How managers are future-proofing real estate

Structural changes mean real estate assets face a greater risk of obsolescence. So how can owners ensure their properties remain relevant?

The past few years have seen a series of changes in the way people use real estate and the demands they make of asset owners. These changes were not necessarily generated by the pandemic, but it acted as a catalyst for flexible working and e-commerce, while increasing the societal focus on environmental, social and governance issues. 

Changes in tenant and end-user demand put pressure on real estate assets and increase their risk of obsolescence, so that they become outdated and practically unusable. The changes accelerated during the pandemic were universal, but the significance of their effects varies across geographies and asset types. 

The area under the most pressure is the office sector, particularly in the US, where office workers have been keen to continue working from home or mixing home and office work. Labor shortages mean attracting and retaining talent is the top priority for occupiers. 

Broker and advisory firm Cushman & Wakefield estimates the impact of hybrid working means the US office sector will have 350 million square feet of excess vacant office space by the end of this decade. This means the overall level of vacancy will therefore be 55 percent higher than was observed prior to the pandemic. This vacancy will be polarized in a small number of outdated assets. Today, C&W estimates that 7.5 percent of US offices have vacancy of more than 50 percent. 

C&W describes the US office market as “trifurcated.” The broker predicts that, by 2030, the top 15 percent of the market will be occupied by the best modern space. There will be a middle slice, comprising around 60 percent of stock, some of which will be good enough but some of which is potentially obsolete. At the bottom, 25 percent of the nation’s office stock will be “increasingly undesirable.”

Alfonso Munk, CIO of Americas at investment manager Hines, says: “With employees adopting hybrid schedules and placing a greater emphasis on wellness and sustainability, it is essential that offices become more attractive to occupiers and their staff in this new age of working.”

Making office assets attractive

Offices primarily need to offer end users features they cannot get in a work from home environment, says Jessica Wichser, global co-head private real estate asset management at Zug-based manager Partners Group. 

“That could be client meeting space, collaboration space, high-tech conferencing capabilities, catering, entertainment, or ultra-private workspaces,” she says. “As a baseline, the office should be convenient and promote wellness. That means natural light and good air quality are must-haves. On top of that, additional amenities such as dry cleaning, day care, food and beverage opportunities and gyms are helpful for attracting talent.”

There are also “softer” options that office owners can take to make their assets more attractive to end-users. Asset manager BentallGreenOak is launching cultural and mental health programs at its New York office assets. 

Rob Naso, managing partner and head of US asset management at BGO, says: “At our 685 Third Avenue, for example, we are launching a new cultural program for the benefit of the tenants, neighbors and guests of our building, and we are hosting a mental health event at the amenity space in our building at 757 Third Avenue. We’ve found that these types of consistent programming offer opportunities to collaborate and build trust, culture and connection to help tenants rebuild fractured cultures that dissipated while remote.”

One traditional real estate factor that remains unchanged, or of increasing importance, is location. Munk says: “Time lost to commuting is a common downside cited by remote workers preferring to remain at home but offices closest to transit will continue to generate outsized interest, particularly when coupled with other tenant preferences of newer buildings and amenities.” 

Office markets all over the world have seen a tenant flight to quality. For example, C&W estimates that Class A office assets in US CBDs have garnered 71.9 percent of leasing activity since Q4 2020, which is a 340-basis-point increase from 68.5 percent from 2015 to 2019. The challenge for office owners is to ensure their buildings offer the quality required. 

Surviving retail

Retail real estate was reeling from the impact of e-commerce before the pandemic hit, but a worldwide move toward online shopping dramatically increased obsolescence. BGO’s Naso says: “Online shopping is undoubtedly here to stay, and retailers should embrace it as a complementary channel, rather than viewing it as a competitor.”

It might have seemed that the heyday of retail real estate was over before covid appeared and the pandemic helped to “quickly weed out the challenged retail,” says Sondra Wenger, head of Americas commercial operator division at CBRE Investment Management. “Many retailers who were on the verge of bankruptcy were forced to file and close stores. Additionally, underperforming retail centers were forced to close, which has helped considerably with the oversaturation of retail in the US.” 

The US retail space has also benefited from a distinct slowdown in development since the global financial crisis. Examples of retail space that are winning at present include experiential retail, showrooms for online sales and local, non-discretionary retail, including grocery stores. Retail can also be a useful amenity for mixed-use properties. Malls with a higher percentage of F&B space are also more popular. 

With shoppers back on high streets and in malls, surviving retail real estate seems to be having something of a renaissance. Tenant mix and positioning are the key elements to success, although retail owners need to provide clean, bright, well laid out malls. 

Wenger also identifies m-commerce (shopping using mobile devices and apps) as a key challenge for retail owners. “No matter the asset, retail must align with the rise of m-commerce, which will soon be the dominant share of digital retail sales. Fortunately, m-commerce elevates the value of the brick-and-mortar store. During the pandemic, neighborhood, community and strip centers were able to pivot quickly to the m-commerce trends of click-and-collect/curbside pickups, and third-party delivery.”

The logistics sector has been a beneficiary of the rise of e-commerce, but that does not mean asset owners can be assured of future success. CBRE estimates 82 percent of the total logistics stock in the US was constructed prior to the year 2000, while the average age of an industrial asset is around 40 years old.  

