We're now well into the development stage of the real estate cycle—even though commercial vacancy rates are higher than average in many markets this late in recovery. Construction activity is still only about half the last peak, a healthy sign of still somewhat restrained lending, but tenant demand remains lackluster. Office developers and their money partners probably properly calculate in many cases that their new technologically-advanced product can lure tenants out of last generation properties, creating value above project cost. It's the older buildings, losing tenants to the upstarts, which will likely suffer the consequences of demand anemia not the new projects. And the lower down buildings stand on the quality pyramid, the greater the risk of obsolescence fatigue setting in followed by value erosion.
So that leads to wondering about why some investment managers are paying record price-per-pound amounts in New York, Los Angeles and San Francisco for older product in fringe, but hopefully up-and-coming, downtown neighborhoods. And when I mention older product we're talking 80- and 90-year-old buildings. Would not these investors be better off at this stage of the cycle developing new rather than making bets on restoring really old?
I guess you can convince yourself that it is worth making a bet on neighborhood revivals driven by tech companies, young entrepreneurs, hip retailers, and trendy restaurants. That's the play in New York's meat packing district, LA's Arts District, and various wards around San Francisco's downtown. High ceilings, artisan detailing, open floor plates in old warehouse buildings, constructed to last with thick masonry and cast iron can have an appeal to store chains and creative shops.
And yes—the “up-and-coming” factor with sustainable demand will be key. These bets are based on anticipating where the next wave of affluence is heading and hoping that hip and trendy translate into enduring enterprise. But older buildings require plenty of capex and higher operating expenses—high ceilings and floor-to-ceiling glass can ratchet up utility bills.
I'd be more wary of the current spate of deals involving buildings in the 30- to 50-year age range without any hip or trendy features. Again investors are paying up in the 24-hour cities and buying product, which eventually will require costly retrofits to compete against those new developments. Didn't we think prices were getting too rich for this product two and three years ago?
So why invest in over-priced existing product now? It's really the same old story… Institutional investors need higher than average returns and have given investment managers money to put out as soon as possible to lock in performance gains. Investment managers aren't giving it back so some have started to force dollars out, holding their nose and probably overpaying. And it's much easier to buy existing than find a reliable developer partner. Most investment managers do not have the developer/operator skill sets and most developer/operators lack fiduciary temperaments. So these marriages often do not pan out.
For a narrow window of opportunity, the rich pricing for existing product makes select commercial development in the 24-hour markets the right play. But better you're topping out, leasing up or nearing completion than just breaking ground…. It's a narrow window.
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Jonathan D. Miller
A marketing communication strategist who turned to real estate analysis, Jonathan D. Miller is a foremost interpreter of 21st citistate futures – cities and suburbs alike – seen through the lens of lifestyles and market realities. For more than 20 years (1992-2013), Miller authored Emerging Trends in Real Estate, the leading commercial real estate industry outlook report, published annually by PricewaterhouseCoopers and the Urban Land Institute (ULI). He has lectures frequently on trends in real estate, including the future of America's major 24-hour urban centers and sprawling suburbs. He also has been author of ULI’s annual forecasts on infrastructure and its What’s Next? series of forecasts. On a weekly basis, he writes the Trendczar blog for GlobeStreet.com, the real estate news website. Outside his published forecasting work, Miller is a prominent communications/institutional investor-marketing strategist and partner in Miller Ryan LLC, helping corporate clients develop and execute branding and communications programs. He led the re-branding of GMAC Commercial Mortgage to Capmark Financial Group Inc. and he was part of the management team that helped build Equitable Real Estate Investment Management, Inc. (subsequently Lend Lease Real Estate Investments, Inc.) into the leading real estate advisor to pension funds and other real institutional investors. He joined the Equitable Life Assurance Society of the U.S. in 1981, moving to Equitable Real Estate in 1984 as head of Corporate/Marketing Communications. In the 1980's he managed relations for several of the country's most prominent real estate developments including New York's Trump Tower and the Equitable Center. Earlier in his career, Miller was a reporter for Gannett Newspapers. He is a member of the Citistates Group and a board member of NYC Outward Bound Schools and the Center for Employment Opportunities.
