Trading spaces

"The rate of change in business today is crazy," observes Steve Pope, senior vice president and director of marketing for Grubb & Ellis. "And as a result, the faster a company can locate new space when it needs it, or unload excess space when it doesn't, the more likely it is going to be successful."

The rapid rate of change is particularly evident among technology-based companies. In the past, a new product introduced to the market might have enjoyed a life cycle of six to eight years. Today, a new generation of technology often lasts no more than 18 to 36 months.

"In addition," says Pope, "the players in any industry change more rapidly than they ever used to." With new technology, people outside a particular industry can take their expertise, apply the technology from a different industry, and suddenly become a new player in a third industry. An example would be a camera manufacturer who applies computer technology and suddenly becomes a viable force in the fields of digital imaging or desktop publishing.

This affects the supply and demand for vacant space in a couple of ways. In one scenario, the older players that are trying to hold on to their old way of doing business become irrelevant. Demand for their product falls, production is cut, and they wind up with excess space.

Or perhaps the company is able to see the change coming. A manufacturer of magnetic tape, for example, decides to switch to compact disc manufacturing, requiring a move to different types of facilities and perhaps abandonment of existing facilities.

As for the type of space that tends to end up as vacant, that really depends on the company from which it came. Wal Mart for example, has a much different portfolio of surplus properties than does Hewlett-Packard.

Rick Pederson, director of research for ONCOR International, expands on Pope's observations. "A corporation outgrows a need for space for a number of reasons," says Pederson. "One, you can become smaller. Two, you can become too big for it. Three, the space no longer supports your core competency. Or four, the space may still be correct, but the corporation may choose to go in a different direction."

"Some of our computer company clients, for example," he continues, "are shifting manufacturing from U.S. locations to Asia. That renders owned or leased space in the United States redundant or obsolete. That's not to say there is any flaw in the space, or even that the firm is making a poor decision, just that they are left with space they can no longer use."

Special purpose space is often difficult to remarket. Because of that, the trend across all industries shows that those firms making a strategic decision to own space will almost always examine the purchase or the fit-out of the building with an eye toward their ability to remarket that building once they move on.

"Companies today want to make sure they don't over-invest in their property," explains Pederson. "As much as possible, they want to keep the property from becoming a special purpose building so it is marketable in a general fashion afterward."

In many areas across the country there is little to no new commercial development taking place. At the same time, the demand for "smart buildings" equipped for telecommunications and information highway access is growing. The net effect renders obsolete many otherwise usable Class-B properties while at the same time increases the impetus to upgrade and recycle currently vacant properties.

For the property owner, this means vacant space must be carefully analyzed to determine the best course of action. If the company has the capital and the time, for example, the question is whether it is better to close the property down and leave it as is, or put some money into the property, reconfigure it, and hold onto it until it can be marketed in its reconfigured state.

According to Pederson, Class-C office buildings are becoming a problem everywhere in the world right now. There is a flight to quality where Class-B tenants are moving up into Class-A properties, Class-C tenants are moving into the Class-B space, and the Class-C buildings are going vacant.

In most areas, the bulk of the vacant space is composed of Class-C, post-World War II era industrial and commercial property. Frequently, this property has been vacant for some time. For a potential buyer, the first question to be asked and answered is why has it been lying vacant for as long as it has? In particular, buyers are concerned about potential environmental issues with older vacant property.

"This is something the manufacturing industries are quite interested in right now," says Pederson. "Everyone from Grumman Aerospace to various public utilities to a number of steel companies have properties known as brownfield sites -- sites where there has been some environmental damage. These are very difficult to remarket."

People are finding uses for such properties, but it typically involves a fairly comprehensive reuse strategy. For example, in many cities including Paris, Los Angeles, New York and Denver, these Class-C buildings are being purchased not for reuse as office, but for reuse as multifamily residential or hotels.

"We are seeing some of these sites being converted into housing," says Pederson, "but that typically requires someone to take responsibility for any environmentals. And there is often some public assistance because it is in the local municipality or county's interest to have that space reused. It has a lot to do with the local market. You have to have users of a demand for housing or retail or whatever this new reuse is going to be in order for such reuse strategies to be successful."

But not all markets are willing to support conversion to residential, and vacant industrial property, if it is to find new use, must remain as industrial or commercial space.