Mary Lang, head of Americas direct logistics strategies at CBRE IM, says: “There is a significant amount of work that needs to be done to modernize current logistics stock and usher in the era of Logistics 2.0.”

She says tenants require more clear height in warehousing, smooth floors that can accommodate robots, wider column spaces to accommodate new racking technologies and roofs that can support solar PV panels. 

Naso adds that, while industrial properties may not be fully amenitized like office buildings, it is still important to deliver the best possible work environment. “An industrial workplace can offer comfortable and functional workspaces, amenities like break rooms or outdoor spaces, and it can promote a healthy work-life balance,” he says.

Demand for multifamily real estate has remained strong. However, the move to hybrid working has increased demand for the space and facilities for working from home. 

“This includes larger gym and wellness facilities and adding co-working spaces,” says Munk. 

He adds that tenants are also demanding “more amenities and high-quality living spaces which closely resemble condos and hotels not only in the way they look, but also in the level of service they provide.”

A key contributor to future-proofing assets of all types is flexibility. This means the asset has the ability to adapt and evolve to meet the changing needs of tenants, markets and economies over time. Buildings that have potential for multiple uses or a variety of tenants have a broader pool of occupiers to tap and therefore should be more resilient. This might mean providing space that tenants can adapt to their needs or by integrating elements of a mixed-use scheme so they remain complementary. 

Naso says leasing flexibility and offering shorter leases are also important in today’s market. “Today, co-working or flexible tenancy is viewed as an essential offering and can serve as an amenity and potential incubator for organizations which can grow out of those small spaces into something larger.”

Shift to remote

Munk notes that an important reason for flexibility, especially in the office sector, is that the future is not set in stone. “The ongoing shift towards remote work and the evolving needs of tenants as a result of the pandemic has not been fully realized yet. As many continue to navigate these changes, tenants are looking for space that is flexible and adaptable to evolving work requirements.”

Making improvements to real estate comes at a cost and this varies widely across markets and asset types. It is challenging to estimate the cost of future-proofing a building because it depends so much on the original state of the building and the scope of work. Relatively inexpensive changes might include installing LED lighting and high-efficiency water fixtures. Deeper retrofits might involve replacing fossil fuel-based heating and cooling. 

Partners’ Wichser says: “Capex which improves energy efficiency, for example, drives lower expenses, which leads to net operating income (NOI) increases. This NOI gets capitalized, leading to a higher exit price. On a stand-alone basis you can look at the yield on cost of an individual improvement. These yields on cost can range widely from low teens to upwards of 50 percent. We engage companies to perform energy audits, which can be low cost, and help us identify which improvements will increase returns.”

Softer improvements such as tenant engagement and community programs can be carried out for lower costs. CBRE IM’s Wenger says an easy win for asset owners is to “dial up the service level.” 

The multifamily naturally does not face the threats the office and retail sector have battled, but it is uniquely suited to ongoing improvements as units turn over or while tenants are in place. 

Hines’ Munk says: “The most immediate impact and effect on revenue are through unit improvements. These improvements can be adding a washer and dryer, painting the walls or replacing carpet with hardwood floors. These improvements have a direct correlation to how much you can increase the rent per unit.”

The situation for industrial buildings is rather different, due to the high cost of refurbishment versus redevelopment, says CBRE IM’s Lang. For example, retrofitting a new warehouse roof to accommodate solar PV could cost around $30 per square foot, compared with construction costs of $80-$100 per square foot for a new building. She says: “Most of what would be required to truly modernize existing legacy industrial product would be cost prohibitive to retrofit. Older stock will need to be redeveloped at scale at some point within the next 10-15 years to appeal to the widest possible occupier demand.”

One thing unaffected by the pandemic and structural changes is the importance of location. In fact, pressures on the real estate market have tended to reinforce location as one of the primary drivers of success. For example, the pressures of the daily commute are one of the drivers of hybrid working, which means offices located near transport nodes, especially public transport, are more valuable than ever. 

However, location cannot be changed. Buildings in secondary locations requiring substantial works or that may not be sufficiently improvable will become obsolescent, requiring a change of use or redevelopment. That will open a new avenue for value-add and opportunistic investors to create new future-proofed assets.

Asia is back to work, but obsolescence remains a challenge

The major drivers of change in real estate – e-commerce, flexible working and the pandemic – have played out somewhat differently in the region. 

Asia-Pacific’s densely populated cities, where development is often centered on transport nodes, have not seen the same fall off in office attendance as North America and Europe.

Additionally, the newer age profile of retail stock means that much prime space has been developed with a mind to accommodating omnichannel retailing. 

However, this does not mean asset owners can be complacent, says Tom Miller, head of sustainability and development, Asia-Pacific at LaSalle Investment Management. “Even though Asia-Pacific is leading the way on global post-pandemic return-to-office trends and office occupancy rates, the continued evolution of office usage patterns will compel companies and therefore asset owners to adapt spaces for new workspace strategies,” he says.

There is a perception that Asian asset owners will always plump for redevelopment rather than refurbishing to prolong an asset’s life, but Miller adds: “As net-zero carbon programs are expanded to include the effects of embodied carbon during both the construction and demolition processes, new building development will become less attractive when trying to meet those net-zero obligations.”