Repurposing Distressed Commercial Assets

Repurposing of distressed properties demands commitment and creativity. Different stakeholders—from owner to redeveloper, from creditors to the local government—must work together toward a common goal. An adaptive use requires vision, a keen understanding of the local marketplace, and the marketing expertise to find a different category of tenant.

Slowly but surely, signs of life are emerging in the distressed commercial real estate market. While the total amount of distressed real estate continues to climb, sales of distressed commercial properties have begun to rebound, and some entrepreneurial owners are developing alternative uses or transitional leases for empty shopping centers, foreclosed condominium complexes, abandoned auto dealership buildings, vacant big-box stores, and other financially struggling properties.

Just within the past two years, darkened spaces in shopping centers and big-box stores have been converted into an artists’ colony in Missouri and a YMCA in Texas, and a transit-oriented redevelopment plan is under development in California. Office buildings have become business school classrooms in Pennsylvania and a green-building showcase in Maryland. Auto dealerships have been repurposed as a bottling plant in Virginia, a grocery store in Michigan, and a church in Pennsylvania.

“You’re seeing the use of specialty leasing everywhere, both in the most upscale centers and the most downtrodden properties,” says Rudolph Milian, senior vice president for professional development services at the International Council of Shopping Centers (ICSC) in New York City and author of The Retail Green Agenda about sustainable retail development. “There are higher vacancies in tough times, so there’s more incentive to lease in-line [interior] spaces month to month with traditional and alternative uses, and you can basically earn a lot of additional income by doing that.”

Most owners of distressed properties are trying to continue with the same use, and the marketplace is still depressed and difficult for any distressed commercial assets—defined as properties that lack tenants and cannot meet their debt service, so they are in or headed for foreclosure. Since the beginning of 2007, overall commercial property values have fallen more than 40 percent, according to Moody’s/REAL Commercial Property Price Index (CPPI), and many retail and multifamily housing complexes have fallen in value to less than half their debt levels. Some experts believe the worst is yet to come. The largest commercial real estate losses are projected for 2011 and beyond, a congressional panel overseeing federal bailout programs reported earlier this year. ULI’s Emerging Trends in Real Estate 2010 called this cycle the worse commercial real estate decline since the Great Depression.

Nevertheless, deal making is already in recovery. Total commercial property sales in the United States were up more than 75 percent during the first half of 2010 from a year earlier, according to Real Capital Analytics. Going forward, Navigant Capital Advisors reports, “The infusion of capital into the commercial real estate sector has been a positive step toward recovery.”

So, more repurposing of distressed properties is expected in coming years, especially as the economy improves and lending practices loosen up. “People are buying these distressed deals and looking at alternative uses, but they have not been able to execute on them yet,” says Spencer Levy, senior managing director in capital markets for CB Richard Ellis commercial real estate services in Baltimore. “It is going to happen when there’s an uptick in the economy, but just not yet.”

Both now and in the future, taking on such reuse projects demands commitment and creativity. Different stakeholders—from owner to redeveloper, from creditors to the local government—must work together toward a common goal. Adaptive use requires vision, a keen understanding of the local marketplace, and the marketing expertise to find a different category of tenant. “The complications of regular real estate deals become exponential,” says Stephen Blank, ULI senior fellow in finance and the principal researcher for the Emerging Trends in Real Estate series. “It takes a different skill set.”

The following are examples of reuses of distressed commercial real estate made in the current real estate climate.

Condominiums: Reverting to Rentals

During the go-go years of condo conversions, Sunset Lake Villas in Margate, Florida, put its units on the market, despite being a Class B property with low-slung, one-story buildings. Only a quarter of the 44 units sold, and when a new appraisal reduced the value of each unit from $125,000 to $40,000 or less, the property could not be refinanced and could not make loan payments. That is when the owner, New York City–based AJG Realty, plotted a new course: conversion of owner-occupied units back to rentals.

It was not easy, requiring approvals from more than 80 percent of voting interests in the condo complex. But a change in Florida law had streamlined the legal process of terminating condo ownerships. Earlier this year, Sunset Lake Villas completed the termination process and became what is believed to be the first reversion of a condo conversion in Florida.

“It’s a complicated transaction, but at the end of the day, it’s the only way to recover value,” says Grant Stern, who guided the effort and heads the Condo Terminators consulting group with Morningside Mortgage Corp. in Florida. “We could see a lot of these over the next five years. It’s going to pick up steam and take off.”

For a property owner or developer, a condo termination offers some benefits: insurance is cheaper on the building, there is no condo association to deal with, and rental occupancies are on the rise following the mortgage meltdown. Now, Sunset Lake Villas is 80 percent occupied, and more such projects are in the works in Florida.

