Developers Turning To Adaptive Reuse; Eye Excess U.S. Property

Posted on March 1, 2012

What’s a developer to do? With development financing still very tough to come by and construction levels at all-time lows, many are turning to redevelopment, adaptive reuse and jump-starting stalled projects ahead of an expected broader recovery as a potentially less expensive and more lucrative alternative to ground-up development.

Developers are closely monitoring dual legislation from the White House and in Congress that could result in the disposition of thousands of excess or under-used federal buildings. The potential disposition targets include choice properties in top U.S. metros, which could be converted or repurposed as hotels, apartments, shopping centers and commercial office projects.

In a rare occurrence of bipartisan agreement, both political parties have supported efforts calling for more efficient use of government space. Last May, the administration sent a bill to Congress that would establish a commission to consolidate, shrink and realign the federal property footprint by expediting the disposal of properties.

On Feb. 7, 2012, the interests of lawmakers and would-be redevelopers of excess federal property converged in the nation’s capital. The GOP-led House of Representatives passed a similar bill to the President’s, the Civilian Property Realignment Act (HR 1734). The legislation, patterned after the Defense Department’s Base Realignment and Closure Commission the 1990s, was introduced by Rep. Jeff Denham, R-CA, who cites an Office of Management and Budget report that such a “Civilian BRAC” commission could raise $15 billion from property sales, and generate much more in savings by eliminating future operating costs of the buildings.

The same day the Civilian BRAC legislation was introduced, the U.S. General Services Administration (GSA) confirmed it had selected an investment group headed by Donald Trump’s hotel group and private-equity firm Colony Capital to redevelop the 113-year-old Old Post Office Pavilion at 1100 Pennsylvania Ave. in Washington, D.C. With its distinctive 315-foot clock tower, the Old Post Office will be redeveloped into a 250-room luxury hotel as part of a $200 million adaptive reuse project.

The drawing down of federal property is already under way at the U.S. Postal Service, which is planning to eliminate more than half of its 487 mail processing facilities and thousands of local post offices in response to declining mail volume, seeking to reduce $20 billion in operating costs by 2015. In one recent disposition, a joint venture of Insight Property Group and Nova-Habitat Inc. purchased a former post office in Silver Spring, MD. The new owners plan to develop a 310-unit apartment building as part of a $75 million project. Other jurisdictions, including Palo Alto, CA, are also weighing active proposals for acquiring postal facilities.

Both the President’s proposal and the Civilian Property Realignment Act, which would require the new commission to sell $500 million in property in its first six months, could result in a wave of surplus federal space hitting private property markets, creating a huge potential opportunity for developers and investors. Charles Pinkham III, vice president of development for Atlanta-based Portman Holdings LLC, which has built 50 million square feet of space globally over the past 60 years, is looking to expand its business model into adaptive reuse of older buildings, primarily conversions of office buildings to hotels.

Adaptive reuse of older properties for purposes other than those they were designed for is hardly a new concept in the U.S., going back to at least the early 1960s when prominent San Francisco businessman William M. Roth bought the late 19th century vintage Ghirardelli Chocolate Co. property near the city’s waterfront to prevent it from being demolished and replaced with apartments. Roth and his group reopened Ghirardelli Square in 1964 as a mix of stores and restaurant that is now among the city’s most popular tourist attractions.

Portman believes it has the skills and resources in place to be equally successful in adaptive reuse as it has been in new development.

“Reuse and repositioning is easier for us today relative to ground-up development, mainly because it can be cheaper,” Pinkham said. “Development financing is currently very difficult, and adaptive reuse is not quite as hard to finance. We would step in after the bones, the basic asset, is already in place, eliminating some of the construction and market risk.”

Pinkham said, assuming one can acquire a half-finished hotel or condominium asset at the fairly common 50% below replacement cost from a developer that has run out of equity, the buyer can complete the development or redevelopment for 75% of replacement costs, which Pinkham calls “good economic sense.”

Pinkham said Portman looked carefully at the Old Post Office in D.C. ultimately won by The Trump Organization, which he called “phenomenal real estate; incredibly well located and an iconic structure in a gateway city.”

“Good real estate is good real estate. A lot of the federal buildings were built in some of the best areas, the business centers of tier one and tier 2 cities. A property on Pennsylvania Avenue like the Post Office with a really nice hotel and a Penn Avenue address with a good flag on it will do very well.”

One of the challenges is the potential high cost of retrofitting and upgrading older federal buildings — and incorporating the historical preservation requirements that may accompany them in some cases.

Other issues include the duration of the leasehold offered by the government. When the RFP for the Old Post Office was issued in March 2011, it described a 60-year lease from the GSA, a somewhat shorter term than what Portman would prefer. Other conditions of the old building also caused Portman executives concern.

“The question is simply, what kind of an investment will it take to get the asset up to peak performance, and get the highest and best use?” Pinkham said. “Trump was just more comfortable with the inherent risk and the cost and was willing to outbid the competition. And he outbid all of us by a pretty significant margin.”

Portman is not yet making a full-throated entry into adaptive reuse. That said, the Civilian Property Realignment Act and other legislation “could set the stage for some very attractive opportunities that we will certainly monitor, and may very well pursue if the real estate and location are good,” Pinkham said.

“The federal government alone owns 1.2 million buildings and some of these that are sold are going to be in the best locations in some of the great gateway, tier 1 and tier 2 cities. Those will be great real estate opportunities for us and a lot of other developers.”

While the market for new construction is slowly ticking up, Portman expects it will continue to look at strategic adaptive reuse projects even when development comes back in full swing.

“It’s not a replacement strategy for new development, it’s just something that makes good sense to embrace on a go-forward basis,” Pinkham said.

By Randyll Drummer, Costar Group