Opportunity through obsolescence

• The drivers of stranding risk vary substantially across asset classes and geographies. Within the three dimensions of obsolescence – functional, locational and regulatory – six thematic drivers emerge: building adaptability, building systems, urban experience and connectivity, property market dynamics, land use policy and sustainability requirements.
• There is no “one size fits all” approach to investment. The scale, risks and returns of potential interventions sit on a gradient ranging from incremental refurbishments and light retrofitting to deep retrofits and partial or whole change of use. While deep retrofits and conversions often lead to substantial value uplift, they have higher risk profiles and market sensitivity.
• Strategic retrofitting, most notably comprehensive energy upgrades that are aligned with the characteristics of the building’s superstructure, is key to future-proofing real estate assets. This approach unlocks additional financial opportunities, especially in sectors undergoing widespread automation and adoption of AI or with exposure to volatile energy prices.

A number of significant issues continue to weigh on owners of aging commercial real estate across asset classes and geographies, including operational efficiency, a preference for high-quality properties, misalignment between the built environment and demand for investment-grade buildings and the growing importance of sustainability and climate risk mitigation in asset valuation. With roughly 80% of the built environment to remain in use through to 2050, comprehensive and holistic assessments of how to best sustain and create value will be more critical than ever.

Despite the initial cost, capital-intensive repositioning strategies can unlock greater returns on investment and help to reshape portfolios with outsized exposure to potential obsolescence. Depending on the balance between market dynamics, macroeconomic forces and locational factors, retrofits or conversions can become integral core, value-add or even opportunistic income-generating assets with greater resilience to shifting structural forces. As dry powder remains at near-record highs and currently stands at nearly $600 billion globally, there is a meaningful first-mover advantage to be gained through proactive investment in bringing assets up to newer standards.

Successful building- and portfolio-level strategies are grounded in an understanding of the multifaceted nature of obsolescence drivers and their relative importance in different asset classes and geographies. Obsolescence exists across three dimensions for both spaces and places: functional needs, locational parameters and regulatory requirements. Each of these dimensions contains two principal drivers that refine the decision tree for owners looking to create value in their assets. Although not all dimensions or drivers are equally present or important for a given asset, the balance between them is critical in creating capital retention strategies. Additionally, these drivers are cross-cutting: energy policy, for instance, is a regulatory driver but also affects building systems and adaptability, just as land use policy influences how the urban experience exists and can be improved. 

• Functional drivers outline if the building structure and building systems can accommodate any engineering or technological updates necessary to meet current occupier requirements.
• Locational drivers focus on the interaction between the asset and the broader built environment, in particular user experience and changing urban development patterns.
• Regulatory drivers shape the contours of potential repositioning and development with respect to sustainability, energy and land use policies.

Although most visible in the office sector, which is facing a “zero-sum” environment in many North American and primary European cities, lifecycle and secular shifts are influencing the decision-making process in every type of commercial asset. At its core, the need for imminent investment is driven by the typical lifecycle and its current and projected supply-and-demand gaps. The typical life cycle ranges anywhere from 50 to 70 years in the case of office and residential properties to under 30 years for data centers, while current trends see office and logistics pipelines contracting on a global scale, retail in late-stage correction, multifamily tied to market demand fluctuations and data centers increasing at pace.

The balance between lifespan and change in the rate of completions helps to define how balanced the importance of each obsolescence driver is. As lifespans increase and completions correct, the relative importance of drivers is more balanced. In the office sector, this is underscored by intense locational sensitivity, extensive necessary systems’ reworking and greater impediments to reducing emissions. On the other hand, data center considerations are overwhelmingly driven by competition for limited land supply and substantial power requirements, while placemaking bears little weight. Meanwhile, the rise of experience-based and programmatic retail puts placemaking and market demand at the forefront, with more limited influence from building systems and adaptability because of greater engineering flexibility and shorter lifespans.

Even though a larger set of drivers mattering necessitates a more detailed plan of action with higher inherent risk, it also means that there are more possibilities for generating value when timed properly. Office assets can benefit from a tripartite set of energy efficiency, user experience and engineering premiums through retrofitting, most evidenced by 30% and 60% reductions in energy costs in medium and deep retrofits respectively, as well as 5.2% rental premiums for private roof and outdoor terraces. Being able to rearrange mechanical spaces and replace outdated HVAC systems can also help to artificially increase the perception of spaciousness in office interiors in older buildings whose 2.4-2.7-meter ceiling heights are less competitive with new construction featuring ceiling heights of 3 meters or more.

