Upsides of Upgrading

 

Given current market conditions, where will landlords get the biggest bang for improvement budgets?

 

When Principal Real Estate Investors acquired the Campbell Mithun Tower in downtown Minneapolis in September 2005, it was confident that the downtown Minneapolis office market was making a comeback.

 

“We noticed the vacancies in previous quarters to our purchase were starting to decline,” says Rick Strawn, a senior asset manager with Principal Real Estate Investors.

 

The Des Moines, Iowa-based company purchased the 725,000-sq.-ft. tower with the intention of upgrading and repositioning the property. The tower is approximately 80% occupied. Major tenants include advertising agency Campbell Mithun, online educator Capella Education Co. and Berkley Risk Administrators Co.

 

“When we bought the tower, we saw an opportunity to reposition it and reintroduce it as a leading, Class A tower and take advantage of the increasing market velocity,” Strawn says.

 

The downtown office vacancy at year-end 2005 was 16.1%, down from 18.3% in 2004. Downtown absorbed 528,000 sq. ft. in 2005—the first full year of positive absorption since 2001.

 

First, they needed a strategy. “We asked what’s our current competitive subset, and what’s the subset we want to be in? And then what do we do in improvements to get to that subset?" says Jim Montez, senior brokerage associate at United Properties, who manages leasing at the tower. "Once you establish a strategy, you assess the asset. What are its strengths? What are its weaknesses? Then you do the same of the competitive subset that you’re in and the subset you want to be in as you reposition. You figure out what you’re doing well—what they’re not doing well—and take advantage of that.”

 

DOING HOMEWORK

They talked to the marketplace—both tenants in the tower and users in other buildings—and to brokers. “We wanted to find out how the building was perceived,” Montez says. “What’s important to users? What services do they look for? Through that, we discovered that the tower was viewed as the ‘old Piper building,’ and Piper Jaffray has been gone for six years. The building became dated. The past ownership strategy hadn’t been clearly defined, and the building got stagnant. We knew we had to get rid of that old image,” which meant physical improvements.

 

Montez says the skyway entrance from TCF into the tower is dimly lit with dark wood. “It has a 1980s financial services feel,” he says, “and that’s inconsistent with Campbell Mithun. They’re creative and fresh. We want to leverage their good branding image.”

 

Meanwhile, the street entrance is a bright, open atrium “but there’s nothing going on in the space,” Montez points out. Also, the first floor has “tons of Piper Jaffray blue,” he adds. “We’re going to update the color scheme.”

 

The goal is to tie the two floors together by introducing lighter woods, Strawn says. On the skyway level, they will move the concierge desk, which is now a big, bunker-like desk. “We want to open it up and make it more approachable,” Montez says. “We want people to feel welcome. We also plan to modify existing retail spaces to open up sight lines.”

 

The plan is to bring in new materials and colors to soften the look. “The theme will be carried out from the parking garage all the way to the tower’s top floors,” Montez says, adding that all common areas, including corridors and restrooms, will get a makeover, and there will be new tenant signage throughout.

 

“Everything needs to connect,” Montez says. “Every step of the process, we’ll send a crystal clear message and deliver a quality project. With so many options for users, there can be no disconnect.”

 

The goal is to be under construction by May and complete a significant amount of the public spaces by year-end. “Timing is critical,” Montez says. “If you miss it—if you’re too early and the improving market appears—nobody cares about it. They’ve seen it. You’ve got to hit it as it’s improving.”

 

Montez says if the tower stayed as is, it was at-risk of dropping to the next price category. “We believe with these improvements, we will move up to the next price point.”

 

THE MOTIVATION

Eva Stevens, senior vice president of Asset Management at United Properties, says landlords investing in upgrades are motivated by something, likely an investment strategy to defend or to create value. They may want to change the asset class for a property or they may be faced with substantial tenant rollover and anticipating new development.

 

“We’re coming into a development market,” she says. “So, as an example in the multi-tenant Southwest market, there are developers considering pulling the trigger on new office development. This causes landlords to think about the market position of an existing asset and its ability to compete for prospective tenants. They’re thinking, ‘Should I defend my market position or should I try to achieve a different market position?’ This decision will drive the type of improvements planned.”

 

Improvements can range from adding more curb appeal to improving building functionality (HVAC, vertical transportation, amenities, etc.). The landlord’s capital investment decision depends on whether they are competing for their existing market or repositioning a building to create market for their asset.

 

Bruce Palmer, United Properties’ senior vice president, Construction Services, emphasizes that it’s beneficial for owners, asset managers and pension fund advisors to listen to their brokers when planning improvements. “They’re down in the street. They know what users are looking for.”

 

Amenities can be a big part of improving a building’s market position. They can include underground parking, restaurants, concierge services, fitness centers, a car wash, a gift shop and ATM machines, according to Julie Hughes, United Properties’ senior vice president of Property Management. “Also, the functionality and the vertical transportation can be improved. You can replace old, slow elevators with state-of-the-art elevator controls while upgrading that first impression of the building with lobby renovations.”

