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The hidden impacts of obsolescence

A hidden factor of increasing importance in commercial real estate markets is functional obsolescence. It is especially important for office space, but also significant for most other types of properties. Many factors are causing buildings of all types that were built in the past -- even just a few years ago -- to become much less useful and attractive than those built to the latest, up-to-the-minute specifications. Those specifications involve not only the technical equipment in the building, but also its design, its location and its amenities.

In fact, today many buildings are becoming obsolete faster than in previous periods. This has profound implications for every aspect of property markets, including choosing locations, financing development, creating architectural designs and managing existing buildings.

The causes of functional obsolescence can be divided into four types, two of which are occurring faster than in the past: technological, regulatory, economic, and site and locational.

The most obvious technological cause of faster obsolescence is the rate of change of electronic and other means of communications. These include computers, telexes, fax machines, modems, telephones, answering machines, networks, satellites and line-of-sight systems. New developments in these fields are legion. They range from shifts in the type of wiring required to service both local-area and wide-area networks and other equipment, such as the use of optical fiber networks, to needs for new antennas, to changes in power loads to handle more electrical equipment per floor. Innovation is occurring so fast in all of these fields that buildings created just one or two years ago with the then-latest equipment are now lagging behind what is necessary to use today's -- and tomorrow's -- most efficient means of communication.

Other technological changes affect requirements for air conditioning and heating systems. The latest such systems permit detailed micro-area control of temperatures and humidity that promise notable cost savings compared to earlier systems that treated large areas as indivisible units. Elevators are also often inadequate in older buildings because workers want faster service with less congestion during "rush hours."

Another rapidly changing source of obsolescence consists of various governmental regulations affecting building design and use. Most older buildings do not contain costly up-to-date anti-earthquake design features. The Americans with Disabilities Act imposed many design changes related to making spaces accessible to persons with various types of handicaps that were never considered in the past. Still other regulations have been drafted to influence the quality of air within office and other buildings in ways that make some past design standards legally unacceptable.

Rather general economic changes also influence obsolescence. A shift from accentuating corporate wealth and opulence in the 1980s to emphasizing cost-minimization in the 1990s has made many grandiosely designed structures too expensive to operate. These include buildings filled with decorative but wasted space, such as huge lobbies and soaring atria, and costly marble and granite walls and floors. Older buildings are often not able to accommodate the flexible space partitions needed to cope with rapid changes in staffing and the downsizing of office floor space per worker. Huge floor plates in some older skyscrapers are not appropriate for the smaller firms that comprise larger and larger fractions of all office occupants in today's economy.

Finally, site and locational factors also cause obsolescence. Many buildings do not have enough parking to cope with the higher-than-ever fractions of all workers who commute in their individual vehicles alone. Still others are located in neighborhoods undergoing declining desirability because of rising local crime rates or downward shifts in the incomes of surrounding residents. This is particularly true of many downtown buildings, thanks to the continuing withdrawal of more and more economically viable firms and households from central cities into outlying suburbs.

When more and more tenants want the latest technical and other features in the space they occupy, they seek the most modern, up-to-date structures. This shifts demand away from older structures that lack such features. Other things equal, the result is a fall in the vacancy rate for Class-A space -- the most modern -- and a rise in the vacancy rate for Class-B and especially Class-C space. Of course, this shift can be partly offset by a decline in the rents of Class-B and Class-C space relative to those of Class-A space. Some tenants really do not need all the latest wrinkles in technology and are willing to forego them in return for lower rents. However, there is some minimum level of modernity and technological capability that even economizing tenants want today. Therefore, many Class-B buildings and most Class-C buildings cannot compete with the best Class-A buildings for top-quality tenants, no matter how far the former lower their rents -- unless those less desirable buildings are significantly remodeled and modernized.

The shift of demand toward high-quality space will cause Class-A buildings to fill up faster than the office space inventory as a whole. Therefore, vacancy rates across the nation in Class-A space will be lower than the average marketwide vacancy rates reported by such firms as CB Commercial, since the latter include at least some Class-B space in their inventories. Also, the lure of technical modernity will partly offset the decline in Class-A space occupancy that would otherwise have arisen because of hoteling, downgrading space per worker and telecommuting. Many commentators on office markets have predicted a huge rise in these practices will greatly diminish the overall growth of office space occupancy in the future, compared to the number of persons doing office-type work. Even if that occurs, the superior desirability of Class-A space means that the resulting slower growth in occupancy will be concentrated in Class-B and Class-C space.

