In the Spotlight: Leasing Distressed Properties

Even with major discounts, leasing commercial real estate can still be risky. The recovery of distressed built assets is not imminent, and corporate real estate (CRE) managers should beware. The existence of a Certified Distressed Property Expert Certification illustrates the problem.

Scope

Lease rates depend on prices. According to a more recent Moody's CPPI research report on real estate, as of early April 2011 property prices were down 42.8% from their October 2007 peak. But the CPPI report shows a significant difference in prices of distressed versus non-distressed properties: Prices on a six-city sub-set of non-distressed properties (that have traded for more than $10 million) are down 18.9% from October 2007. Prices on distressed properties, however, have declined 53.9% since October 2007. An article in the Pittsburgh Business Times said the value of distressed properties as of Sept. 30, 2010 was $307,946,400,000. Because these consistently distressed properties are probably obsolete in different degrees, occupying them could lead to further problems. Although the early 21st-century building boom was almost global, occurring in both developed and emerging economies, distressed properties are fewest in mature northwest European countries and disproportionately high in urban areas of younger quasi-market economies like Moscow and Dubai. In the U.S., the high level of distressed properties is partly a result of the many degrees of freedom possible in development, something rarely possible in many European countries. Consequently, mistakes are easier to make in the U.S.

Obsolescence

One of the causes of a property's value loss ' obsolescence ' is typically difficult to observe. More easily recognized is deterioration, loss of value due to normal wear and tear. In U.S. real estate and appraisal literature, two broad categories of obsolescence are discussed: 1) external, anything extrinsic to the building or site; and 2) functional. One form of external obsolescence is economic obsolescence, which is caused by business cycles and macro-market fluctuations. Another external form is contextual, resulting from influences affecting the building or site. Functional obsolescence involves a specific property more directly, through technical equipment, amenities, access conditions, aesthetic and spatial design of the building or site.

Some forms of obsolescence are more predictable than others. For example, economic obsolescence can be predicted by analyzing macro-economic and geographic market trends. External obsolescence caused by contexts can be observed, for example, in aging office and industrial parks in aging areas. Certain kinds of aesthetic obsolescence can also be observed, although not always effectively cured.

Several factors can induce varying degrees of almost instant obsolescence. Weaknesses in spatial configuration affecting visibility, pedestrian accessibility and movement have led to the premature and rapid obsolescence of retail and multi-use developments. Changes coming from site design mistakes, government takings, nearby development patterns and road improvements can permanently hamper vehicle access to a building or site. Workspaces have been the subject of design experimentation for several decades, sometimes successfully, too many times not. And almost every move to a new workspace is an uncontrolled experiment.

Functional obsolescence is both a rapidly growing problem and more difficult to predict. In 1995, Downs pointed out that many commercial buildings, because of a variety of developments, are becoming functionally obsolete faster than in previous periods. He says this has profound implications involving choosing locations, financing development, creating architectural designs and managing existing buildings. Unfortunately, his observations were not reflected in many real estate decisions of the last 15 years and as Brown put it, “recessions expose the functional obsolescence of buildings the way receding floodwaters expose the mess they covered.” Brown, M. Gordon (2008), Proximity and Collaboration: Measuring Workplace Configuration, J Corp. Real Estate, 10:1, 5-26.

Three Main Problems

Obsolescence occurs in every industry but the idea of “creative destruction” put forward by Schumpeter decades ago has not taken hold in real estate. Schumpeter, Joseph A., 1975, Capitalism, Socialism and Democracy, Harper [orig. pub. 1942]. Obsolescence underlies many distressed properties because of: 1) latency ' it is often latent and difficult to observe; 2) supply ' fresh supply means tenants, especially prime tenants, have a greater selection; 3) non-rationality ' investors and managers have biases described in behavioral economic analyses that inhibit rational decisions.

