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Practical Concerns with Adaptive Re-Use Office Projects

Special considerations in adaptive re-use office projects range from drafting the lease document to projecting operating expenses.

Creative office space is all the rage in the commercial office world, with adaptive re-use offices being a prominent part of that newly popular office class. Such office space, often found in unique parts of cities that have long been abandoned or underutilized, appeals to a younger talent pool because of its novelty. These spaces, which can include old manufacturing facilities and warehouses, are also viewed as environmentally responsible because no new ground is disturbed by their development.

As the demand for adaptive re-use space increases, certain challenges unique to this real estate product are emerging. These include leasing, construction and operational and property management-related concerns.

Leasing concerns

Leasing concerns for adaptive re-use projects generally fall into two areas: tenant-specific and lease-specific.

Adaptive re-use projects attract a different type of tenant than traditional office developments. While there has been progress in upgrading the tenant pool in adaptive re-use projects from a credit and longevity in business standpoint, as the product becomes more accepted, the vast majority of tenants looking into occupying this space are still from the creative arts community or are start-up enterprises (TAMI sector tenants: technology, advertising, media and information). The credit of these tenants, while it generally has been improving as more traditional users opt to occupy this space, has been and can be a challenge.

One way to address the lack of credit and security deposit is by providing highly functional, versatile and easily-modified space. Then, if the first tenant fails, there is not a long way to go, or much work to do or expense to incur, to lease it to the next user. Design can be kept spartan with uncovered floors, walls and ceilings, and—because many tenants are primarily attracted to the unique building fixtures—high ceilings, exposed brick, concrete floors and roll-up garage doors. The mechanical, electrical and plumbing work that the landlord does for the first user will have utility going forward.

Hours of operation in adaptive-use projects also become an interesting challenge for landlords, because they often differ from traditional office hours. This can increase costs arising from basic services like cleaning, trash removal, maintenance and security, among other items. For instance, employers may need to escort employees to their cars at the end of the work day, which may require more on-site security guards. Adaptive re-use projects are frequently found in less developed neighborhoods that can come with more risks than exiting a high-rise building in the heart of downtown.

In addition to the challenges associated with specific tenants, new issues need to be addressed in the lease drafting itself to allocate risks between the landlord and the tenant and to properly document the business understanding.

Creating a “building standard condition” for the tenant user can be a challenge: In what condition is the space that the landlord is providing to the tenant? The traditional “vanilla” shell offered in a new office building does not exist in this circumstance, so the landlord should be careful in disclosing conditions in the older building that might have a dramatic impact on a tenant's construction costs. This becomes more challenging when the landlord does not know the exact building condition—what the tenant will find when the tenant starts ripping out walls. Overlaid in this concern is how well the landlord can rely on a statement in a lease that the tenant takes the space “as is,” in an attempt to shift liability to the tenant for adverse conditions that might exist behind the walls, under the floors and wherever else there are risks that cannot be seen by the tenant’s initial walk-through and inspection of the space. Thus, there may be uncertainty for both landlord and tenant in construction-related costs.

Construction concerns

The construction-related concerns for leasing adaptive re-use projects center upon the difference in what you have in an adaptive re-use asset that would not be present for the build-out in a newer building.

One typical example of this is what also makes these buildings so popular: the extraordinarily high ceilings which were necessary in accommodating manufacturing as a use. The high ceiling adds to the feeling of authenticity; it also can require a 22-foot demising wall to separate spaces leased to different tenants. That demising wall requires a lot more material at a much greater cost.

Floors in these older buildings typically are not to a level standard like in modern buildings. Landlords can leave the rolling floors of an older building in place (concrete pours were not as precise 100 years ago, and sometimes produced a dramatic settling), at the expense of having the tenants' furniture systems not work well, their doors not close properly and their HVAC systems not circulate air well. In doing so, landlords also run the risk of more slip-and-fall or tripping-related injury claims, which may be insured claims, but can eventually increase insurance premium costs.

These older buildings often have more hidden flaws (latent defects) than seen in newer buildings because construction materials and techniques have improved over time, years of wear and tear on the converted building can leave their mark, and there were simply different requirements for the building's original use (which was likely industrial). The chances of, for example, a leaky roof, poorly sealed windows or improper drainage around the foundation of the building increase substantially in an older building.

Adding to the severity of this issue for the landlord is that contractors' warranties will typically be more limited, because the contractor may not take responsibility for components they did not create from scratch or that they do not have confidence in, so repairs can become a substantial cost that may not be passed through to the tenants.

Finally, during the early stages of this style of "newer" development, professional expertise may lag behind the increased demand for the skills necessary to properly complete this work. The lack of experience on these types of deals can manifest itself as an inability to properly price or perform the work or an inability to properly pull permits for the work. Improper pricing by a contractor can lead to cost overruns and contractor disputes about who pays for those cost over-runs. Improper work performance can lead to unhappy tenants, and weak performance on permitting and dealing with local authorities can lead to delays in construction start and completion.

Operational/property management concerns

Operational and property management concerns and challenges for adaptive re-use projects arise both out of the building and building structure and materials used in the building, and with respect to the tenant pool typically drawn to these projects.

Regarding issues that involve the building itself, the first challenge is to identify how difficult it is to project operating expenses on a go-forward basis when landlords and tenants are establishing the rental rates. Many rental rates are quoted either on a “gross” (with all expenses included) or “modified gross” basis (where first year operating expenses are included, and the tenant pays operating expenses in excess of that first year’s operating expenses). Under a gross or modified gross lease, underestimating operating expenses in that first year of a lease when the building is first open for business can create a loss of rental income for the entire term of the lease. Because of this challenge, many adaptive re-use landlords will quote rental rates on a triple-net basis (the tenant pays all utility costs, with no base year), which passes this risk onto the tenant. For landlords, this addresses the rental shortfall risk. Tenants must endure an occupancy cost that does not have the price certainty of a gross lease rental rate.

With older buildings, the chance of underestimating operating costs in an adaptive re-use building is much greater than one would have with a new building. The unique nature of the older building means the data available to make an operating expense estimate is much rarer. Because of the factors cited previously (potential leaks, capital repairs), owners may see expenses in that first year of operation that they did not expect to incur and that they may not be able to pass through to tenants.

The charm of very high ceilings presents a second operational challenge. Those ceilings may look great, but it is very difficult to heat and cool a room with that much volume. Air handlers in the ceiling must be employed to pump hot and cold air to properly heat and cool a room 22 feet down versus 9 feet down.

Finally, much of the charm and attractiveness of these buildings arises out of the neighborhood, atmosphere and community programming. If that positive vibe and activity is the promise and the difference that attracts tenants, then the landlord and the property management team must create an environment and events that meet the promise. That atmosphere and environment must be cultivated and created; it does not just happen. Scheduled events, street vendors and other attractions must be organized.

There is a clear desire to occupy space in the creative office space sector by tenants, which means there is a clear market for developers to pursue these types of deals. However, the adaptive re-use product has several built-in difficulties and challenges that must be addressed for the developer in the leasing, construction and operation phases to deliver a workable and profitable adaptive re-use project.

Mark L. Elliott is a partner with the law firm Troutman Sanders, based in its Atlanta office. Liz Koteles is vice president of agency leasing with real estate services firm JLL.

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