The commercial real estate and mortgage industries are taking a new and dynamic approach to maximize the financial and operational performance of many older properties. Often referred to as adaptive reuse, the trend of retrofitting older buildings has gained momentum in recent years for many reasons, including the need to seek new uses for certain asset classes, such as office and retail. Other reasons include rising construction costs, the push to be more environmentally sensitive, and the growing interest in industrial and multifamily properties.
Through this refurbishment process, commercial mortgage professionals and property owners are enabling these structures to serve their highest and best uses while delivering a greater upside to tenants and lenders. This trend promises to be among the most important in this decade for commercial mortgage brokers and bankers.
Compared to initiating a new-construction project, transforming existing real estate into dynamic spaces offers a faster, more cost-effective way of addressing the persistent shortage of affordable housing, as well as the declining occupancy rates in some commercial asset classes. Adaptive reuse also reduces greenhouse gas emissions and is a trend welcomed by socially responsible investors who use the environmental, social and governance (ESG) issues posed by a project to help quantify whether to make an investment.
According to the Certified Commercial Investment Members (CCIM) Institute, for an existing structure to qualify as an adaptive-reuse project, it must be in functional or economic obsolescence, or both; renovation must change the property’s use; and the reuse must be economically viable. Research from the University of Pennsylvania, meanwhile, traces the term “adaptive reuse” to 1973, when the global energy crisis created a greater awareness of scarce material and land resources.
The idea behind reusing older buildings, however, dates back at least to the 18th and 19th centuries when European governments discussed the reuse and preservation of religious sites and historic monuments. In the U.S., the reuse trend has really taken off since the 1980s. Listings company CommercialSearch found that of the more than 4,000 U.S. buildings that have been retrofitted since 1920, about 90% of these projects took place during the past 40 years. These renovations peaked in the first decade of this century, but apartment conversions may only be getting started.
Over the past decade, many new apartment buildings that have entered the market have opened in rehabbed buildings. RentCafe found that more than 20,100 units that were formerly used as offices or for other purposes were slated to be adapted into apartments by the end of 2021. This trend is expected to continue. Yardi Matrix lists 306 future redevelopment projects listed for 2022 or later, which would create more than 52,700 additional apartment units.
Refashioning older properties helps investors, lenders and other stakeholders achieve ESG goals. Converting legacy structures avoids demolition and new-construction activities, both of which contribute wastes and pollutants that harm the environment.
Through this refurbishment process, commercial mortgage professionals and property owners are enabling these structures to serve their highest and best uses while delivering a greater upside to tenants and lenders.
Even a new building that is 30% more efficient than an average-performing existing property takes 10 to 80 years to reverse (via more efficient operation) the negative climate-change impacts related to its construction. Developers also can bolster their projects’ environmental benefits by selecting sustainable construction materials, building methods and operational practices. Adaptive reuse not only has practical advantages in terms of natural preservation and cost reduction, but this strategy also supports the revitalization of local communities and the preservation of historic and culturally significant sites.
The renovation and adaptation of existing structures enables developers to simultaneously address common problems for communities in two ways. First, these projects can revitalize and decontaminate facilities that may have been abandoned and may pose health and safety risks. They also can lead to sustainable growth by raising the value of a renovated property and spurring development in economically challenged neighborhoods.
Adaptive reuse comes with its share of development and financing challenges. In a 2018 report, the CCIM Institute highlighted many challenges of adaptive-reuse projects, including:
Limited collection and reporting of metrics that would help participants understand certain factors, such as the impact of renovation projects on a local community
Permitting and zoning issues
An absence of an industry-recognized methodology for underwriting and valuation tasks
High risks that may turn away institutional investors
Developers also may discover pollutants such as asbestos or lead paint on-site once work has commenced on a project. The resulting mitigation delays and cost overruns are more reasons why developers need to conduct thorough due diligence before plunging into these types of rehab projects.
Another issue that developers may face is that some community members won’t appreciate the finished product of adaptive reuse. Also, obtaining variances for zoning and other regulations can be expensive and time-consuming — and may ultimately be impossible.
Additionally, older structures may need significant changes to meet modern building codes, not to mention that these facilities often do not use energy as efficiently as today’s facilities do. Aside from the condition of a structure, other considerations include community sentiment, demographics of surrounding areas and zoning regulations that could undermine any potential uses of the facility.
On the positive side, there are a variety of tax credits that can help support an adaptive-reuse project. A number of government agencies provide incentives (such as grants, loans and tax credits) to help offset expenses.
Joel Cohn, a certified public accountant, wrote in a recent issue of Commercial Investment Real Estate Magazine that a recent financing trend for historic rehabilitation projects is the addition of a state credit to the subsidy pool. He wrote that some states offer credits of 5% to 25% of eligible costs. Unfortunately, the availability and size of historic tax-credit incentives vary greatly from state to state.
While tax breaks can help, public financing can be tedious to tap into, and the demand for these credits often outweighs the supply. Given the challenges a retrofit project can face, senior mortgage lenders are more likely to provide a smooth funding process. The complexity of financing an adaptive-reuse project may present nonrecourse lenders, such as debt funds and mortgage real estate investment trusts, as viable choices.
To keep the funding options open, mortgage brokers should initially secure debt for their clients and ensure it is underwritten so that the capital stack allows economic development tools such as public financing. These financial incentives can bridge the gap between the project’s budget and any conventional financing it has obtained. Although these financing sources may seem like a hassle to pursue, they can be worth it.
For instance, the Historic Preservation Tax Credit includes a 20% credit for buildings designated as historic. Another fiscal cushion is the Low-Income Housing Tax Credit, which is available for various renovation needs, from homes to factories, as long as the final product provides housing for low-income individuals or families. Additionally, properties located in qualified low-income communities can earn economic support through the New Markets Tax Credit. As the financing process unfolds, developers should solicit community input to get the public on board.
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Giving older buildings new life can be a challenge, but this type of work offers mortgage professionals and their clients the chance to align their interests with the community’s needs. Adaptive-reuse projects preserve a community’s character and improve public health by removing contaminants in outdated structures.
At the same time, adaptive reuse has many environmental benefits, including reduced raw-material consumption, natural land use, and less pollution from manufacturing and construction. Refurbishment projects often embrace the requirements of socially conscious investors as part of the sponsor’s value proposition. Adaptive reuse is a timely opportunity to harness the shift in demand between asset classes along with the synergy of available financing and fiscal incentives. ●
Rob Finlay is founder and CEO of Thirty Capital, an advisory, investment and technology firm serving growth-minded real estate operators and investors. He is a forward-thinking entrepreneur devoted to building companies that support and advance the commercial real estate industry. Finlay has expertise in tech-enabled asset management and capital markets services and solutions. He recently authored the book “Beyond the Building,” an operator’s guide to building a competitive advantage through innovation. Visit robfinlay.com, or connect with him on LinkedIn.
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