When mega-manager Brookfield Asset Management purchased a 12-property, 2.4-million-square-foot office portfolio in the Washington, DC metro area from local real estate investment trust WashREIT during the third quarter, the price took some by surprise.
At $766 million, the portfolio traded at a low-8 percent cap rate and $325 per square foot – 20 percent below the mid-6 percent cap rate and $410 per-square-foot pricing estimated by Green Street. The California-based commercial real estate analytics firm attributed the lower-than-expected sale price to the office properties being lower-quality and under-leased, as well as requiring significant time and higher capital expenditures to be re-tenanted.
WashREIT had been selling off its office and retail holdings over the past couple of years as it refocused its business on the multifamily sector.
“We had a motivated seller that got us a basis that was sufficiently low that we could justify putting money into these and bringing them to a modern standard, and the rents will be there to justify it,” explains Brian Kingston, chief executive of Toronto-based Brookfield’s real estate group. “These assets probably did trade at an attractive price because they do require more capital than people might have underwritten five to 10 years ago.”
Welcome to the age of accelerated obsolescence, as more stringent ESG requirements and tenant demands have now rendered many properties no longer up to standard. PERE interviewed 20 managers, investors and advisers about how elevated obsolescence risk is affecting investment decision making in private real estate.
“Broadly speaking, one of the outcomes of the pandemic is the acceleration of obsolescence, where things like wellbeing, energy efficiency and tech have been called into question in all aspects of commercial real estate,” says Karim Habra, head of Europe and Asia-Pacific at Ivanhoé Cambridge, the real estate subsidiary of Canadian pension plan Caisse de dépôt et placement du Québec. “We’ve seen assets that were built just a few years ago already deemed outdated, and those assets remain expensive because they still look brand new, are high quality and often in good locations.”
Neil Slater, global head of real assets at UK investment manager abrdn, agrees. “For a relatively slow-moving industry, things seem to be moving pretty damn quick,” he says. “Leases have become shorter. Real estate is far more operational. We’re having to be more thoughtful about what we build, how we build and its impact. If you don’t have all those aspects together in the right way, you can suddenly find you have something that in three to five years’ time doesn’t meet the regulations you thought it did. It may be really expensive to change, it wasn’t quite so flexible and relevant as you hoped it would be for people in a post-covid environment, and I think that’s the challenge.”
Obsolescence will be widespread in real estate, says Stephen Conley, executive managing director of capital markets at Chicago-based commercial real estate services firm JLL. “There’s a significant inventory of buildings across the country and across the world where it will just cost more money to make them more functional… If you think about the percentage of buildings around the country and around the world that qualify for the new standards, it’s a miniscule percentage.”
Consequently, “we are having conversations on a regular basis with owners of everything that’s not a brand-new shiny object,” Conley observes, “whether it’s to apprise them of what the value differentiation is or what we think that they will need to do in the future: A, to attract tenants; and B, to attract buyers.”
Although obsolescence is far from a new concept, “what I think is changing is our assumptions around the timing of when that’s going to start to impact value,” Kingston notes. Greater obsolescence risk has also led to a shrinking of the investable universe, he adds: “If you pick any city and you took a 10-block radius, and you said, ‘Here are all the buildings that are inside that 10-block radius. Which ones would you consider investing in and which wouldn’t you?’ If you did that 10 years ago and you did that today, there are fewer buildings today.”
For Peter Papadakos, head of European research at Green Street, the fact the WashREIT office portfolio’s actual pricing fell short of expectations shows how “pricing is changing in real time at a faster pace than most people in the market think.” He anticipates a huge pricing disparity between buildings that were recently built or being built today and those that are 25-30 years old. Whereas the owner believes the latter can be sold for a 100 basis-point higher yield than a newly built property, Papadakos says the spread should be more in the 200-250bps range.
“At today’s private market pricing, I don’t think full transition risk is priced in,” he adds. “When that dawns on people, you’ll see a 15-20 percent drop. Right now, because access to debt is so easy and corporate bonds so low, real estate has held up higher than a lot of other assets. But the way things are moving on ESG, in 24 to 36 months, you’ll see a drop.” Such a price decline will equate to a roughly 100bps hit to expected long-term unlevered returns.
Slater concurs. “Pricing has not been materially impacted yet,” he observes. “There’s a lag, and I’m expecting that to happen over the next 12-18 months. What we are already seeing is occupiers making decisions based on some of these aspects. We’ve had some occupiers deciding to move into a different office building because one is not just more environmentally friendly, but also far more amenable to their staff. I think that will also start to drive the pricing, not just on the investment side but the occupier side.”
