From a small northwestern observatory…

Last week I talked about the industrial sector. I’m hoping to alternate sector analyses with reports about the REIT market in general. Today, the issue of adaptive re-use has caught my attention, and if you are an active REIT investor, it should be of some interest to you as well.

For the uninitiated, adaptive re-use is the repurposing of buildings for some use that has more demand in the current market. For example, I visited some old “rust-belt” cities in the mid-west with underused early 20th Century brick industrial buildings. Many of these buildings had great bones and were often near the more vibrant and transitioning downtown areas. With some brownfield redevelopment assistance, these buildings were repurposed as mixed-use residential, office, and light retail centers.

The Pratt Street Power Plant in Baltimore was converted to retail, restaurants, and office uses.

REITs are working with cities to develop incentives for this redevelopment, such as flexibility in zoning and use requirements. For example, city zoning may be extremely restrictive for office use, but such buildings may be in the right place, and highly adaptable, for light retail, medical laboratories, and even schools.

Prologis (PLD), a REIT I discussed last week, recently issued a report that office-to-logistics conversions are likely in areas with high land cost and limited competition. However, cities need to incentivize by reviewing zoning, entitlement, permitting, and approval delays.

According to Dennis Shea, the executive director of the Terwilliger Center for Housing Policy, key elements include zoning reform, tax abatements, tax incentives, and regulatory reforms. “For example, in Washington, DC, the city relaxed the requirement that certain percentage of construction workers on projects that receive government funding be D.C. residents. They’re also offering a 20-year property tax break to developers who convert commercial buildings to residences.

In San Francisco, in June, city agencies issued a request for information to identify potential sites for adaptive reuse, estimate their feasibility for a conversion, and evaluate regulatory barriers to the projects. In July, Boston announced the Downtown Office to Residential Conversion Pilot Program, reducing property taxes for up to 29 years for commercial properties who converted to residential. California has allocated $400 million for the next two years to encourage adaptive reuse. A further proposal will limit fees, prevent parking requirements, and streamline the approval process if the conversions include an affordable housing component.

In New York City, the Office Adaptive Reuse Task Force recommended a new tax incentive that could create 20,000 new housing units over the next decade. This includes rezoning certain areas in Manhattan to allow residential buildings, streamlining conversion policies to make more buildings eligible, and eliminating parking regulations. Mayor Adam’s and the Department of City Planning laid out a plan to convert vacant offices into housing as part of the “City of Yes” plan. They are also launching an Office Conversion Accelerator to expedite complex office-to-housing conversion projects.

Five projects were recently selected by Chicago for conversion from office to residential use with tax increment financing, grants for retail businesses on the ground floor, low-income housing tax credits, and historic tax credits.

The federal government is also stepping in to encourage adaptive reuse, with the Neighborhood Homes Investment Act to loosen restrictions on density and provide tax credits. the Biden administration announced a working group to leverage federal funding to support commercial to residential adaptive reuse projects. Also, the General Services Administration (GSA) is reviewing underutilized federal buildings for conversion to housing, and HUD is funding research on how to make conversions less costly.

“For a successful adaptive reuse project, you need real estate in a prominent location that’s supported by income growth to sustain the rent, plus you need to be able to convert the property in a way that makes it attractive,” says Shawn Tibbetts, COO of diversified REIT Armada Hoffler Properties (AHH). “It’s not just the right building, it has to be the right market.” His REIT converted the former Dominion Energy headquarters in downtown Richmond to a 174-unit multifamily property using tax credits. They lso converted Chronicle Mill, a former textile mill outside Charlotte, into a mixed-use development, also with tax credits and support from the local government.

“At Chronicle Mill we were able to combine adaptive reuse with a new adjacent building, which also helped make that project financially viable,” Tibbetts says. “Along with the rehabilitation, adding a new building helped lower the overall cost per unit, plus it is an incentive to the city since they gain more taxable property.”

In Rockville, Maryland, for example, BXP (BXP) acquired 31 acres with seven offices that will be demolished and replaced with purpose-built lab space and multifamily housing. “The I-270 corridor is the epicenter of the life sciences market and the office buildings on this site are obsolete,” says Pete Otteni, executive vice president and co-head of the Washington D.C. region for BXP. The location is already amenitized with transportation, shops, and restaurants, so it’s the right kind of environment for us to develop a sense of place.” In Herndon, Virginia, BXP acquired a 10-acre site with 350,000 square feet in two vacant office buildings. They are applying to rezone the site for residential use to allow for 350 apartments and 101 townhouse units.

Despite increased interest, in July the Adaptive Reuse Report from Yardi Matrix reported that in 2022 the conversions of offices dropped 15% from the previous year, to a 10-year low. Nonetheless, Yardi also found that future adaptive reuse projects in the pipeline includes 122,000 converted apartments, compared to 77,000 apartments in the pipeline in 2022’s report. Office conversions are expected to represent 37% of the total, followed by hotels (23%) and factories (14%). Hotel conversions were more popular than office conversions in 2022, and the number of apartments converted from hotels rose by 43% compared to 2021, primarily for affordable housing.

While challenges remain for adaptive reuse, public-private partnerships and concern about revitalizing downtown cores are likely to push developers to find creative solutions for vacant commercial buildings.

Thanks to Michele Lerner writing for NAREIT for most of this information.

Once again, I’m not an investment advisor, and this is not a solicitation or recommendation to invest in anything. Further, I and the entities I’m involved with may have positions or interests in one or more of the securities discussed here. However, if you have any questions about this, please don’t hesitate to reach out.

John A. Kilpatrick, Ph.D., MAI

john@greenfieldadvisors.com