The industrial, logistics, data center and to some extent retail sectors will find value through partnerships with public and private infrastructure providers as part of the planning process to better align provision of power systems in new or expanding campuses. In addition, tightening tenant demand from the industrial and logistics sector will require substantial capital upgrades to space in this sector, with 65% of future demand from top industrial users being tied to a carbon reduction budget, sixfold increase in electric vehicle fleets and 40% of sectoral space commitments needing to run fully on renewable energy. Although near-term rises in input costs may weigh on the viability of these investments, the longer-term gains and stability are likely to keep them worthwhile for owners over the longer-term.

Just as the built environment is diversifying and blurring the lines between traditional single-use districts, so too is the composition of commercial real estate investment. Office and retail now comprise a combined 34% of global commercial real estate investment, well below their 2013-2019 annual average of 54%, whereas industrial and logistics as well as living sales are 98% and 25% above their longer-term averages respectively. In this context, portfolio optimization strategies should seek to ensure that capital expenditures align with creating a more robust inventory of properties. This will be the case both for upgrading the quality of product and changing its use where appropriate. The gradient of intervention intensity maps well with the perspective of future cash flow, operational complexity, risk-and-reward dynamics and, ultimately, return on investment.

To determine the category of a given repositioning project, revitalization measures must be contextualized both with respect to improvements in future operational as well as financial performance. Operational revitalization focuses on the initiator, scope, improved resilience and aggregate capital cost of work, while financial performance is a result of achievable rent and spatial advantage. In isolation, both spectrums identify the scale of work and the amount of value needing to be restored relative to the previous cycle, but when combined they deliver insight into portfolio-wide and sector-specific options for value creation.

Under these parameters, a number of different combinations can yield core, core-plus, value-add and opportunistic possibilities, such as:

• Opportunistic and value-add plays to avoid obsolescence are often based on “beating” the repricing cycle, such as a deep retrofit of historic buildings in creative, urban fringe submarkets to go from Class C to Class A+, meeting the majority of core tenant needs at a discount compared to prime space. Such strategies are predicated on high-paying, often boutique, occupiers and creating highly differentiated space, but risk a rapid rate of saturation and chasing a relatively small amount of the demand pool.
• Core-plus plays to avoid obsolescence have less of a “beating-the-cycle” focus and can be realized through a medium retrofit of more recent buildings with deeper and corporate-oriented designs to go from Class A- to Class A+, also achieving meeting most tenant requirements at a relative discount to prime space. Such strategies are based on a faster delivery of quality space for value-conscious users as well as spillover product for companies that may have too aggressively rightsized during the COVID-19 pandemic.
• Core plays can take advantage of space that is relatively straightforward to upgrade or convert in asset classes with lower levels of volatility and need for differentiation. Light-to-medium retrofits of moderately older industrial and logistics product, for instance, can continue to generate consistent cash flow as fundamentals are broadly in check, land prices are more amenable and projects tend to be less technically complex with a focus on quick-turnaround take-up rather than providing a distinct experience.

The return on investment from these varying approaches is highly dependent on the asset and market at hand, but the savings and cost re-basing can be substantial, even in the face of high capital expenditures. A medium retrofit can range from $300 per square meter for logistics with a 25% reduction in energy consumption to well over $3,500 per square meter for a deep retrofit of CBD office product, which can save upwards of 60% on energy costs. This is in comparison to the 5%-8% cost of capital expenditures as a share of total asset value for medium retrofits to around 12% seen in deep retrofits. By retaining much of the existing structure, owners can save anywhere from 30% to 40% compared to demolition and rebuilding, critical for ensuring viability where engineering realities and market forces have the potential for an upswing.

Where retrofitting and/or repositioning is not a viable option, replacing existing structure(s) and repurposing asset(s) for an alternative use can help sustain and enhance value​ and maximize ROI

Understanding the dimensions of obsolescence and their related drivers is crucial in creating a strategy that sustains the value of an at-risk asset or makes a portfolio with exposure to stranding more resilient. This is of particular importance as the requirements to remain competitive in the commercial real estate market shift at an ever-faster pace as well as during a period of increasing economic uncertainty. Deciding on a revitalization strategy should focus on ensuring financial performance, compliance with current and future regulations, tenant requirements, market positioning, and branding to maximize visibility.

Investors will need to place more attention than ever before on creating resilient and distinct assets that address sustainability issues and get ahead of not only regulatory changes but also longer-term trends in local and regional urban growth. This will involve using AI-powered technologies, entailing smart building systems and data analytics, to enhance asset performance, improve tenant experience and advance sustainability goals. In doing so, owners can view retrofitting, repurposing and conversion not as impediments to success but rather a concerted method of boosting resilience and gaining an upper hand in an ever-changing real estate landscape.