 

There’s also a trend in older building renovations to improve HVAC systems, Stevens says. “With the continuing trend of ‘dense packing’ and open-space plans, being able to deliver a comfortable environment is critical, and landlords are willing to invest in that,” she says.

 

Construction Services is seeing quite a few lobby renovations. “It’s mostly curb appeal. How the entrances look. It’s getting tenants from the parking lot into the lobby and up to the floor,” says Palmer. “I’m also seeing a few more elevator modernizations as buildings get older.”

 

Palmer says the timing depends on the specific owner, building and market conditions. “Most owners are willing to spend as long as it gets tenants in their buildings.”

 

Dan Gleason, United Properties’ vice president, office brokerage, emphasizes that owners can get a return on their money very quickly in an improving market.

 

“In a slow market, I can spend $2 million on a lobby renovation and end up with no new leasing,” he says. “But when you reposition a property in a strong market, then you have an opportunity to capture new deals in a shorter time frame and at better rates. The return on improvements today is as good as it will get.”

 

RETAIL UPGRADES

The trend of "de-malling"—removing interior common areas in retail centers—continues, says Ned Rukavina, United Properties’ vice president, retail brokerage. This opens up the center, and space is reconfigured for new retailers or existing tenants to expand. Examples include Rosedale Mall in Roseville, Ridgehaven Mall in Minnetonka and Knollwood Mall in St. Louis Park.

 

At Ridgehaven, the interior mall space was removed, Palmer explains. “Target and Byerly’s were connected. They took that out, raised the roof on some of the other spaces and were able to lease the space they couldn’t lease before. Also, the facades were changed. It made it much more appealing from a curb standpoint.”

 

 

Another retail trend is landlords evaluating possible expansions or adding pad sites. “Landlords are scrutinizing codes to see how they can increase gross leasable area, and therefore, revenues,” Rukavina says. “I’ve heard some contemplate adding additional vertical levels. As the cost of land continues to increase, owners are trying to maximize use of their land.”

 

Rukavina also points to a trend of putting on new retail fronts and using enhanced materials. “The owners at Highland Shopping Center did this, and it will probably work well for them for many more years,” he says. “The center had an overhang walkway, which they removed. They used new materials, put up new signage and enhanced the property.”

 

The property was nearly full leased, but the upgrades helped the landlord with some renewals. “It also helped with valuations,” Rukavina says.

 

INDUSTRIAL UPGRADES

Flexibility is key when it comes to upgrades in industrial product, says Tony DelDotto, a senior industrial leasing associate at United Properties. Flexibility helps attract tenants because it creates the “path of least resistance” when prospects surface.

 

“Often industrial tenants build out space specific to their use,” he explains, “so when this unique space is vacated, landlords are faced with the decision to keep or gut the space. In order to create the path of least resistance, landlords often gut such space because it is extremely difficult for most prospects to visualize a reconfigured office when they are touring through a maze.”

 

“I’m a huge proponent of gutting space,” Gleason adds. “The ability to move that space will improve by gutting it. Tenants have a lot of options, and you’ll always stay in the competition if you say you can build out space. If tenants can’t picture themselves in the space, you’re out in the first tour.”

 

 

DelDotto says the costs to make major improvements to industrial buildings are often so significant that it deters most landlords. “Raising a ceiling is frequently talked about,” he says, “but once it is priced out, it rarely makes sense as a speculative investment. However, there are companies in other parts of the country that specialize in raising roofs, so it is proving to be cost effective for some, but I have not heard of it being done much in the Twin Cities.”

 

“Distribution demands have changed significantly during the past 20 years, so new development has followed this change,” DelDotto says. “We continue to hear more about just-in-time inventory management. Also, as land and construction costs continue to rise, distributors are racking higher to minimize paying for floor space. In fact, I have even heard of some markets pricing high clear distribution space by the cubic foot. Given this trend, we are not seeing any new distribution buildings being built with less than 24-foot clear height ceilings. This makes it tough for the older lower clear building to compete for these tenants unless they can offer a larger amount of floor space at a reduced price.”

 

Industrial product can be challenging, agrees Lisa Dongoske, United Properties’ senior vice president of Property Management. “What developers build today isn’t what they built yesterday. Front loading is 'out' today. How do you fix that? Are you going to acquire land to deepen your truck courts for today’s semis? It’s challenging, because it’s continually changing.”

 

DelDotto says most industrial improvements are made on demand. “Unless there are obvious issues to address, landlords seldom make significant changes to industrial buildings before they are taken to the market. Instead, brokers react to the needs of each prospect and demonstrate how the specific space can be configured to accommodate their needs. If you need it, we can do it.” Flexibility is key with the broad range of industrial users.

 

“Like the office market, the industrial market is improving and landlords are most optimistic,” DelDotto says. “Some are willing to offer higher tenant improvement allowances to achieve higher rates, especially for credit tenants.”

 

In all of these cases, it’s all about understanding your property and making the right improvements at the right time, Gleason concludes. “There’s a huge return on that.”