Future pricing is a concern for Pertti Vanhanen, managing director for Europe at Cromwell Property Group. The Brisbane-based manager conducts annual portfolio reviews and tenant engagement surveys to identify and manage potential obsolescence issues. But “we are not the only ones who are doing this exercise,” says Vanhanen. “If you are a late mover, however, there is a risk that a lot of obsolete assets will be on the market at the same time and then when there’s too much supply, prices will go down.”
Vanhanen likens assets that are not future-proofed to UK shopping centers, which have attracted little interest from buyers even though prices have declined by 30-40 percent from the peak. “Everybody knew that e-commerce was coming. But why didn’t you sell those assets when you were able to get a good price?” he asks. “Somebody was holding those longer than they should have. Will that same kind of theme repeat itself with these obsolete assets?”
Cap-ex and returns
For Cedrik Lachance, director of research at Green Street, “obsolescence in the real estate space is effectively unavoidable. But it can be reduced and greatly minimized via cap-ex.” Cap-ex as a percentage of net operating income is typically higher in more challenged sectors like retail or office. But getting to net zero requires additional cap-ex for each sector. “Sectors like lodging, cold storage and data centers are the places where we see the greatest risk of value erosion associated with the desire or need to go to net zero,” with the latter two being massive consumers of energy, Lachance explains.
Cap-ex has become a critical component of decarbonization initiatives in real estate, since retrofitting produces lower emissions than demolition and new construction. “We need retrofitting to become a much bigger part of the solution,” asserts Cate Harris, group head of sustainability at Australian manager Lendlease. For example, with the refurbishment of One Triton Square in London, the firm doubled the net area of the building but saved 57,000 tons of greenhouse gases by opting to retrofit rather than demolish and rebuild.
Financially, green cap-ex can boost long-term rent growth potential as well as risk-adjusted returns. For office REITs in Europe, Green Street estimates a 300 bps increase in cap-ex, but concurrently a 20 bps increase in long-term rent growth, which in aggregate would contribute to marginally higher long-term expected returns. “There are tenants and there are industries in which being in a green building is going to be so important that tenants will be willing to pay for it,” says Lachance. “Owners of high-quality office buildings will gladly invest in additional green-related cap-ex. It’s going to increase the total cap-ex cost for the building. But their rent growth over time is going to be better than before and so much so that it will be a net positive on total returns when investing green cap-ex in high-quality office buildings.”
Indeed, Brookfield expects such a trade-off between cap-ex investment and rent growth. “We think the location, the markets, the bones of these assets justify that spend, that if we spend a little bit of capital, we’re going to be able to get occupancy back up to where it was, at rents that make sense relative to both the purchase price, plus the additional capital we need to put into it,” Kingston explains, speaking on the WashREIT office portfolio. “We think it’s going to be a good return.”
When it comes to the firm’s existing property holdings, the reverse can also be true, he points out: “When they get to that place where we have put a lot of money into this and I just don’t think the rents are going to be there, we sell them and move on.”
New York-based manager Apollo Global Management frequently evaluates the short-to-long-term cap-ex requirements for its property portfolio. “In doing so, we have increasingly started taking into account various current or incoming environmental regulations across the different geographies we operate,” says Boris Olujic, head of the firm’s European core-plus business.
These reviews have resulted in early strategic asset sales, including the disposition of a seven-property Belgian office portfolio to Patrizia for a total of €190 million in December 2019, according to data provider Real Capital Analytics. “By moving early, we managed to sell at an attractive level to our hold basis,” Olujic notes.
In other cases, Apollo has opted to reposition assets, including a Brussels office property currently undergoing a €20 million refurbishment that would result in a BREEAM Excellent rating as well as improved amenities and technical operating systems. “We believe this will allow us to attract high-quality occupiers while achieving a rental uplift of about 50 percent or higher with a commensurate capital value uplift,” he says.
Not all obsolete properties are suitable candidates for retrofitting or repurposing, however. While some low-energy-efficiency buildings are “green viable,” others are “brown trapped.” The former can achieve improved energy performance without extensive redevelopment work and are likely to see significant rental growth. The latter is likely to be uneconomical to retrofit from a yield on cap-ex perspective and suboptimal in terms of embodied carbon emissions.