Latency

Whether buying, selling or refurbishing, investors need to identify and evaluate obsolescence factors. For example, a building that sold for $320 per square foot in 2007 could be attractively offered today at $230 and might benefit from retro-commissioning to reduce energy costs and gain LEED-EB credit. But if it suffers from significant obsolescence, its value, even after LEED-EB credit, may be even less than $200 per square foot. While many aspects of obsolescence can be considered latent defects and not necessarily known by the seller, buyers and sellers need to understand fully the meaning of “as-is” clauses and perform thorough due diligence. Knowing what to look for helps. A UK analysis suggests the following categories: 1) structure ' functional, configuration, technological; 2) site ' economic, environmental, locational; 3) regulatory ' lease structures, fire, planning, conservation, building regulations; 4) aesthetic ' original features, users' image.

Supply

Because new buildings in almost every category have state-of-the-art features, they provide benchmark standards against which older buildings are compared. For example, during the wave of major sport facility building in the 90s, the obsolescence of many existing facilities (including some that were relatively new) became apparent and cities were faced with the prospect of losing their franchises if they did not develop new stadia and ballparks. And as long as lower cost, greenfield developments in metropolitan peripheries continue to be available, increased demand for refurbished or retrofitted facilities will not expand. A growing reality goes beyond the single metropolitan area. Because major tenants are usually globally mobile, they have expectations about buildings that cannot be met by what some geographic markets can supply.

Rationality

Of the decision biases, behavioral economics and finance research has identified conservatism, optimism, overconfidence and the disposition effect adversely bias the decisions of investors owning obsolete buildings. Brown, M. Gordon and Tjibbe Teernstra (2008), Examining Investor Perceptions of Obsolescence and Value Through a Behavioral Economics Lens, J European Real Estate Research, 1:3, 267-290. Conservatism, also known as status quo bias, is a tendency to be slow in picking up on change. Optimism is a tendency to believe one's own probability of facing an adverse outcome is lower than it actually is. Overconfidence is a tendency to think one's knowledge and ability to do well on tasks is better than that of others. The disposition effect is a tendency to sell assets whose price is increasing too quickly and keeping assets that have dropped in value too long.

What Can Be Done?

Distressed properties offer genuine opportunities and what might have been obsolete for one occupier can be a real find for another. But whether a distressed property should even be considered depends on CRE strategy and the capability of corporate real estate management. There is no way to prevent obsolescence, but there are ways to slow it down, to avoid its more powerful impacts and to adapt and respond to it. Knowledgeable tenants can evaluate some factors, but, as in any thorough due diligence process, specialized expertise will identify and diagnose the extent they exist and are curable.

Sound property condition assessment will likely identify a built asset's physical/technical problems. But most obsolescence problems involve non-technical factors like image, configuration, access, context: These affect functionality, a building's tenant- and user-(un)friendliness. The most pervasive involve movement of people and information and these two typically are interactive because they impact decision-making. Ultimately, though, moving information successfully though IT networks will not compensate for keeping staff, customers and clients from interacting effectively. The problem is that non-physical functional factors do not have accepted performance standards and are routinely addressed intuitively and subjectively. Furthermore, non-physical latent defects, according to some court rulings, are not covered in implied warranty of suitability.

A systematic and objective diagnosis of obsolescence factors will identify their scope and curability. The subjective knowledge of tenants, investors, managers and users is collected systematically. Field checked as-built drawings and specifications along with data from observations are reviewed and analyzed. Key factors, from least curable (especially) to most curable, need to be identified, tested and measured to rule them out or determine their extent. Factors of spatial location, access and configuration are usually the most complex and least curable, so they are addressed in a two-step process (audit then, if necessary, model). This diagnostic process leads to an understanding of the influence of behavioral/cognitive biases behind obsolescence factors and an objective ranking of their curability. Depending on the size and complexity of the asset, the diagnostic process will take from a few days up to three to four weeks. The cost/benefit of curability can then be considered.

M. Gordon Brown, DTech, MRICS, is Principal of Space Analytics, a Chicago firm providing building, site and urban design evaluation for real estate. Dr. Brown was recently Academic Fellow of the Urban Land Institute, Academic Dean of Business and Information Technology at the Higher Colleges of Technology in the UAE, and Head of the Real Estate Management and Development Group at Eindhoven University of Technology in The Netherlands.

