Correction: Some information on the Goldtex Building transaction in the "Values matter" section of the story has been updated and corrected.
The appearance of a new tower that alters a familiar skyline is always going to garner a lot of attention. In fact, one mark of boom times is the race to build the tallest, biggest or most expensive project.
In contrast, in normal recessions development takes a dip. But the recent recession was far deeper and more severe than normal. As a result, new development remains dormant. Instead, as the recovery continues to take shape, developers are finding work increasingly in the form of adaptive reuse.
“During a recession, when real estate is slow, investors will sit on a greenfield site longer than an existing building,” says First Hospitality Group’s Bob Habeeb. “A building cries out: ‘I’m built. I’m here. I’m lonely. Do something with me.’”
Cities across the nation are littered with projects that failed during the downturn as well as half-built projects in need of a new vision. Moreover, many boast historic downtown districts—areas that once hosted businesses that eventually left, but are now being reborn.
There are many reasons why developers are attracted to adaptive reuse today. There is an increased demand from cities, residents and tenants for renewed urban cores. Americans are regaining a taste for urban living and moving from suburbs back to redeveloped cities.
The tax credit market has also rebounded and redevelopment projects can qualify for a variety of programs. Decreased property values and distressed opportunities offer developers options to buy buildings to redevelop on the cheap. In addition, with lenders largely unwilling to fund ground-up development due to weak overall demand for new commercial real estate, there’s less potential competition. Lastly, some municipalities have modified their codes and zoning regulations to encourage adaptive reuse projects.
“Adaptive reuse is becoming more and more popular, and it has a lot to do with re-energizing historic downtowns from coast to coast,” says Claire DeBriere, executive vice president and COO of the Ratkovich Co., a Los Angeles-based company that has worked on adaptive reuse projects. “A lot of cities are pursuing preservation and adaptive reuse projects aggressively. And they’ve been very thoughtful in how they can encourage development and rehabilitation of their cores into something that is new, different and engaging.”
Where credit is due
One of the main drivers in the recent bout of redevelopment stems from the rebound of the tax credit market.
variety of options are available for adaptive reuse projects including historic, low-income or New Market tax credits.
Federal Historic Preservation Tax Incentives are managed through the National Park Service. Commonly referred to as historic tax credits, these incentives are available for income-producing buildings that are determined to be “certified historic structures.” The incentives, which come in the form of 10 percent and 20 percent tax credits, are used for rehabilitation. There is no limit on the amount of historic tax credits that are available. Moreover, many states have their own historic tax credit programs.
Low-income housing tax credits (LIHTCs) are part of a federal program that is administered on the state level. There is a finite amount of LIHTCs available annually, and developers aggressively pursue these credits. They apply exclusively to multifamily projects, but can be targeted toward specific groups such as seniors, veterans or former prisoners, among other groups.
The New Markets Tax Credit Program (NMTC Program) was established by Congress in 2000 to spur new or increased investments into operating businesses and real estate projects located in low-income communities. 2011 was the final year of the program unless Congress decides to extend it.
Approximately $7 billion in LIHTCs will be allocated for 2012. $3.5 billion of NMTCs will be issued in 2012, and current estimates place the size of the 2012 HTC market between $550 million and $650 million credits, according to Novogradac & Company LLP, a San Francisco-based accounting firm that specializes in both federal and state tax credit markets.
Tax credits are transferred into equity through syndicators, which bundle tax credits and sell them to large companies that need to offset taxable income. For example, Developer A receives $10 million worth of tax credits. Syndicator B buys the tax credits from Developer A, offering a market-rate reimbursement in cash, 85 cents per $1 of tax credits for example. Developer A ends up with $8.5 million in cash. Large company C buys the tax credits from Syndicator B and uses the tax credits to reduce its taxable income by $10 million.
“Experienced developers that have pursued ground up in the past are looking now at alternative ways to decrease risk, and tax credits can make development more attractive,” says Jeffrey Rogers, president and COO of Integra Realty Resources. Including historic, low-income or New Market tax credits in a project’s capital stack makes the entire project seem less risky and more viable, Rogers says.