Shopping Mall: Artists’ Colony

The struggling Crestwood Court mall in suburban St. Louis sold in 2007 for less than 20 percent of what it had sold for a decade earlier. The new owner, Chicago-based Centrum Properties, intended to demolish it and build an open-air, pedestrian-friendly lifestyle center. But before Centrum could get started, the recession hit, sticking the firm with Crestwood’s rising vacancies. By early 2009, two of the three big-box department stores had closed, and one wing was virtually empty.

Crestwood’s leasing team at Jones Lang LaSalle pursued a novel idea to fill some of the vacant storefronts: invite artists to move in at reduced rents. It was an immediate hit in the St. Louis art community. While the leasing agents initially hoped that perhaps 20 artists would respond, Crestwood’s ArtSpace now encompasses more than 60 storefronts, from art galleries and dance classes to an art school and pottery studios. Together, they occupy 200,000 square feet (18,600 sq m)—nearly half the mall’s small-space retail footprint.

ArtSpace by itself produces negligible revenue for the mall, but the increased foot traffic helped the facility attract a few small tenants and retain a few more, says Leisa Son, marketing manager for the mall. More important, ArtSpace has generated a bonanza of good publicity. St. Louis’s alternative newspaper named Crestwood its Best Mall of 2009, and earlier this year Crestwood won a prestigious MAXI Award for public relations from the ICSC.

“We have effectively changed the public perception of this center and reengaged the community in the center,” Son says. Centrum still intends to demolish the mall—all ArtSpace tenants are on temporary leases—but Son says the artists’ colony has “become a key part of the center that we hope to carry forward in the redevelopment.”

Office Building: Going Green

Merritt Properties in Baltimore specializes in building new office and warehouse buildings, but it decided to branch out into the redevelopment market when it bought a vacated, Class B call center with a leaky roof in suburban Hunt Valley. The redevelopment market that Merritt chose to target was green office space.

Merritt stripped off the three-story brick exterior and created a curtain wall of low-emissivity green-colored insulated glass for daylighting. On the inside, Merritt replaced the mechanical systems and added high-performance lighting that helped reduce the building’s energy consumption by more than 10 percent. The restrooms were refinished with self-metering faucets that reduced water use by 40 percent. And to top it off, part of the roof was turned into a green roof with a plant tray system. The redevelopment cost was more than $10 million.

Despite reopening in 2008 in the midst of the recession, the newly christened Schilling Green immediately attracted finance and technology tenants interested in the Class A building’s energy-saving features and likely recognition under the U.S. Green Building Council’s Leadership in Energy and Environmental Design (LEED) program. They were rewarded earlier this year when the building was certified LEED Core and Shell Platinum, the first building in metro Baltimore to achieve that rating. “We’re probably the most talked-about adaptive use building in the marketplace, and we’re attracting quality tenants,” says Merritt’s leasing director, Lou Boeri. This past summer, Schilling Green reached 63 percent occupancy.

Auto Dealerships: Schools and Churches

Until the recession hit, the poster child of distressed commercial reuses was perhaps the big-box store. Across the country, shuttered Kmarts, Walmarts, and the like were turned into libraries, health centers, go-cart tracks, even the Spam Museum in Austin, Minnesota. Today, a new symbol of creative commercial reuses may be emerging: auto dealerships.

With car sales plunging and U.S. automakers downsizing during the recession, more than 2,000 dealerships have closed across the country since the beginning of 2009, according to Norm Miller, vice president of analytics for the CoStar Group, a commercial real estate research company. Sales of dealerships jumped some 70 percent in 2009 over 2007. Most were snatched up by rival dealerships, but plenty of others have found new uses: a discount grocery in the western Michigan town of Whitehall, classroom space for a technical school in Tulsa, a yoga studio in Los Angeles, a plumbing company’s headquarters in suburban Pittsburgh, a new church campus in Harrisburg, Pennsylvania, and on and on. Dealership sites are in some demand because they typically offer a medium-sized building with lots of parking along a well-trafficked thoroughfare. As the Rev. David Ashcraft of the Harrisburg church told the local newspaper this past spring, “We wanted to be located near the freeway. We wanted something contemporary with a lot of space and a lot of parking. I thought this would be the perfect place.”

Overall, some tenants across the country are being drawn to distressed commercial real estate because of the properties’ low lease rates, visible location, or promising redevelopment plan. Owners, developers, and financiers of distressed properties need to be creative and committed in pursuing alternative reuses that fill needs in their geographic markets.