With the desire by many Arizona residents to experience a more urban lifestyle, the repurposing trend of commercial buildings/areas has increased. From the extensive “raze, scrape and re-build,” to merely “gut and renovate,” commercial real estate developers and investors are creating imaginative and dynamic projects. In most instances, this transformation is a result of market forces, where an office building suffers from a lack of tenant demand, an industrial space gets upgraded to “back office” use, or a regional shopping mall loses the anchor tenants.
With the benefit of a growing population and economy, the greater metropolitan Phoenix area appears to be fostering many repurposed projects, as evidenced in Phoenix by the Seventh Street Corridor, Roosevelt Row, and ASU’s downtown campus. Repurposing commercial real estate requires thorough due diligence, significant time, and a relatively large scope of review with the legal and development team.
Adding to the challenges for redevelopment is the state of the current credit market for commercial real estate, which has grown increasingly conservative. This is due in part as a result of the shift in “favored” sectors, where the perception by investors is that retail is struggling, office is generally not desirable, and multifamily seems stable primarily as a result of the relatively low supply of new single-family homes and the continued influx of new residents.
The opportunity presented is to purchase the commercial real estate at its existing value (e.g., the current NOI, with the current capitalization rate), then reposition the project for its highest and best use, where the amount of the development investment will be less than the expected appreciation.
The good news is that most of the due diligence areas to be considered are common to any commercial real estate project. The bad news is that the failure to investigate and evaluate the risks might leave an investor with limited prospects for salvaging even the initial investment.
key issues to address when repurposing commercial real estate
Title Review: Reviewing the title, including an ALTA/NSPS survey is essential. Obtaining title insurance in the amount of the purchase may not adequately address the scope of the risk, where the “fully developed” value is projected to be worth more than the cost of the land. (Consider obtaining “subsequent issuance” endorsements.) Potential problems include covenants of record, long-term leases, access limitations, easements, mineral reservations, use restrictions, architectural constraints or approvals, or other burdens, including amenity sharing agreements (e.g., parking, signage, retention, etc.) with third parties. In some cases, recorded covenants may not have clear means to amend or terminate or to identify who would be the appropriate parties.
Zoning and Entitlements: The regulatory powers of the local municipality must be vetted. Even with the support of a project by city staff, the neighbors may have an opportunity to intervene. Zoning and building codes will control all aspects of a development, including the use, architectural guidelines, density, access, parking, and landscaping. Decisions regarding whether to demolish and reconstruct could be swayed based on grandfathering of non-conforming improvements or uses, applicable fees, and rights of neighbors to object. Historically significant features, if preserved, could give rise to favorable subsidies or tax credits.
Offsite Infrastructure: Great care is required where a repurposed use will result in a different impact on the offsite services (e.g., utilities, traffic, drainage, etc.). Project design consultants must evaluate the requirements for the repurposed project and the capacity of the “in place” improvements, or alternatively, the determination of any necessary additional offsite improvements.
Environmental: “Legacy” projects often have legacy problems, whether in the form of abatement or remediation of asbestos, underground storage tanks, chemical residue from agricultural uses, or even septic tanks. The environmental consultant will need to review the historical use of the property, as far back in time as possible (i.e., even predating the current use which will be terminated), regardless of the applicable ASTM standard.
Development Matters: Subdivision plats may need to be abandoned. However, before undertaking this effort, confirm what benefits or issues are addressed by the existing plats. Legal counsel is not always involved with subdivisions, lot splits, etc., yet these recorded covenants can create issues (or problems) if the text (which sets forth dedications, restrictions, “notes,” etc.) is not tailored with precision.
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We encourage those who have specific questions about repurposing commercial real estate or any commercial real estate law topics, to contact the author, Jim Connor.
About the author
James Connor is a shareholder at Gallagher & Kennedy, practicing in corporate finance and real estate law. Jim represents local and national real estate developers, lenders, and investors with commercial real estate matters including apartments, industrial, office, and retail projects, master-planned communities, and shopping centers. With more than 43 years of experience, Jim is well-versed in all corporate finance and real estate matters, having dealt extensively with a wide variety of legal issues.