And in many of those cases, Doug Urqubart, managing director of AMRESCO points out, the cost of putting in capital improvements in order to attempt to lease up the property -- particularly in markets that are still fairly depressed -- often leads the property owner to the decision that it is better and wiser to sell the property as is and let somebody else worry about it.

"There's that old saying," relates Urquhart, "`There's a price for everything.' And then there's the other saying, 'One person's junk is another person's treasure."'

The point of repeating such dusty homilies, he says, was to underscore that there are still opportunities available in surplus space, if one knows how to go about it properly.

"We're selling small multifamily projects in the Los Angeles inner city area," he explains. "Some of them are in fact boarded up, and you say to yourself, `These are teardowns,' but there are people who come back and reply `Not at all. We recognize the neighborhood, we know how to handle it, and people still need a place to live."'

On the other hand, vacant office buildings in Southern California are not doing quite as well. "The market still isn't there," he says. "It just doesn't make sense to put in $8 and $10 tenant improvement dollars to get $8 rents."

But in Dallas/Ft. Worth for example, office space is on the rebound. Vacant buildings there are more likely to be re-fitted because property owners feel confident that if they put some capital expenditures into the building in order to attract new tenants, they will be able to realize a payback.

According to Urquhart, the typical vacant property in the extreme southwest tends to date from the building boom heyday of the '80s. "Back when funds were readily available and the underwriting by the lenders was poor to nonexistent," he comments.

"Take retail for example," he illustrates. "You have retail centers built on corners with poor to limited access, poor visibility and incorrect features such as exposure and bay depths."

One major problem with properties from this era was that because people had to pay so much for land, they would try to maximize their return by building two-story retail buildings, for example. "That's one of those ideas that looks good on paper but doesn't work in reality," says Urquhart. YOU just don't find retailers who want to be upstairs."

AMRESCO is in the business of buying distressed vacant properties and either selling or leasing them to new end-users. "If you can buy such properties cheaply enough and leave yourself some margin," Urquhart explains, "eventually someone else is going to come along and find a use for it."

Typically, says Urquhart, the type of companies attracted to such problematic spaces tend to be smaller and undercapitalized. As a consequence, AMRESCO will often decide not to invest much in tenant finish but will instead draft a low-cost lease allowing the tenant to add his own finish, or the company will try to sell the property outright at a price that makes money for the seller and leaves the buyer with enough room to pay for needed finish.

Most of the vacant distressed property on the market is coming from the portfolios of the lending institutions responsible for financing their construction. These institutions now have the properties as a result of default and foreclosure, and are attempting to divest themselves of those properties while maximizing value and minimizing write-offs.

But the returns are often no better than 50 cents on the dollar of their original book value. Many of the properties have some environmental issues that must be resolved (often at considerable cost) before they can be delivered to the ultimate enduser. Because of that, some properties have literally zero value. Those properties will remain vacant either until the market improves or until legislation is passed easing environmental liabilities for existing brownfield situations.

"For us," says Urquhart, "the big question isHow long is this situation going to last?' I would suggest there certainly are fewer opportunities for us to buy these assets at discounts today than there were last year, but the opportunities are still there and they are coming from a couple of sources."

The first source feeding the supply of vacant space comes from institutions which, two and three years ago during the peak of the default wave, restructured many of their notes through forbearance, cash flow mortgages or reduced interest rate notes.

"These notes are now maturing," says Urquhart, "but in many markets the situation that created the need for the restructuring still has not improved. Now the institutions find they have to deal with it. For those properties that were in effect Band-Aided and propped up two and three years ago through their work-out scenarios, the day of judgment has finally come. The institutions must either go ahead and foreclose, or sell the note to someone like us, who will then foreclose on the property. Those properties are going to be coming into the marketplace this year."

A second source for vacant space, Urquhart notes, comes from institutions that have worked their way through selling off most of their more troublesome loans, and have now begun to divest themselves of some of their limited partnership and joint venture interest in properties as well.

In summary, says Steve Pope, looking at the vacant property market as a whole, "There's no way we're going to run out of the older properties. Not for the foreseeable future."

As the pace of change continues to pick up, so will the turnover of property. Companies will continue to evolve and adapt, and their space requirements will evolve right along with them. The challenge for owners, agents and property managers is going to be finding ways to ensure older properties are able to evolve to meet the needs of the marketplace.

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