However, the tax credit market took a hit from 2008 to 2010. Since the tax credit investment market is typically driven by large corporations looking to offset taxable income, tax credits are more in demand during booms than in recessions.
During the most recent recession, the most active tax credit investors—banks and other financial institutions—suffered huge losses, and they didn’t need tax credits to offset their taxable income because they didn’t have any, Maxwell says.
Fortunately, as the economy has recovered, so has the tax credit market.
The price per tax credit the amount of pennies on the dollar that tax credits garner—has rebounded “amazingly,” Maxwell says. “Values are as strong today as they were prior to the financial crisis—in the high 80s to the high 90s. In California and New York, they’re getting more than $1 per credit.”
Prior to the recession and credit crunch, the reimbursement range was high 80s to over $1 for high-demand areas. During the recession, the range dropped to the 70 cent range and even a bit lower for rural areas. The credit crisis and recession really slaughtered the tax credit market. That meant that developers were dealing with a moving target in terms of how much equity they could expect from the tax credits. In a lot of cases, developers ended up with an equity shortfall because they expected more from their tax credits.
The amount that each tax credit is worth on the open market depends on demand for the tax credits, and again, that demand varies based on how much taxable income these companies need to offset.
A lot of creative projects are in the works across the nation. For example, Ratkovich is spearheading the adaptive reuse of the Hercules Campus at Playa Vista in Southern California.
The landmark property is comprised of 11 historic buildings totaling 537,130 sq. ft. on more than 1.2 million sq. ft. of land. The campus includes the hangar where Howard Hughes built his legendary flying boat, the Spruce Goose. “We’re able to tell a story about a place that is rich and unique that you just don’t get out of a new building,” DeBriere says.
Revived historic downtowns have also become popular. “When talking to people young and old, we hear that they want to experience dense environments,” says Brandon Raney, CEO of BC Lynd, an Austin, Texas-based hospitality development and management company. “The focus is moving away from suburban development and shifting to downtown and adaptive reuse.”
Indeed, some studies show that migration patterns to urban cores increased during the 2000s and that trend is expected to continue. According to a report by the World Bank, the percentage of the U.S. population that lives in urban areas has grown about 1 percent per year in recent years and reached 82 percent in 2010, the last year for which data is available.
Buildings with a rich history and unique architecture have proven to be a huge draw. In downtown Cleveland, for example, a number of historic office buildings have found new life as apartments.
Jack Waldeck, a partner at Walter & Haverfield in Cleveland who specializes in real estate law, represents MRN Limited Partners, the development company that has transformed the National City Bank building at 629 Euclid in downtown Cleveland into a mixed-use complex that will eventually include office space, a hotel and multifamily units. Over the past several years, and using a mix of historic and New Market tax credits, the firm updated the 1890s-era office building with new office suites and converted part of it into a Holiday Inn Express.
The top stories of the building were set aside for apartments, and MRN Limited Partners will begin work on that component this spring. The firm will finance the rehabilitation with conventional construction debt, Waldeck says. “Lenders are willing to finance the project because of the demand for apartments in downtown Cleveland,” he explains.
In addition, suburban residents also make their way downtown to take advantage of dining and entertainment options. In fact, many employers who moved their operations to the suburbs are moving back to the urban core because of the amenity base that downtowns provide.
Google recently purchased one of the largest office buildings in Manhattan, a beaux arts building in central Paris, a historic warehouse in downtown Pittsburgh, and a property anchoring the pedestrian mall in Boulder.
Companies pay to be close to knowledge, so as to reap the benefits of learning and collaboration. Biogen Inc. recently decided to leave its Weston, Conn., headquarters after only one year to return to Cambridge, Mass. This situates the company near Harvard University, MIT and a quickly growing cluster of pharmaceutical companies.
When it comes to hotels, providing an authentic experience in an historic setting can be a great selling point.
First Hospitality Group, a Rosemont, Ill.-based firm, is involved in transforming a Milwaukee, Wis., landmark—the Loyalty Building—into a 128-room Hilton Garden Inn.
