Changing rooms: Distressed assets provide opportunities for residential

At the height of the covid-19 pandemic, homes became not only places to eat and sleep, but they also had to quickly convert to remote workspaces. Kitchen counters became desks, spare bedrooms transformed into Zoom meeting rooms.

Houses became many peoples’ high streets as shops remained closed, playing further to the shift to online shopping. Many homes resembled retail warehouses, as they received deliveries of grocery orders, while bedrooms became fitting rooms.

The upshot is a growing trend for developers, and capital providers, to look to distressed property assets, such as office and retail buildings, for conversion to residential use. This solves two problems: making use of obsolete commercial space and addressing the undersupply of housing.

As Nick Whitten, head of UK residential and living research at JLL, says: “There are places to live, places to work and places to play. What the pandemic showed – and, in fact, history has repeatedly demonstrated – is that we might change the way we work, we might change the way we play, but the one certainty is that we need places to live.”

The shortage of housing is a global issue. In the US, research by Freddie Mac estimates that as of Q4 2020, there was a housing supply deficit of 3.8 million units, up from 2.5 million units in 2018. In its Australian Residential Market Update published in May 2022, Knight Frank refers to a NHFIC forecast that the country will be 163,400 homes short of demand between 2025 and 2032.

From retail to residence

Adam Cradick, executive director, residential land at CBRE, has witnessed a trend in London in recent years to repurpose retail warehousing and shopping centers into residential property. This has been driven by changes in the retail sector.

“Going back 12 to 24 months, there were a number of retailers experiencing challenging circumstances, and that meant some retail assets were struggling,” Cradick says.

Whitten says the move from a high street to an “i-street” – alluding to the e-commerce boom – means some retail assets are now obsolete. He observes that retail outlets in central high-street locations “more naturally lend themselves” to being converted into housing. But shopping malls and out-of-town retail parks might require a bit more vision from a developer and will certainly be a longer-term project.

“It’s a bit harder to see how those immediately convert and they, perhaps, become the seed of a larger new town or regeneration scheme, rather than an easy conversion,” Whitten says. He describes these redevelopment opportunities as “a new kind of mixed-use community,” which will include some retail, but on a much smaller scale than the type of retail that previously existed, as well as access to other amenities, such as schools and health services, and additional infrastructure to accommodate residents.

It is not just retail assets that have been given a new lease of life. Many developers have identified buildings that were originally designed and used as offices that could be better suited for residential.

Pieter Akkerman, co-head of Schroders Capital Real Estate Netherlands, says the shortage of homes in the Netherlands means more than 300,000 residential units must be built “over the next [few] years at least, and it’s only increasing.”

He observes that in the aftermath of the global financial crisis in 2008, offices were being bought by developers to convert into flats and apartments. “In the Netherlands, during the last four to five years, 10-12 percent of newly created residential was coming from conversion from offices,” Akkerman says.

In the UK, developers have been incentivized by the government to buy and convert vacant office space into homes. “Offices-to-residential has been the big one in the UK, over a period of about 10 years now. Permitted Development Rights were put in place to allow owners of vacant office space to automatically get planning permission to convert that into a new use for housing,” says Whitten. “It would be fair to say it’s been a useful policy in terms of increasing supply.”

“We might change the way we work, we might change the way we play, but the one certainty is that we need places to live”

Nick Whitten
JLL

Bringing buildings up to standard

Cradick says that growing interest in redeveloping secondary office stock over the coming years will be predominantly driven by sustainability requirements.

“Investors holding secondary and tertiary office space that is moving towards obsolescence will be aware of the significant investment they’re going to have to spend in order to bring those up to standard in regard to ESG. Those assets may well then be perceived as opportunities for alternative use, such as residential,” he says.

Research published earlier this year by JLL shows that more sustainable buildings can have increased rental value of between 6 and 11 percent, and lower void periods.

Schroders Capital Netherlands is part of a consortium working on a redevelopment project in Amsterdam to convert a former prison site into a mixed-use neighborhood of around 1,350 dwellings. At completion in 2026-27, the site will be part of a car-free district of Amsterdam, the buildings will be 100 percent energy neutral, and 98 percent of the materials from the demolition of the former prison will be re-used, either for this project or others.

Akkerman calls it a new model for “urban healthy living,” which will provide a blueprint for other, similar developments in the country. However, he adds: “One of the main challenges is the sustainability ambitions that we had and realizing them in practice. We are working with a lot of very skilled parties – from universities to engineering parties – to realize these aspects.”

High rise or rising costs?

Like many residential developers and investors, Akkerman is wary of build cost inflation.

“The combination of rising construction costs, with higher interest rates is going to be a big challenge for residential developments, not only in the Netherlands but all over Europe. Also, because municipalities still want to get the highest price for the land they provide to developers for new residential development,” he says.

While land values remain buoyant, so too have the prices at which residential dwellings sell for, mainly driven by the global shortage. Whitten says: “[Globally] we’ve been seeing values rising at circa 10 percent per annum, to a certain extent shielding some of this build cost inflation.

“There’s still a widely held view that this spike in build cost inflation will begin to normalize at some point – it’s just peaking at a higher level and lasting for longer than most forecasters had imagined at the outset, which is the challenge.”