Even with major discounts, leasing commercial real estate can still be risky. The recovery of distressed built assets is not imminent, and corporate real estate (CRE) managers should beware. The existence of a Certified Distressed Property Expert Certification illustrates the problem.

Scope

Lease rates depend on prices. According to a more recent Moody's CPPI research report on real estate, as of early April 2011 property prices were down 42.8% from their October 2007 peak. But the CPPI report shows a significant difference in prices of distressed versus non-distressed properties: Prices on a six-city sub-set of non-distressed properties (that have traded for more than $10 million) are down 18.9% from October 2007. Prices on distressed properties, however, have declined 53.9% since October 2007. An article in the Pittsburgh Business Times said the value of distressed properties as of Sept. 30, 2010 was $307,946,400,000. Because these consistently distressed properties are probably obsolete in different degrees, occupying them could lead to further problems. Although the early 21st-century building boom was almost global, occurring in both developed and emerging economies, distressed properties are fewest in mature northwest European countries and disproportionately high in urban areas of younger quasi-market economies like Moscow and Dubai. In the U.S., the high level of distressed properties is partly a result of the many degrees of freedom possible in development, something rarely possible in many European countries. Consequently, mistakes are easier to make in the U.S.

Obsolescence

One of the causes of a property's value loss ' obsolescence ' is typically difficult to observe. More easily recognized is deterioration, loss of value due to normal wear and tear. In U.S. real estate and appraisal literature, two broad categories of obsolescence are discussed: 1) external, anything extrinsic to the building or site; and 2) functional. One form of external obsolescence is economic obsolescence, which is caused by business cycles and macro-market fluctuations. Another external form is contextual, resulting from influences affecting the building or site. Functional obsolescence involves a specific property more directly, through technical equipment, amenities, access conditions, aesthetic and spatial design of the building or site.

Some forms of obsolescence are more predictable than others. For example, economic obsolescence can be predicted by analyzing macro-economic and geographic market trends. External obsolescence caused by contexts can be observed, for example, in aging office and industrial parks in aging areas. Certain kinds of aesthetic obsolescence can also be observed, although not always effectively cured.

Several factors can induce varying degrees of almost instant obsolescence. Weaknesses in spatial configuration affecting visibility, pedestrian accessibility and movement have led to the premature and rapid obsolescence of retail and multi-use developments. Changes coming from site design mistakes, government takings, nearby development patterns and road improvements can permanently hamper vehicle access to a building or site. Workspaces have been the subject of design experimentation for several decades, sometimes successfully, too many times not. And almost every move to a new workspace is an uncontrolled experiment.

Functional obsolescence is both a rapidly growing problem and more difficult to predict. In 1995, Downs pointed out that many commercial buildings, because of a variety of developments, are becoming functionally obsolete faster than in previous periods. He says this has profound implications involving choosing locations, financing development, creating architectural designs and managing existing buildings. Unfortunately, his observations were not reflected in many real estate decisions of the last 15 years and as Brown put it, “recessions expose the functional obsolescence of buildings the way receding floodwaters expose the mess they covered.” Brown, M. Gordon (2008), Proximity and Collaboration: Measuring Workplace Configuration, J Corp. Real Estate, 10:1, 5-26.

Three Main Problems

Obsolescence occurs in every industry but the idea of “creative destruction” put forward by Schumpeter decades ago has not taken hold in real estate. Schumpeter, Joseph A., 1975, Capitalism, Socialism and Democracy, Harper [orig. pub. 1942]. Obsolescence underlies many distressed properties because of: 1) latency ' it is often latent and difficult to observe; 2) supply ' fresh supply means tenants, especially prime tenants, have a greater selection; 3) non-rationality ' investors and managers have biases described in behavioral economic analyses that inhibit rational decisions.

