Landlords and Developers Adapt as COVID-19 Rearranges CRE Landscape

As the pandemic heads into its third year, multiple asset classes in commercial real estate are undergoing profound change—some due to COVID-19, others as an acceleration of trends that were already underway. And while industrial, multifamily, self-storage, and life science are thriving, the outlook for the hospitality, retail, and office sectors is much murkier.

“Significant change in commercial real estate across multiple industries is evolving and has accelerated the need for strategic changes,” affirms Scott DiGuglielmo, SIOR, vice president of brokerage at Burns Scalo Real Estate, a Pittsburgh boutique firm that develops, manages, leases, and provides third-party real estate services across multiple asset classes. “So it’s important for property owners and operators to have a long-term view."

Some investors and developers are adjusting to that changing landscape by rethinking strategies to reinvigorate cash flow, investing in upgrades to existing assets or repurposing those assets to meet the increased demand in the multifamily, life science, and industrial market segments. For the hospitality industry, that means converting some struggling hotels and motels into multifamily rental properties, creating affordable workforce housing. Retail conversions of malls and strip centers are gaining traction, and although many have encountered zoning challenges, some municipalities are re-assessing their stance to allow for alternative uses as they face the reality of lost tax revenue.

THE OFFICE MARKING IS EVOLVING

For the office sector, the persistence of COVID-19 variants continues to delay a return to the office, but the pandemic had already permanently altered how workplaces will operate post-COVID-19—with a hybrid model the most likely solution for many companies. DiGuglielmo believes this will present problems for a significant portion of the office market, particularly for older buildings. “With so many people working from home, the smartest companies are leveraging their real estate to create a place where their employees want to be,” he says. “If you’re working from home in a beautiful office and your corporate office is in a Class B or C building, why would you want to go back?”

DiGuglielmo says companies are using high-end amenities such as cafés and tenant lounges as well as natural light, open space, and sophisticated air filtration systems to produce a work environment that appeals to employees. “We’re seeing companies take less square footage (10% to 15%) while they figure out the hybrid model, but they’re willing to pay the higher rent to get into a new building to attract and retain the best talent,” he says. As for the older buildings, DiGuglielmo thinks those properties will be difficult to lease, even when the pandemic eases. “I believe there will be a massive bifurcation between the new and old office product, and I think owners of Class B and C high-rises in downtown Pittsburgh may be compelled to convert to multifamily.”

Although the trend began before the pandemic, office conversions are picking up steam as the market responds to COVID-19. Since 2018, 45 office properties totaling 11.3 million square feet (MSF) in the 10 largest markets have been converted to industrial product, according to a Q3 2021 report by Newmark. CBRE reports that there were more than 8.6 MSF of office conversions in the pipeline in New Jersey in late 2021, including 4.4 MSF of residential and 2.3 million of industrial. And with life science demand exploding in markets like Boston/Cambridge, the San Francisco Bay Area and San Diego, office-to-lab conversions represent more than 20% of total lab space under construction in six out of the 11 largest U.S. life science markets. There was 8.5 MSF of office-to-lab conversions planned or underway in 2021 in Greater Boston alone, fueled by average asking rents of nearly $100 per square foot, according to a Newmark report.

The draw of life science is spreading to other markets as well. DiGuglielmo’s firm, which primarily develops Class A office, recently switched gears during the spec construction of a 155,000 square foot Class A office building. “The University of Pittsburgh came to us and said, ‘We love your building and all the amenities, but you’re building the wrong building. We need wet lab space.’ So we made the pivot and converted the building to 100% wet lab life science building.”

RETAIL CONVERSIONS

On the retail front, the debate over the practicality of mall conversions has garnered the lion’s share of press, but high-vacancy strip centers are also being converted to other uses. “We’re seeing an interesting phenomenon of Class B and C retail being converted into flex/service centers, depending on the functionality of the building,” says Sarah LanCarte, SIOR, president of LanCarte Commercial in Fort Worth, Texas. “Typically, it’s blighted centers in cities that are allowing for conversion because the properties are sitting vacant and not doing much for the city, so they’re willing to work with us on zoning so we can bring new life to the area.”

