What’s driving adaptive reuse, and how can private equity tap into this increasingly common but misunderstood and under-analyzed property segment? Adaptive reuse, which involves repurposing a building designed originally for something else, is fast becoming a global phenomenon; from turn-of-the-century warehouses to castles to train stations, developers and investors have untapped enormous value from obsolete building stock. Adaptive reuse projects constitute between 1 to 2 percent of all commercial real estate space in the U.S.—and will likely increase to 4 percent over the next five years. What’s more, experts say that by 2023, adaptive reuse projects will make up a greater percentage of investment activity than self-storage and other select non-core property types. While these projects often are associated with lifestyle trends, such as the renewed popularity of urban living, other, less-glamorous factors also are at play: · The increased cost of land and construction for ground-up projects. · A desire by cities to remove blight and reinvigorate their tax bases. · An increased awareness of sustainability in development; and · The seismic changes in retail, which have freed up vast amounts of empty retail and warehouse space. While historic preservation projects are the most familiar reuse developments, adaptive reuse projects vary widely and are spread across markets of all sizes. In 2017, private equity-backed Soho House made a splash in London when it turned the former Midland Bank headquarters, built in 1924, into the swanky The Ned. In Kansas City, Ryan Companies transformed the 1965 Commerce Tower into a LEED Gold-certified 32-story vertical neighborhood, with commercial and residential use, as well as a day care facility, green space, and a university branch. In Brooklyn, Jamestown Properties, Belvedere Capital, Angelo Gordon, and Cammeby's International currently are expanding adaptive reuse on the 16-building, 6 million square-foot Industry City complex. The challenges of adaptive reuse While such developments can be appealing to investors, adaptive reuse still faces some hurdles. For more capital to flow into this asset class, it is essential to have an industry-recognized definition of adaptive reuse coupled with a methodology for valuation and underwriting. CCIM Institute, in partnership with Alabama Center for Real Estate at the University of Alabama, has been instrumental in establishing a solid definition. To qualify as adaptive reuse, a project must include four factors: 1. Existing structure: While adaptive reuse projects may involve some level of new construction or an expansion/addition of space, they always start with an existing structure. 2. Functional and/or economic obsolescence: The old use is no longer productive or economically viable, and the tenants have left. 3. Change of use: The project/property must involve a repurposing of a prior structure and use, not a mere re-tenanting with tenant improvements. Defining the new use is vital for capital sources to perform proper valuations of the project. 4. Economic viability: The new project/property must pass the ultimate test of highest and best use. Not only does the reuse need to be physically possible and legally permissible, it also must be economically viable. The underlying objective is to provide both regulators and capital providers the specificity needed for everything from tax codes and legal structures to valuations and due diligence. Ultimately, it also will pave the way for aggregation by private equity portfolios and REITs. AdRu opportunities for PE For those PE firms interested in ESG or socially responsible investing, adaptive reuse projects often tick all the boxes. These projects also tick the box for cost effectiveness. On average, AdRu projects are 15 to 20 percent cheaper and faster than new construction. In addition, private equity firms can take advantage of a wide variety of incentives for these projects, such as new market or historic tax credits, TIFs, low-income housing tax credits, and opportunity zones. Cities also are becoming more creative with incentives offered. After all, no one wants vacant properties in their town. Opportunity zones, in particular, are prime candidates for private equity and adaptive reuse deals. Looking at the available inventory in these newly defined opportunity zones – such as abandoned factories, warehouses, parking garages, and big boxes – these properties are perfectly suited for multifamily, mixed-use, hotel, or creative office projects. Adaptive reuse also can be an ideal solution for site selection for a private equity firm’s portfolio companies. Whether the company is expanding or relocating, adaptive reuse not only saves time and money, but can attract and retain a strong workforce. With the growing desirability of live-work-play lifestyles, particularly among millennials, the conversion of a unique property in the city or an urban satellite can be very attractive to this desired demographic. The social goodwill and public relations benefits shouldn’t be underestimated either. Adaptive reuse brings jobs, economic activity, and people back into communities and often saves or transforms a beloved structure in the neighborhood. Look to this combination of adaptive reuse and opportunity zone incentives as a powerful driver of growth in this asset class for years to come.