Latency

Whether buying, selling or refurbishing, investors need to identify and evaluate obsolescence factors. For example, a building that sold for $320 per square foot in 2007 could be attractively offered today at $230 and might benefit from retro-commissioning to reduce energy costs and gain LEED-EB credit. But if it suffers from significant obsolescence, its value, even after LEED-EB credit, may be even less than $200 per square foot. While many aspects of obsolescence can be considered latent defects and not necessarily known by the seller, buyers and sellers need to understand fully the meaning of “as-is” clauses and perform thorough due diligence. Knowing what to look for helps. A UK analysis suggests the following categories: 1) structure ' functional, configuration, technological; 2) site ' economic, environmental, locational; 3) regulatory ' lease structures, fire, planning, conservation, building regulations; 4) aesthetic ' original features, users' image.

Supply

Because new buildings in almost every category have state-of-the-art features, they provide benchmark standards against which older buildings are compared. For example, during the wave of major sport facility building in the 90s, the obsolescence of many existing facilities (including some that were relatively new) became apparent and cities were faced with the prospect of losing their franchises if they did not develop new stadia and ballparks. And as long as lower cost, greenfield developments in metropolitan peripheries continue to be available, increased demand for refurbished or retrofitted facilities will not expand. A growing reality goes beyond the single metropolitan area. Because major tenants are usually globally mobile, they have expectations about buildings that cannot be met by what some geographic markets can supply.

Rationality

Of the decision biases, behavioral economics and finance research has identified conservatism, optimism, overconfidence and the disposition effect adversely bias the decisions of investors owning obsolete buildings. Brown, M. Gordon and Tjibbe Teernstra (2008), Examining Investor Perceptions of Obsolescence and Value Through a Behavioral Economics Lens, J European Real Estate Research, 1:3, 267-290. Conservatism, also known as status quo bias, is a tendency to be slow in picking up on change. Optimism is a tendency to believe one's own probability of facing an adverse outcome is lower than it actually is. Overconfidence is a tendency to think one's knowledge and ability to do well on tasks is better than that of others. The disposition effect is a tendency to sell assets whose price is increasing too quickly and keeping assets that have dropped in value too long.

What Can Be Done?

Distressed properties offer genuine opportunities and what might have been obsolete for one occupier can be a real find for another. But whether a distressed property should even be considered depends on CRE strategy and the capability of corporate real estate management. There is no way to prevent obsolescence, but there are ways to slow it down, to avoid its more powerful impacts and to adapt and respond to it. Knowledgeable tenants can evaluate some factors, but, as in any thorough due diligence process, specialized expertise will identify and diagnose the extent they exist and are curable.

Sound property condition assessment will likely identify a built asset's physical/technical problems. But most obsolescence problems involve non-technical factors like image, configuration, access, context: These affect functionality, a building's tenant- and user-(un)friendliness. The most pervasive involve movement of people and information and these two typically are interactive because they impact decision-making. Ultimately, though, moving information successfully though IT networks will not compensate for keeping staff, customers and clients from interacting effectively. The problem is that non-physical functional factors do not have accepted performance standards and are routinely addressed intuitively and subjectively. Furthermore, non-physical latent defects, according to some court rulings, are not covered in implied warranty of suitability.

A systematic and objective diagnosis of obsolescence factors will identify their scope and curability. The subjective knowledge of tenants, investors, managers and users is collected systematically. Field checked as-built drawings and specifications along with data from observations are reviewed and analyzed. Key factors, from least curable (especially) to most curable, need to be identified, tested and measured to rule them out or determine their extent. Factors of spatial location, access and configuration are usually the most complex and least curable, so they are addressed in a two-step process (audit then, if necessary, model). This diagnostic process leads to an understanding of the influence of behavioral/cognitive biases behind obsolescence factors and an objective ranking of their curability. Depending on the size and complexity of the asset, the diagnostic process will take from a few days up to three to four weeks. The cost/benefit of curability can then be considered.

M. Gordon Brown, DTech, MRICS, is Principal of Space Analytics, a Chicago firm providing building, site and urban design evaluation for real estate. Dr. Brown was recently Academic Fellow of the Urban Land Institute, Academic Dean of Business and Information Technology at the Higher Colleges of Technology in the UAE, and Head of the Real Estate Management and Development Group at Eindhoven University of Technology in The Netherlands.