Bloomberg, front and center: “Apartment and Warehouse Deals Start to Sputter as Rates Sting.” A harsh headline for a harsh July morning where it’s already topping 100° in my Dallas office. After a high performing first half of 2022, recent weeks have felt arduous and lethargic. Declining transaction volume coupled with yo-yoing rates have left the market unstable, and deals are suffering from the fallout. Gone are the days of rate-locking a deal on the same terms you entered with, and once the transactions that do make it to the closing table are finalized, it feels like the pickings (as far as assets go) are rather slim.
Enter adaptive reuse.
Adaptive reuse allows creative investors to pivot alongside the changing market. It’s becoming more prevalent as the inventory of choice properties and vacant sites dwindles. By targeting underperforming or misaligned assets in dense urban markets, savvy developers are not only making financially advantageous decisions; they’re often providing a much-needed product to the surrounding community (and cashing in on any tax incentives that may come with it). Adaptive reuse expands site selection and usually results in less competition for deals. It can also offer hearty proceeds at completion.
But the reward comes with risks. “Sometimes, efforts to preserve and revitalize historic buildings run up against financial obstacles, restrictive zoning and codes, contamination, and structural problems that create challenges in reusing these unique structures” writes Sophie Francesco Cantell in her 2005 report The Adaptive Reuse of Historic Industrial Buildings: Regulation Barriers, Best Practices and Case Studies. From both an environmental and engineering standpoint, there are a handful of hurdles that may present themselves during a due diligence period.
Phase I Environmental Site Assessment
A Phase I Environmental Site Assessment (Phase I, also called ESA) is one of the first initiated reports in the due diligence period, as environmental issues can be difficult to navigate and may need to be addressed before any onsite rehabilitation or renovation activities commence. The Phase I will include a site visit to opine if hazardous materials or “recognized environmental conditions” may be present at the subject property, look for evidence of any environmental impacts, and check for proper operations and housekeeping practices of any present occupiers. The ESA provider conducts interviews with those knowledgeable about the site, as well as historical research into any past tenants and uses. The ESA provider should also comment on geology, hydrology, and other geophysical attributes of the site.
A clean Phase I will provide a foundation that the site is clear of any major environmental issues and likely push a deal forward. A Phase I with issues is navigable with the help of a strong environmental consultant. To minimize delays, order the Phase I as early as possible in your due diligence process.
Zoning and ALTA Survey
With adaptive reuse, the intended use of the subject property may be 180° from its former use in hopes of better performance and meeting community needs. Without ensuring proper zoning compliance, adaptive reuse projects fail to launch.
Obtaining a zoning report ensures peace of mind regarding the conforming use, current status and designation, parking requirements, and ordinances governing the project. By commissioning a zoning report, you can ensure any ongoing design plans fit the requirements of any governing bodies, as well as have a strong understanding of any current or past violations issued to the property. Couple that with a design-appropriate ALTA Land Survey to ensure parcel acreage, utility locations, and any of the zoning feedback regarding setbacks, height restrictions, etc., and you’re ready to take on the structure itself.
Property Condition Assessments
In an industry full of numbers, some of the most important you can crunch include those of the immediate repairs tables and reserve schedules in a Property Condition Assessment (PCA or PCR). Engineering consultants perform a detailed site assessment of the current conditions of the site to identify deficiencies in the mechanical, electrical, and plumbing attributes of an asset, as well as to address roof life, building envelope condition, asphalt issues, and major structural defaults. Adaptive reuse projects hinge on utilization of the current structure, so getting a PCA is critical to identify pre-rehab/reno repairs and finalize construction plans. It’s imperative to understand the bones of the structure for both design and implementation prior to finalizing plans for either.
A PCA will also help quantify the asset in its current condition should you want to reuse as much of the property as possible. Reserve tables can span from as short as 3 to as long as 20 years and project annual expenditures to keep the asset operational. Moreover, an extensive rehab/reno plan will require the support of an engineering firm that can produce an equity-level PCA as well as provide construction services to bring the findings and the plans to fruition.
With supply-chain shortages and ever-increasing production timelines, it’s easy to see why developers of adaptive reuse projects want to outsource as much as possible on the build-side. Having an independent third-party perform Document & Cost and Project & Budget Reviews provides surety on rapidly changing product costs, shifting contractor schedules, and conformance in a time of ever-evolving governances. Being able to subcontract Construction Progress Monitoring reports, Funds Control, and even Completion Commitment reports allows developers to focus on all the other project-related minutia, and not the day-to-day build schedule.
Particularly for adaptive reuse projects, it may be helpful to add the following assessments to your due diligence package:
- Industrial Hygiene: for properties constructed prior to the mid-1980s, an investigation into Asbestos Containing Materials (ACM), Lead Based Paint (LBP), and mold or moisture is strongly recommended. Some cities (Houston, Texas for example) require extensive pre-renovation or pre-demolition surveys for items like ACM prior to disturbance.
- Energy Audits/Certification: Incorporating ESG efforts during due diligence allows for efficient data gathering and cost-effective implementation. Energy audits benchmark consumption and lay the foundation for efficiency planning and green building certifications. Not only do efficient buildings save operating expenses, green building certifications with programs such as LEED, BREEAM, EnergyStar, and Green Globes can help attract and retain quality tenants.
Adaptive reuse strategies can keep CRE players competitive despite the cooling market and reduced inventory—but rehabbing, repositioning, or redeveloping an asset comes with specific risks. Success in the adaptive reuse game requires careful due diligence and the support of a quality due diligence consultant that can offer the data and perspective you need to quantify and offset those risks and bring profitable projects to life.