle of a given asset. Whole-building retrofits involving a reduction in energy usage of between 40% and 65% have an average saving of US$31 per square meter. If applied under a medium scenario for global at-risk office product in the eight highest-risk markets for stranding, this would yield US$2.7 billion in annual energy savings alone for institutional office owners. These opex benefits are coinciding with sustained growth in tenant and investor demand alike for low-carbon buildings across asset classes and intensifying emissions reporting and benchmarking mandates from national and local governments. As a result, owners who are proactive about bringing product up to and above sustainability expectations will find greater return on investment and minimize the incidence of stranding.

The geographic concentration of aging product and places in cities with higher shares of emissions coming from buildings means that the rewards from decarbonization scale rapidly. Under even a moderate scenario, more than 52 million square meters of current office product in Boston, Washington DC, Paris, London, Seoul and Tokyo is likely functionally obsolete, but more than 60% of emissions in these metro areas originates from the built environment. Similarly, European and Asian cities with strengthening regulatory regimes also have more than half of their emissions emanating from buildings, meaning that the risk of stranding is now an impetus to accelerate wholesale retrofitting and meeting net-zero targets.

Sustainability and regulatory changes will also affect the spectrum of asset classes at highly variable rates, with significant implications for capital costs, portfolio optimization and stranding risk. Most sectors have a typical site energy use intensity of 800 to 1,550kBtu per square meter, although this rises above 2,400 for data centers and approaches 3,500 for lab space. On the other hand, warehouses fall below the 500kBtu per square meter threshold and the broader industrial and logistics segment skews near the bottom, creating significant opportunity for a 100-200bps rise in returns in stringent compliance regions such as Europe. 

Intertwined with asset- and regulation-specific forms of obsolescence is the broader shift from spaces to places and the increasing need to create cohesive, amenitized and balanced destinations that encourage residents, workers and visitors alike to utilize and enjoy. Over the course of the post-pandemic recovery, the gap between “origin” submarkets such as traditional CBDs and business-heavy districts and off-core, less business-centric “destination” submarkets has only widened. Mixed-use environments including Shibuya in Tokyo, 22@ in Barcelona and Fulton Market in Chicago continue to reshape the spatial trajectory of investment and interest from residents, visitors and businesses alike.

Public authorities making conscious efforts to focus on both high-level regeneration and small-scale reparative approaches are already beginning to prove advantageous. In the City of London, intense demand for prime office space is being met through strong development activity that not only consolidates commuter footfall but also places great weight on user experience. Streetscape improvements to reduce car traffic, activating office lobbies with arts and cultural spaces, and experiential spaces such as observation decks in new developments all help to create a stimulating environment even outside of working hours. 

On the other hand, sustained conversion of mid-century office product to residential and hotel use in New York’s Lower Manhattan neighborhood is adding thousands of new apartment units to a traditionally 9-to-5 neighborhood that has long struggled to attract visitors and retailers for recreational purposes, all while helping to keep market fundamentals in check. Master-planned new development is reflecting this movement as well, such as the regeneration of a former post office site in Tokyo’s Azabudai Hills precinct which is further diversifying the real estate balance and offering for the wider Toranomon submarket.

While owners and municipalities will have to take the initiative to tackle many of their challenges quickly and independently, the full potential to create value through higher-quality, sustainable and resilient buildings and precincts can only be achieved through collaborative engagement between stakeholders and planning that takes into account how multiple forms and levels of obsolescence interact.

Owners will need to assess their portfolios from the perspective of how they fit into their respective built environments and how age, layout and other physical factors affect the ability to better respond to changing locational preferences and exposure to national and local changes to sustainability and development regulations. Public authorities should consider where clusters of similar buildings or uses exist to focus regeneration efforts to catalyze new non-commercial development and inject residential and footfall to boost business activity, while also retrofitting to decarbonize at scale. 

Importantly, this framework for obsolescence emphasizes that strategies do not exist in isolation. Asset repurposing in the form of adaptive reuse, for instance, routinely forms part of post-industrial precinct regeneration, while repositioning product to improve retail provision can be part of incremental improvements to enhance the user experience. In all cases, however, market forces and external considerations will shape time frames, financial viability and quantum of achievable change. 

There are four core pathways to avoid stranding risk, each with requisite market, financial and political considerations

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