Where’s the Tipping Point for CRE?
“Look at the world around you. It may seem like an immovable, implacable place. It is not, with the slightest push — in just the right place — it can be tipped.”
— Malcolm Gladwell
Commercial real estate obsolescence has been keeping us up at night. When does a building become obsolete? What are the forces? What is the impact? How can it be avoided?
Office vacancy rates in major city centres have increased dramatically around the world due in large part to remote work and pandemic-driven de-urbanization. Unfortunately, there are no signs of these troubling trends reversing, especially as economic conditions tighten. In New York City, for example, vacancy is about 15% according to a recent Bloomberg article (New York City’s Empty Offices Reveal a Global Property Dilemma).
Obsolescence is an obvious and known risk for the CRE space - you have to keep your product in line with target customer demands. The less obvious risk, however, is how the impact of these vacancies accrue.
In tougher economic times, Class A buildings with modern, energy-efficient designs in great locations and packed with amenities will see attrition, but owners can adjust rents or offer incentives to weather the storm. Occupancy may drop from the mid-90s to the high 80s which is not great given the 3% cap rates of recent years, but cyclically manageable.
Class C buildings, on the other hand, in less desirable locations with high operating costs and slimmer tenant offerings find themselves between a rock and hard place. They can’t compete on quality (vs. Class A & B buildings) and they can’t compete on price (vs. WFH and/or hybrid work alternatives). As a result, any increase in vacancy should accrue disproportionately to this segment of the market.
If vacancies in New York City continue to climb and end up averaging 20%. You could very well see median vacancy closer to 30% and Class C vacancy in the 40-60% range! This is what obsolescence looks like; it’s catastrophic - both for buildings and for neighbourhoods. And obsolescence isn’t something that is experienced gradually. Once the tipping point is reached, there is no coming back. Revenue can no longer cover the cost to operate, and cash will now likely be too constrained to update/fix problem areas and earn customers back. Many of these buildings will end up being worth zero. A large tower in St. Louis (909 Chestnut), for example, recently sold for $4 million. It was appraised at more than $200 million in 2014! I can assure you that no one modelled that outcome.
This asymmetric downside risk has important implications for asset owners and financial markets, especially as costs continue to pile up due to increasing energy prices and decarbonization demands (e.g. NYCs Local Law 97). Do rising interest rates + inflation + increased regulatory burden + a recession = the tipping point? The risk that we are getting that “push” in “just the right place” should not be ignored.
So what can be done? What happens to these buildings that are at risk of obsolescence? Can they be upgraded economically? Do they need to be reimagined (residential conversion, urban manufacturing, distributed fulfilment centres, vertical farming)? When is it better to cut and run?
To answer the above, an owner must understand where their obsolescence risks are piling up. We have provided a simple obsolescence definition framework (below) that we hope will serve as an informative starting point for exploration into obsolescence drivers. We hope that you’ll reach out and share more examples, whether or not they have a clear categorization. In an upcoming newsletter, we will look at some of the tools and technologies that can inform the decision making process and improve ROI to help fend off obsolescence going forward.
From your friends at GroundBreak Ventures
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Obsolescence Matrix
There are three main categories of obsolescence (economic, functional, and physical) and two types of obsolescence (curable and incurable).
Economic - loss in value due to some external factor such as a traffic pattern change
Functional - loss in value due to some element of its outdated design features, amenities or technology (don’t fit market tastes or standards)
Physical - loss in value due from physical degradation stemming from mismanagement and/or neglect
Curable - the issue can be fixed
Incurable - the issue cannot be fixed, can only mitigate the effects of the issue; else, the required updates/repairs are too costly to justify (tear down, start over)