Green cap-ex, moreover, is increasingly becoming mandatory for building owners. “What happens is you have no choice because in some areas; your brown building may be stranded, meaning that depending on the regulations, you may not be able to lease it,” Lachance says. For example, the UK now requires all commercial rental properties to have an Energy Performance Certification rating of ‘B’ or above by 2030 – up from the current minimum ‘E’ rating – to be leased to tenants.
Papadakos estimates that 60-75 percent of current office stock will be compliant by 2030, with the remainder needing to be destroyed or converted to another use. Assuming some of the remainder is repurposed, “maybe 75-80 percent of today’s stock could be compliant, and there’s another 20-25 percent that just won’t make it,” he says.
Knowing the FACTS
abrdn is now scoring its office assets based on a combination of tenant- and sustainability-focused factors.
abrdn has taken a more intensive approach to portfolio analysis as obsolescence risk has accelerated.
For the past decade, abrdn has scored its property portfolio for ESG criteria by its team of in-house environmental engineers. During the pandemic, however, the firm also began assessing its properties by sector-specific factors. In the office sector, for example, abrdn has developed a scoring mechanism called FACTS, which stands for flexibility, amenity, convenience, technology and sustainability. With a couple of the firm’s real estate funds, the use of FACTS ultimately led to the disposition of certain assets.
“We’ve been using tools in a much more focused approach to help us debate, ‘are the assets we’ve got fit for future?’” Slater explains. That said, “it doesn’t mean that if I get a really bad scoring that I must sell the asset or I must spend lots of cap-ex. I’ll look at everything: where is the asset, is it in New York, is it in London, is it in Singapore? I’ll look at the land value, I’ll look at the positioning, then I’ll look at this FACTS scoring, which has me think about, ‘how relevant is my office today?’”
Meanwhile, a third of retail space could easily be lost from both green compliance and structural issues, as the overall stock in the sector will decrease with no new development taking place. Office and retail “are the only two sectors where we might actually have a lower absolute amount of space in 2030 than we do today,” Papadakos says.
In addition to regulatory requirements, owners also face mounting pressure from other parties to update their properties. “As a lender we’re really focused on what we would call next buyer analysis about the person who’s going to either buy the building at the end of the loan or refinance our debt,” notes Jim Blakemore, head of debt at Toronto-based manager BentallGreenOak. “So, we’re very focused on making sure the collateral we’re lending on is futureproof.”
That analysis is more challenging to perform than in the past, particularly in evaluating the debt-per-square-foot and anticipated rents for a building. “There’s more space today that might just be unlettable at any price,” Blakemore says. “There was always an element of that in the market. But there was some view that at a certain price, you could let almost any space, and we think that may not be true anymore, especially in office.”
For assets with higher obsolescence risk, BGO will either reduce the amount of debt the firm would provide or just not do the deal. With shopping centers, for example, “we were quoting really low leverage and weren’t winning any deals because we didn’t think they were long-term viable,” Blakemore remarks.
‘A continuous evolution’
One of the biggest challenges relating to obsolescence is the unpredictability of future changes. “It’s still unclear in some countries what type of requirements they will have. It’s unclear what type of requirements tenants will have in the future because it’s a continuous evolution,” says Vanhanen.
Cromwell’s tenant surveys – which the firm has conducted since 2018 – have been one tool for gaining insight into future occupier requirements. Notably, sustainability has ranked as the top issue among respondents each year.
Meanwhile, Cromwell stays on top of regulatory updates via its on-the-ground teams across Europe, Australia and Singapore, including local ESG champions which share information through regular virtual meetings. “We are trying to collect from the bottom up, from the country level, information on what the local regulators are talking about and that helps us to understand local markets,” Vanhanen explains.
As for Lendlease, its strategy for managing obsolescence risk is setting an industry-leading sustainability agenda. The firm is aiming to reach net zero for operational carbon emissions with offsets by 2025 and for all emissions – both operational and embodied – without offsets by 2040.
“Sustainability leadership is a clear differentiator for us, with both short-term and long-term benefits, not least of which is the future-proofing of our assets from obsolescence,” says Harris. “Our targets currently outpace many of the local net-zero policies and targets in the regions in which we operate.”
Brookfield is likewise trying to stay ahead of the curve. “I don’t know what the standards and requirements will be 15 years from now,” Kingston says. “But we have a lot of people who spend their time understanding that and working with local authorities, trying to predict where this is going. We try to get out in front of that where we can and plan for it as best as we can.
“The only constant in our business is change. Whatever the standards are today, they will be higher in the future, no question.”