Right now, most American office space markets are in the gradual absorption phase of the three-phase commercial real estate development cycle, often described in this column. (The other two phases are the development boom phase and the overbuilt phase.) Some analysts of office space have predicted that the gigantic oversupplies built in the 1980s would last throughout the 1990s, keeping office rents severely depressed in that period. They cite as reasons lower population growth rates, slower growth in the number of women working outside the home, the rise of hoteling and other space-cutting methods noted above and economizing trends in space per worker involved in corporate downsizing. These factors will, they claim, prevent office space demand from rising enough in the 1990s to absorb most of the space built in the previous decade.

But even if that prediction proves correct for all office space as a whole, it will not be correct for Class-A space. The shift of demand away from Class-B and Class-C space toward Class-A space will cause the latter to fill up much faster than many of these "prophets of gloom and doom" have predicted. Therefore, rents are going to rise in Class-A space sooner than they forecast.

Rents have already risen in Class-A space relative to those in Class-B and Class-C space -- mainly because the latter two collapsed farther than the former in the commercial real estate depression of the early 1990s. Moreover, construction of new Class-A office buildings will resume long before these same nay-sayers have been forecasting. I do not anticipate any large amount of such construction before the next general recession. But I believe a significant amount will be launched in the next development boom phase, which will start around the peak of the next general business cycle expansion near the end of this decade.

Another longer-run impact of faster rates of change in space technology is a reduction in the average lifetime that office and other buildings can achieve without major renovation. Even the most modern buildings created today will have to be remodeled and significantly upgraded earlier in their life histories than was the case in the past, on the average. This shortens the period over which such buildings can be fully amortized without allowing for substantial capital improvements. Therefore, building owners should build up reserves for modernization at a faster rate than in the past. And financial institutions making loans upon, or taking equity positions in, such structures should insure that bigger reserve funds for modernization are set up than has been typical heretofore. In order to prevent these higher reserve requirements from reducing overall investment yields, current rents must become somewhat higher in relation to initial building costs than in the past.

Many building owners and managers are not recognizing this need for greater spending on modernization over the lifetime of a typical structure. When purchasing structures for investment, they are bidding prices that are really too high because they are not fully allowing for the capital improvements that must be made to keep these properties competitive in Class-A markets. This is also true of some investors who have recently purchased existing buildings at huge markdowns compared to their original cost, or their current reproduction costs. In some cases, the prices being paid do not allow for the substantial deferred standards even if they are just a few years old. So some of these "hot bargain" properties may not turn out to be such "great deals" after all.

Another implication of these obsolescence trends is a big build-up of vacancies in Class-B and especially Class-C buildings. Many Class-C buildings today have vacancy rates of 50% or more. In some cases, they are too obsolete in structure or location ever to be used as office space at all. Even slashing their rents to almost zero will not lure many tenants worth having into them. This is going to create substantial neighborhood problems for areas where large numbers of Class-B and Class-C structures are concentrated. Examples are secondary office nodes lying in the first rings outside of major metropolitan downtowns. These office districts may gradually decline into dominance by secondary and tertiary uses, such as storage and loft uses, rather than office uses. This result will be aggravated by, and will contribute to, the continuing movement of firms and households with money out of older portions of central cities into new suburban locations.

Office buildings are not the only types of properties subject to serious functional obsolescence, though it is not necessarily occurring faster than in the past concerning other types. Warehouse buildings constructed just a few years ago with lower ceilings are no longer as efficient as those with 30-foot ceilings, because new hoisting and racking devices make it possible to store materials at greater heights. Regional malls built with many relatively small stores need to be modernized to provide larger floor plates for many merchants launching "super-size" outlets such as the new book stores that include coffee shops. Power centers have mushroomed in the past few years because they provide cheaper space for "big boxes" which reduce their overheads and also allow people to get in and out faster in this age of personal time pressures.

So taking proper account of obsolescence is vital concerning all types of properties. But it is especially crucial concerning office space because of the faster rate of change of its technological and regulatory causes in such space.

Investors, developers, managers and users of office space need to be aware of the importance of taking its rate of obsolescence into account in planning their activities. Recent technological and regulatory forces in particular have speeded up the rate at which office structures become out of date and therefore relatively less desirable than the latest versions. Those who fail to pay heed to these forces will suffer serious economic losses; whereas those who do take them into account will profit handsomely.

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