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Late-Cycle Site Selection: Risk Management Principles

If your company chooses an asset that calls for renovation or adaptive reuse, risk management needs to be an important component of your strategy.

Q1 2019
The site selection process is an important investment in your business, and choosing the wrong property can have negative repercussions for years to come. Unfortunately, during a time like the present — the late stage of a robust CRE market — selecting a site for your company becomes even more challenging.

Because of the long timeline of developing properties, choosing a new, ground-up development entails risk; if you miss the optimal economic window, you might end up spending more on space than your competitors. For this reason, recently renovated, remodeled and/or repositioned properties have become a more prevalent option in today’s unpredictable CRE environment. For property owners, value-add investment hedges risk in the short-term, and diversifies strategic opportunities in the long-term because the extended run of this particular CRE cycle, paired with optimism for a gentle downturn, means that CRE remains an excellent investment.

In addition to economic considerations driving developers’ decisions, changes in technology and demographic preferences are transforming building function and layout, creating a variety of options for end-users. These changes include the rise of e-commerce, evolving office trends, and demand for experiential space in lieu of traditional retail anchors. Millennials are increasingly looking for co-working space and offices with on-site amenities as an incentive in a competitive hiring environment. E-commerce has created a growing need for industrial warehousing and logistics spaces, while challenging the reinvention of traditional retail space. This has provided developers with opportunities for late-cycle value acquisitions, such as repositioning a big-box store into a brewery or a restaurant, or converting a blighted, abandoned building in a derelict industrial zone into a “last-mile” logistics center.

Millennials are increasingly looking for co-working space and offices with on-site amenities as an incentive in a competitive hiring environment. Many of these value-add projects can give a building a new lease on life for tenants in search of space and can quickly optimize the hottest sectors and locations. Investors have been turning to secondary and tertiary markets for several years in search of higher yields, and as prices of raw materials remain uncertain, adaptive reuse of existing historical properties is an attractive alternative to new construction.

Strategies for Managing Site Selection Risks
The first key question to ask is how a parcel of real property will accommodate your company. This includes many considerations, including location, necessary structural modifications, and whether the property owner intends on holding the asset for the long term or is pursuing an investment-to-resale model. Can you physically make your business objectives work on the existing property? Will the existing office space accommodate your desire for Class A amenities and high-end finishes, for example? Will the proposed commercial asset have a different capacity than the previous use, thereby necessitating more parking and accessibility?

Before proceeding, conduct a feasibility study to see what is possible. Can the property owner get a zoning exception for parking requirements, or a special permit for a business classification change that differs from the specified zoning use in that area? Understanding the zoning requirements and what changes can be made “over the counter” without triggering a lengthy entitlement process avoids delays and additional fees.

All construction requires on-site risk management, and this includes renovations/repositioning projects. Next, understand the building’s current condition and evaluate its potential future capabilities by conducting a thorough “Value Add” Property Condition Assessment (PCA). This is especially critical for renovations and repositioning involving industrial assets. If you plan to use the repurposed asset for warehousing storage or e-commerce delivery, will existing roofing, floors, and ceilings support industrial bulk storage weights and dimensions, storage racking, and loading dock space? Will the existing MEP (mechanical, electrical, and plumbing) systems support additional refrigeration or cooling for grocery storage and delivery models? Does the useful life span of the building’s HVAC system optimize the indoor air quality requisite for modern office and hospitality spaces? A detailed “Value Add” PCA will provide a detailed opinion of costs for capital expenditures and immediate repairs necessary for transforming the asset and can even evaluate proposed construction documents and costs for feasibility, to help you build a forward-thinking strategic plan that increases investment return.

Particularly if the property is the adaptive reuse of any industrial, abandoned, or brownfields assets, you will also need to invest in thorough environmental assessments by an experienced consultant to determine risks or liabilities associated with potential contamination on site. Should the presence of environmental contamination be discovered, a remedial cost estimate plan can provide an accurate picture of the total cost of the actual cleanup and provide guidance regarding adherence to state and federal regulations. In many cases, an environmental consultant can navigate serious remediation concerns, such as vapor intrusion, removing contaminated soil or water, or the removal of an underground storage tank, so as not to derail the transaction altogether.

All construction requires on-site risk management, and this includes renovations/repositioning projects. You never know what’s really in or behind a wall, especially for older buildings, so the property owner MUST test for asbestos before swinging that hammer! Several recent news stories have cropped up involving asbestos exposure of occupants during renovations, which is an enormous liability. Yet this is just one of many industrial hygiene considerations that must be tested for. In addition to asbestos, the presence of other hazards such as lead paint and mold on site may pose additional costs and should be mitigated before and/or during construction.

Certain changes of use may necessitate seismic reinforcement or retrofitting for building safety. This is often a concern when repositioning or renovating multifamily and apartment assets in high seismic risk zones. Over the last few years, a number of cities have instituted seismic retrofit ordinances — including San Francisco, Santa Monica and Los Angeles, with others in high seismic risk zones likely to follow suit. Consult with a seismic expert to perform a Probable Maximum Loss assessment and help you determine if the property is listed in an inventory for retrofitting. Even if it is not, engineers can help determine soft-story conditions and a scope of work that provides seismic strengthening, depending on the property owner’s risk tolerance.

Construction risk management is critical at any stage of CRE development, but particularly late in an economic cycle, when cost savings on projects become more important. Finish Work on Budget and on Schedule with Construction Risk Management
Construction risk management is critical at any stage of CRE development, but particularly late in an economic cycle, when cost savings on projects become more important. Compounding these concerns are some rising economic headwinds that have put pressure on construction, including price increases on material goods, trade concerns and tariffs on steel and aluminum, and a persistent labor shortage that predates the recovery cycle of the last 10 years.

These growing costs can drain the profit from projects — even from a simple renovation, which increases the likelihood of contractor and subcontractor failure. Despite the risks, there is still room for developers to take advantage of waning market opportunities and changing trends, but as the end-user, you must be wary of choosing a project that is rushed on the front end or being built by contractors that have taken on too many projects or projects outside their realm of expertise. You can help mitigate these risks with construction risk management oversight measures such as up-front independent cost evaluations, contractor evaluations, monthly progress inspections, and funds control.

Ultimately, if you choose an asset that calls for renovation or adaptive reuse, approaching the project with risk management and planning is an important component of strategy. Rely on a team of experienced consultants and technical experts to help assess feasibility and building condition, limit environmental liability, manage timely construction progress, and adhere to a strict project budget.

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