If You Don't Want Your Property To Become Obsolete, Here Are The 10 Things You Need To Know

“As long as real estate has existed, obsolescence has been a challenge: Buildings have always deteriorated, and the way people use them has changed. But today the issue is acute.”

That is the opening of a new report from the Urban Land Institute and PwC, Emerging Trends in Real Estate: The Global Outlook for 2019, which examines how real estate needs to operate in a new world where the way people use space is changing fast. As a result the business models that have served real estate well for decades are becoming increasingly challenged. 

“The customer used to be the capital markets, but now it is the person using the building,” one report interviewee said (interviewees are anonymous).

From working out how to make money from unloved retail, to the hidden dangers in logistics; from the need to bring hospitality into every sector, to working out how to put a value on how people feel about a building — these are the things real estate professionals will need to know to stop their property from becoming obsolete in the new world of winners and losers.

The Problem With Retail Conversion

The report had a major focus on the issues facing retail amid its seismic change. Conversion of failing retail to other uses like residential, office, leisure, logistics or public services like libraries will be a major trend over the next few years — but it will not be a short, simple or cheap process.

Unibail-Rodamco-Westfield Chief Financial Officer Jaap Tonckens discussed the possibilities and challenges to converting struggling department stores on a panel discussing the report at the Mipim property conference in Cannes, France.

“I would love it if [owner] Mike Ashley handed me back the House of Fraser store at Westfield Stratford,” he said. “I have got coworking space above that store which is performing really well, and I could drop that down into the unit and have much better-performing space. The amount of rent most department stores pay is de minimis.”

However, he was more pragmatic when it came to the question of the financial return from converting space from retail to other uses.

“Capital expenditure can only be justified if you make a return from it,” he said.

ULI/PwC’s report said conversions will be held back by the current structures used by real estate, be it in the form of leases or valuation.

“The big issue for retail owners is that current valuations preclude them being able to engage in alternative uses,” one investor said in the report. “They are leased at high rents that will fall and the cap rates are wrong, 4.5-6%.”

While it might seem counterintuitive, owners that do not invest to convert or improve obsolete retail may just be exhibiting rational self-interest, the report said.

“If you are a leveraged investor, you might know that the equity value of the scheme that you own is zero,” one investor said in the report. “With that in mind, the only value the property has for you comes from the leases that are currently in place. So why would you invest money in the property or do anything that reduces the income from those leases?”

On top of this, it will take some time before those willing to step in and undertake the process of repositioning retail get the chance, the report said.

“The private market takes a long time to reflect the reality, which is clear to see from values in the public market,” one investor told ULI and PwC. “Every owner in the private market has a story about why their specific piece of real estate is different and won’t suffer like everything else.”

The New World Of Delivery

The report painted a picture where the worlds of retail and logistics become even more blurred than they are today. In Asia, consumers can walk through a store like Decathlon, pay for items via their phones without taking them to a checkout, and have them delivered to their home within three hours.

At Alibaba’s Hema grocery store chain in China, shoppers can buy goods using their smartphones, have dinner at an in-store restaurant, and have their groceries delivered within 30 minutes. Alibaba has also built a shopping mall in Hangzhou featuring stores from its online platform, with the same cashless, instant-delivery technology.

The ability to have goods delivered from stores in malls means retail owners need to pay greater attention to the “back of house” and how deliveries can be facilitated from their properties. But it also poses a challenge to logistics: If deliveries can be fulfilled from stores, a retailer might not need as much logistics space.

Hospitality Leads The Charge

“Five years ago, if you had asked people, they would have said that hotels were one of the asset classes that were most susceptible to obsolescence, but today good hotels are seen as a safe haven because they’ve survived the onslaught of Airbnb,” one global investor said in the report.

Hotels have been at the forefront of adapting their business model and converting assets to better fit what customers want. Where possible, unused amenities are being converted to new rooms, and in general there is a move toward better communal areas and a greater number of smaller, design-led rooms, all of which increase the potential revenue of the space available. That makes brands like Yotel, CitizenM or 25Hours more profitable for owners.

“We underwrite deals for hotels with small rooms and big common areas, and instead of looking at 180 rooms, you now have 280. That is more potential revenue, and these kinds of hotels are also much more efficient to manage,” one investor said in the report. 

Everything Becomes Hospitality

Hospitality is changing, but its influence is also spreading throughout real estate. The need to understand the customer, the individual end user of a property, means the strategies employed in hospitality are being taken on board elsewhere, particularly in office real estate.

“The role of the landlord and space provider has changed,” one operator in the office space said in the report. “It is no longer okay to just give people a box and then not speak to them for the next 10 years. People want you to design, develop and manage the space for them. They want you to provide amenities, experience and help to create a community.”

This requires a fundamental shift in the mindset and organisational structure of traditional property companies, PwC and ULI said. As an example, the Crown Estate’s 2M SF London office portfolio was historically run by a team of about five people. But its 25K SF coworking facility on Heddon Street employs the same amount of staff in one small building, many of whom have been hired from the hospitality sector. Creating community and experience does not come easy to an industry that until very recently provided space not service, the report said.

Food Glorious Food

Technology will enable the conversion of some obsolete real estate to other uses that previously did not exist. Food delivery platforms like Deliveroo and CloudKitchens, the new company of former Uber Chief Executive Travis Kalanick, are taking obsolete real estate — offices, shops and industrial land — and using it to create kitchen space for delivery-only restaurants.

The Hidden Danger In Real Estate’s Favourite Sector

A major part of the conversation about obsolescence surrounds retail and office assets, beset as they are from disruptors like Amazon and WeWork. But logistics might be storing up problems for the future too.

“We all know you have to be closer to your customer today,” CPPIB Head of Real Estate Peter Ballon said on the panel at Mipim. “Hospitality and retail have always traditionally been the closest, office is moving that way, but logistics is the sector where you are furthest away from your customer. It is a box, and most real estate owners have no idea what goes on inside that box. Technology is changing so rapidly, and no one knows what the big users of logistics space are going to need in five years’ time.”

The Move To Mixed-Use

Today, mixed-use doesn’t just mean having a large campus development with multiple uses, or an office building with shops and cafés at the bottom. Truly mixed-use buildings are becoming increasingly common. At the Twentytwo office building in London, there will be 150K SF of amenities in the 1.2M SF building, including a health centre, food court and gym, as well as incubator and flexible office space for occupiers to utilise. 

Increased Operational Intensity

All of these factors can be defined by a wider trend, the report said — real estate is becoming a business which is increasingly operationally intense, and owners will be required to manage and run assets as well as just collect the rent. This is a difficult and expensive process, and is likely to mean, over the long term, returns from real estate are not quite as high. But if owners don’t adapt to this new world, they risk being left with empty properties people simply don’t want to use.

New Forms Of Value

Another major conclusion of the report is that real estate will need to come up with new measures of value. As mixed-use buildings become more prevalent, how are these buildings valued? What value is attributed to communal amenities that might not have a direct link to an income stream? And how will valuers and appraisers see sectors like coworking or co-living, where leases are short and turnover high?

“You have all of these business models that have never been seen before, and the capital market has not evolved yet to work out how to value these assets,” one investor said.

A major part of real estate’s challenge to adapt to the new needs of customers will be finding how to value what has never really existed before.