Find out how flexible office space could improve your building’s value, in this CBRE report; also, trends for medical office buildings and warehouses

by Brianna Crandall — February 22, 2019 — Global commercial real estate services and investment firm CBRE published three reports in recent weeks covering the transaction value added by flexible office space; the rise of outpatient centers as medical office building rents hit record highs; and the previously “implausible” number of retail facilities converting to warehouses.

Flexible office space

A CBRE analysis of recent national building sales that include flexible office space found that nearly 40% of these transactions achieved values greater than the average for office buildings in their market.

The CBRE study also found that another 52% of those deals were sold at values roughly equivalent to their respective market average. The analysis included 31 transactions within the past five years of buildings with at least 10% of their square footage dedicated to flexible space.

Julie Whelan, Americas head of occupier research, CBRE, stated:

Our analysis found that in some cases the presence of flexible-space tenants — and the building improvements they initiate — may benefit overall property values, causing some lower-classified buildings with flexible space to perform as if they were Class A assets. By investing in build-outs and progressive real estate structures, such as partnerships with flexible space providers, landlords can differentiate their properties and, under the right circumstances, boost their value beyond that of their peers.

CBRE’s analysis included comparing sales of buildings with flexible office space to sales of similar, same-market buildings without flexible space.

The CBRE study found that most buildings with modest portions of their square footage dedicated to flexible office space registered no detrimental impact to their cap rates — a measure of a building’s value relative to its cash flow. In transactions of office properties with flexible space comprising less than 40% of the building, 67% produced capitalization rates on par with non-flex peer transactions.

Conversely, in transactions where flexible office space comprised more than 40% of the building, 64% produced cap rates less favorable than in peer transactions. The divergence is likely due to the perceived risk associated with higher concentrations of flex space, as well as the fact that buildings with high flexible space concentrations are much more likely to be Class B buildings.

CBRE points out that while the analysis reveals several interesting patterns, the sample set is limited to a small pool of building with flex space that have been sold. As flexible workspaces become more widespread and more buildings with this space are sold, a clearer valuation picture will emerge.

Whelan added:

Despite our expectation that the flexible space segment will continue to mature and expand in the coming years, real estate fundamentals will remain the most important consideration for investment, regardless of the presence of flexible space.

To download the report, U.S. Property Value Implications of Flexible Space January 2019, upon brief registration, visit the CBRE website.

Outpatient centers and medical office buildings

The US outpatient care center sector has grown robustly in recent years as asking rents for medical office buildings continue to rise and health systems seek to provide a better patient experience at a lower cost, according to the second new report.

The US average asking rent reached its highest level on record in the second quarter (Q2) of 2018, rising 1.4% year-over-year to $22.90 per sq. ft., due to tight market conditions and the completion of new, high-quality space.

Andrea Cross, Americas head of office research, CBRE, remarked:

Rents increased in two-thirds of the markets tracked by CBRE and grew fastest in some of the markets with the lowest vacancy rates, including Nashville, Manhattan, Louisville, Seattle, and Indianapolis.

In addition to rising rents, health systems have increasingly turned to lower-cost outpatient centers — which enable them to provide lower-cost services closer to where patients live — due to higher capital costs stemming from mergers and acquisitions and a surge in in employer-sponsored, high-deductible health plans requiring patients to pay larger out-of-pocket amounts.

According to the report, the total number of outpatient centers grew more than 50% to approximately 41,000 from 2005 to 2016. Outpatient center employment has more than doubled since 2003, and grew 3.5% year-over-year in October 2018, compared with 2% annual growth in overall healthcare employment.

Mark Lamp, executive managing director, Healthcare, CBRE, pointed out:

Healthcare systems are increasingly catering to patients as consumers — rather than simply users — of healthcare services. They are creating outpatient facilities that provide a more “hotel-like” experience — and at a lower cost than the more expensive hospital services — with technology-enabled check-in, abundant natural light and incorporated outdoor spaces, and patient care concierges trained to support guests with any needs.

Development trends

Medical office development strongly correlates with population growth, with Phoenix, Houston, Dallas/Ft. Worth and Atlanta among the top markets for total completions from Q3 2017 to Q2 2018, along with Minneapolis/St. Paul, a leading healthcare cluster. Houston, Minneapolis/St. Paul, Atlanta, Chicago, the Inland Empire, Kansas City and Boston rank among the top markets for square footage under construction.

After nearly 60% growth in medical office completions between 2011 and 2017, under-construction levels have started to slow, with lower levels of new supply in the coming quarters likely.

Cross continued:

Many hospital systems have slowed their development activity to reexamine their operations, including how to adapt their real estate strategies to provide a better patient experience at a lower cost.

The U.S. Medical Office Buildings — Strong Demand, Aging Population Fueling Growth report is available from the CBRE website.

Retail to warehouses

Retail real estate left behind by the retail industry’s evolution can find new life as warehouses and e-commerce distribution centers, as shown by the third new report from CBRE detailing 24 such conversion projects across the United States.

CBRE found various types of retail-to-warehouse conversions, including demolition of obsolete malls to be rebuilt as warehouses in Baltimore, Atlanta, Chicago, Detroit and several markets in Ohio. Other retail structures were left standing and repurposed for industrial uses, including a former Toys ‘R’ Us in Milwaukee now occupied by a business that remanufactures transmissions, and Sam’s Club’s conversions of several of its stores to distribution centers.

The conversion trend, while growing, remains a niche in the industrial-and-logistics real estate market. Still, it draws momentum from ongoing factors in each industry: Demand for warehouse space is so strong that vacancies are at or near historic lows in many markets. Meanwhile, though the broader retail market is healthy, closures by national big-box retailers and department stores have created opportunities in many cases for nonretail uses to move in.

David Egan, CBRE’s global head of Industrial and Logistics Research, commented:

In nearly every market in the US, there are sites where this kind of repurposing could work, at least on paper. But many conversions are more challenging to execute than it might seem, given that the developer-owner of each site often needs to get a wide group of stakeholders to agree on a fairly dramatic change.

Location an advantage

Factors favoring retail space for conversion include the prime location of many retail centers, which often sit at busy intersections or highway interchanges. Another advantage is site access. Standalone big-box stores, in particular, offer backend docks and easy access for trucks. They also have the high ceilings needed for distribution uses.

Finally, some retail spaces simply are available, which isn’t always the case for industrial properties in many markets. Most of the conversion projects analyzed by CBRE are in markets with vacancy of less than 5% for industrial-and-logistics real estate.

Gaining consensus a challenge

The primary impediment to conversions is that retail centers are designated for retail uses, by economics and by covenant. Many centers are encumbered by mortgages predicated on retail lease rates rather than traditionally lower industrial lease rates. Any landlord looking to convert their center also would need the approval of their lenders, city officials, neighbors and, in many cases, the center’s other retailers. Some mightn’t appreciate the increased truck traffic and decreased shopper traffic.

Adam Mullen, Americas leader of CBRE’s Industrial and Logistics business, noted:

These types of conversions were once unthinkable, and now they’re not only happening, they’re gaining traction. That industrial uses can overtake what are usually higher-rent uses illustrates the strength of demand for industrial real estate, especially last-mile distribution centers.

To access the report, Trading Places: Retail Properties Converted to Industrial Use, as well as an interactive map of the 24 conversion projects, visit the CBRE website.

With more than 90,000 employees in 480 offices worldwide, CBRE offers a broad range of integrated services, including facilities, transaction and project management; property management; investment management; appraisal and valuation; property leasing; strategic consulting; property sales; mortgage services and development services.