Photo Courtesy of Khakimullin Aleksandr via Shutterstock

Two things every commercial property investor looks out for when evaluating a potential acquisition are elements of functional obsolescence and items of deferred maintenance. The presence of either or both can substantially decrease property value in several ways, and with so many of Orange County’s office, retail and industrial buildings now being over 20 years old, these two important components of value determination pose more of a challenge every day.

Functional Obsolescence, a commonly used term in real estate, is the decrease in desirability and usability of a property due to physical deterioration such as outdated design or amenities. It can result in depreciation of property value.

That challenge can also be converted to an opportunity, as those investors with the necessary skills, resources and capital are often able to acquire property at a discount and add value by addressing issues areas of obsolescence and deferred maintenance. But, before we get into that, let’s take a high altitude look at both conditions starting with the tougher of the two, functional obsolescence, to frame the topic.

In most cases, elements of obsolescence in older office buildings are built into the original structure and are not economically or architecturally feasible to fix. Orange County’s inventory of Class C office buildings is a good example. Built mostly in the 1960s and 1970s, these structures exhibit several elements of functional obsolescence including minimal window lines, shallow bay depths, low ceiling heights, lack of elevators and are generally of wood-frame construction. Hence the term “woody walk-up”.

With the possible exception of an elevator, it would be prohibitively expensive or structurally impossible to change these basic structural components. Built with smaller tenants in mind, Class C product attracts local businesses looking for shorter lease terms and the lowest lease rates. That means higher turnover, more frequent changes to interior finish and a higher risk of rental income loss due to vacancy and/or tenant defaults.

Does this mean Class C buildings don’t make good investments? Absolutely not. It just means they have limitations that will impact their value to investors and their desirability to tenants, both short and long term, and that needs to be taken into account when they are acquired, marketed and also when making capital improvements.

You may be wondering why these buildings were built the way they were if they are considered obsolete. That’s because they weren’t obsolete at the time they were constructed. Buildings became obsolete as the market changed around them. Who in the 1960s, when we barely had electric typewriters, could have predicted what American business would be like today? Who could have known that millennials would shun the once-coveted private office for open space, more natural light, polished concrete floors and free Kombucha on tap?

Building structures are static while market trends are dynamic. Sometimes, markets change so much that buildings just can’t keep up. That pretty much defines functional obsolescence, and it can happen to the highest quality Class A buildings as well as the middle of the road Class B structures, which make up the bulk of the market in Orange County.

How could that be? How could a granite-clad, steel frame building with floor to ceiling glass lines, high-speed elevators and upscale amenities be functionally obsolete? If it was built to accommodate tenants who can no longer justify the higher cost for space in the best buildings, those features become elements of functional obsolescence. Tenants may be willing to lease the space, but will not pay the premium needed to cover the cost of its construction and upkeep.

That may, in part, be the reason that the vacancy rate for Class-A space is much higher than the rate for Class C buildings. These days, more businesses are changing their business models so that they require less space, and their employees are leveraging new communication technologies that allow them to spend more work time off-site rather than in a cubicle or office all day.

Photo Courtesy of Jacob Lund via Shutterstock

So, how do you as a property owner tackle the issue of functional obsolescence? That depends on what the problem is and how much time and money you are willing to spend on it. If you are simply not prepared or capitalized to deal with your particular issues, selling your property to someone who is and exchanging into a more up-to-date asset might be your best bet. But, if you are willing to roll up your sleeves and commit additional capital, you might be able to add significant value to your property.

The most important step is to objectively evaluate every aspect of your property and come to grips with where it fits into the competitive building set. If your building is in a highly desirable location with walkable amenities but is not elevator served, has the original windows and is covered in cedar shingles, it might be worth making a substantial reinvestment. An updated exterior façade, new landscaping and a refresh of the common areas, may mitigate the importance of other functional shortcomings like wood frame construction and lack of an elevator. However, if your property is under-parked and poorly located then you may not get the desired return on your additional investment no matter what you change. So, the takeaway here is to do your homework and only invest capital in items that will allow you to attract more tenants willing to pay higher rates.

Adding value to obsolete properties is a specialty of ours. We have extensive experience in repositioning underperforming assets. If you would like to learn more about the process or get a professional evaluation of how your property could be repositioned, give us a call at (949)668-1110.