LanCarte recently worked with developers on two such projects: a 57,000 square foot center in Fort Worth located within one mile of the interstate that was 70% vacant, and a 40,000-plus square foot strip center in Dallas with less vacancy but expiring leases. Both were purchased by developers who re-purposed the assets into service-oriented product that will target tenants like plumbing and electrical contractors or other small industrial users, while retaining some solid-credit retail tenants. “Investors are seeing this as an opportunity because these assets are viewed as traditional retail, but the acquisition pricing is below that of industrial, so there’s a serious value-add component.”

CONVERTING MALLS AND OTHER LARGE SITES

The idea of converting malls to industrial uses has always been enticing, given their proximity to population centers and connectivity to roadways and infrastructure, but the reality of such conversions has always been more complex, with numerous well-documented challenges. Still, the repurposing of malls into fulfillment centers, housing, medical uses, or mixed-use has been gaining momentum, as evidenced by 2021 deals like the 92-acre Paradise Valley Mall in Phoenix that will be transformed into a mixed-use development comprised of 3.25 MSF of residential space, office buildings, and restaurant/retail space.

Shopping malls are not the only large sites that are being re-purposed into higher and better uses. David Robinson, SIOR, is principal of the Montrose Group in Columbus, Ohio, which helps national developers prepare sites for industrial, office, and multi-family development. Montrose is working with Atlanta-based Stonemont Financial Group to redevelop the Columbus Steel Castings factory, a 70-plus acre urban infill site in Columbus. The site will be redeveloped for approximately 860,000 square feet of industrial, although the specific use had yet to be determined at press time. “The site has a strong history of manufacturing, but the logistics market is really hot and it’s close to a large population base in Columbus, so it could be either,” says Robinson. “Breathing new life into former industrial sites makes total sense from a real estate perspective, with a location with dual rail service and a ready workforce, serving as a critical job center in a distressed neighborhood.”

In redeveloping large sites, Robinson emphasizes the need for public-private-partnerships that may include local and state site development grants (including brownfield remediation), property tax abatement, and infrastructure financing. “Unless you can develop an approach where the local governments and the schools can gain something from the development project, it’s very rare that it can get the necessary abatements because redevelopment sites can be very complicated.”

THE RESURGENCE OF RAIL

In addition to the repurposing of assets, there are other shifts underway in the world of development, including an increased focus on rail. “Rail is becoming the flavor of the day again, and more companies are now looking at it as a significant piece of their intermodal transportation model,” says John Colglazier, SIOR, partner at NAI Partners’ San Antonio office.

He cites issues within the trucking industry—a lack of drivers due to both wage and benefit competition from Amazon and major retailers, as well as the government crackdown on substance abusers in the industry, which has sidelined over 60,000 drivers since 2020. And as traffic issues in major metros mount, rail offers a more timely alternative.

Colglazier’s firm recently partnered with developer RCR Rail Co. to develop a 750-acre rail-served logistic/industrial park with dual rail service in Taylor, Texas, located adjacent to Samsung’s planned $17 billion chip plant, 35 miles from Austin’s central business district, between the DFW Metroplex and Mexico. The master plan calls for 13 warehouse buildings, with eight of the warehouses at 500,000 square feet. The first building, a 350,000-square-foot spec rail-served distribution building, will deliver in Q4 of 2022. “Historically San Antonio has had some rail positions, but Austin has not, so this will basically serve the rail needs for central Texas,” says Colglazier.

As the CRE industry continues to undergo change, successful owners and developers—as well as the brokerage industry—will adapt to meet those challenges and continue to thrive.

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CONTRIBUTING MEMBERS

John Colglazier, SIOR

Scott DiGuglielmo, SIOR

Sarah LanCarte, SIOR

David Robinson, SIOR