The building was constructed in 1886 and served as the original headquarters of Northwestern Mutual Life. It is a Milwaukee and Wisconsin Landmark, and is listed on the National Register of Historic Places. It features a four-story atrium, original granite and limestone floors and façades, and one of the best-preserved and most celebrated 19th-century commercial interiors in the state. In addition to the hotel, the property will house 4,500 sq. ft. of ground floor retail space.
Another factor driving recent adaptive reuse work is the devaluation in commercial property, which has made redevelopment a more viable option. “This is a great time to be doing adaptive reuse projects because of the rare opportunity to get a good deal on marquee locations,” Habeeb says.
Raney, who has experience in both ground-up development and adaptive reuse projects, is also convinced that adaptive reuse makes more sense today. Adaptive reuse projects allow developers to invest in cities and areas that otherwise would be inaccessible because of prohibitive land prices or lack of available land, he adds.
Philadelphia-based Post Brothers Apartments has also taken advantage of the current cycle. The firm, founded by brothers Mike and Matt Pestronk, currently is transforming a rundown, vacant, former textile factory in the Pestronk’s hometown into a 162-unit, high-end apartment building.
Known as the Goldtex Building, the property changed hands several times during the recent real estate boom. The Pestronk brothers were looking for buildings to rehab in the same area, and when the Goldtex Building went into foreclosure, the duo jumped on the opportunity to acquire it.
They plan to invest a total of $40 million (including what they paid for the building) to transform the eyesore, which includes the creation of a 5,000-sq.-ft. external “green” wall and other sustainable elements. The previous owner of Goldtex had paid $12 million for the property in 2006 and still owed $9 million in 2010 when the property went into foreclosure. The Pestronk brothers say they paid $5 million for the property in 2010. They declined to name who the previous owner was per confidentiality agreements.
Post expects to achieve IRRs north of 20 percent. “This is generally what we shoot for on all of our projects,” says Matt Pestronk. “Some think we are very aggressive in our rent projections, but we don’t use a lot of leverage so our downside is generally insulated.”
“When a property has major physical or cash flow issues, they are not as easy to finance with debt, and those are the opportunities we look for,” Pestronk says. “Where others see stability, we see the danger of overpaying, and where others see risk, we see fundamental value by being able to more cheaply buy an asset we are confident in our ability to fix.”
Post had the opportunity to acquire Goldtex previously but passed. The previous asking price was more than twice what the brothers paid to eventually gain control of the property.
A last factor is that some cities are revising ordinances to promote more adaptive reuse. Los Angeles originally approved its Adaptive Reuse Ordinance in 1999, which paved the way for its downtown revitalization, specifically allowing the creation of apartments and condos.
Now, the City Council’s Planning and Land Use Committee is looking to change the ordinance in hopes of spurring more development, specifically some of the derelict buildings on Broadway. As it stands today, the adaptive reuse ordinance conflicts with some of the city’s building codes. For example, the city’s commercial zoning code allows five employees for a live/work unit, while the Adaptive Reuse Ordinance only allows one. In addition, the ordinance addresses the repurposing of buildings into hotels, while the current building code does not. The review has been written up in several different local publications.
Developers like Raney and the Pestronk brothers who have focused on adaptive reuse for several years, enjoying nominal competition, recently have noticed a greater number of developers entering the sector and creating a more competitive environment.
These “interlopers” generally have no experience with adaptive reuse, having previously focused exclusively on ground-up development, yet they’ve been compelled to tackle adaptive reuse projects because of the overwhelming push toward repurposing older buildings.
“There are more players in the adaptive reuse arena than in the past, both developers and investors,” says Tom Maxwell, vice president of originations for WNC & Associates Inc., a national investor in urban renewal and affordable housing projects. “We’ve seen the entrance of traditional developers coming into this business because the number of opportunities to do ground-up new construction profitably is fewer than five to 10 years ago.”
However, Habeeb warns that adaptive reuse projects require a lot of discipline because of their complexity. “It can be heartbreaking to not do some of these deals—especially for grand, old buildings—but you can’t fall in love with these projects. They have to make financial sense, and there are a number of developers who have gotten snake-bitten when doing adaptive reuse.”