How real is the conversion proposition for Commercial Property in Perth?

24 November 2016

This article first appeared as a presentation to the Property Council of Australia’s (PCA) Commercial Property Conference in Perth on 26 October 2016.

It’s no secret that the commercial property in Perth is going through a hard time, with office vacancies rising to more than 20%. There are also a high proportion of early lease renewals, new deals and extended terms, and an increased churn of higher quality spaces.

Unstable market indications and limited tenant demand mean that refurbishment or re-positioning of existing stock is likely. Incentives have also increased in the Perth office market which has resulted in a decline in effective rents.

Framing your approach

Identifying whether your asset can compete successfully in the future of the office product is one of several important questions you need to ask to frame your approach. If your asset can’t compete as a ‘pure office’ use, then what other uses might work? Do you demolish or can you adapt to achieve your desired use? Recognising what specific market demand you are trying to satisfy will also help you to understand your objectives and help you determine future uses of the space.

In developing answers to these questions, we suggest you undertake the following approach:

  • Reiterate and reconfirm the land owner’s objectives for the site;
  • Develop and complete a high level comparative assessment of an initial list of options. The objective of this analysis is to remove those options that are clearly not optimal and have very limited opportunity to meet development objectives; and
  • Once several options have been eliminated, arrive at a shortlist of options (usually 3-4) that are worthy of further refinement leading to a recommendation for investment.

Your initial list of options will no-doubt include taking no action, refurbishing the building to enhance the office product, and adapting or reducing tenancy size to suit demand for smaller space.

You need to find something to create a point of difference or to serve a niche demand. It’s important to think about creating an attractive place that is unique to and leverages the positive characteristics of its context.

Refurbishing the current office use to enhance the office offering are informed by factors such as the extent of natural light penetration, shared facilities and amenities, cafés, floor to floor heights, proximity to public transport, car parking and freeway access, amenities and retail.

Does your client want maximum value, or are there other drivers? Typically there are almost always other drivers, including those informed by the aspects noted above. Frequently it’s not just about maximising yield. For example, sometimes a client wants to stay on the site, or the client desires the current use to continue to be accommodated on the site – both of which may compromise the maximum the return you might be able to create.

There are also important considerations within a commercial context. Some key considerations include:

  • Is it in a fund that requires a certain asset class weighting?
  • When is the asset in the fund due to be valued?
  • How much debt is in play on the asset, and what is the cost of debt outlook vs yield outlook?
  • How much equity currently sits in the asset, and what is the cost of debt outlook vs yield outlook?

Reuse options

In this current market if you are going to pursue a reuse, it needs to be worthwhile. So a creative mix of uses tailored to the specific content of the site is critical to success. This requires assembling information on different uses and demand profiles from various specialists and distillation into a coherent mixed-use “story” for the product and the place.

There is a difference between Highest and Best Use done by a valuer and a business case to optimise your site. The HBU done by a valuer does not have the influence of the developer’s financial context or portfolio objectives to consider, and rarely will it consider future zoning changes. That’s where we can help. Embarking on an adaptive reuse journey holds risk and takes time. So exhausting the opportunity to make your commercial asset competitive is worthwhile. Understanding the practical issues associated with creating a product that supports different uses is also critical to informing early selection of shortlisted options for further analysis. It’s not just about market demand.

Mixed use options

There are a number of mixed use options, drawing on awareness of where the demand cycle is and in some cases retaining office use to some extent. Examples of alternative uses include hotel, residential, retail, student accommodation, aged care, vertical school or tertiary education facility, vertical farm, vertical village. Typically a blend of uses is what you’re looking for to create a place that people want to be in.

The development of the mixed use alternative option is informed by an initial high level view on the following:

  • Site and building desktop constraints and opportunities assessment;
  • Building – general condition, structure and floor loading capacity, overall height and opportunity to increase height for different use arising from structural capacity and planning zoning opportunity, floor to floor height, BCA compliance, services – electrical, IT and hydraulics, floor plate flexibility, fire egress and booster pressure, hazardous materials;
  • Site planning – can you rezone, what uses attract bonus FSR, environmental/contamination, geotechnical, groundwater, services, proximity to public transport, proximity to general amenity;
  • Real estate advice on likely product demand and income per unit. This is provided by the real estate agency and supplemented by advice from specialist consultants as required;
  • Initial concepts developed by architect to provide indication of yield;
  • Initial costs prepared by quantity surveyor;
  • Outline program to provide indication of time to revenue generation; and
  • Capacity of the developer. This includes financial capacity, personnel and system capacity to undertake development successfully, intention to operate facility.

Planning aspects to consider

The City of Perth has put in place various mechanisms and incentives to promote and encourage development, including:

  • Flexible provisions for the conversion of existing commercial buildings;
  • Generous plot ratio bonuses for residential and hotel uses in many parts of the city;
  • Transfer of floor space from constrained heritage sites; and
  • Wide range of uses generally permissible throughout scheme.

The City is very supportive and also prepared to consider amendments to scheme on a site by site basis to encourage certain development outcomes. In some areas, development can now receive up to 50% bonus plot ratio, if it provides some or all of the following eligible facilities….(slide 11)

Redeveloping an office to incorporate additional retail and public amenity is achievable under Perth’s planning scheme. If you want to convert use, you can convert to a range of uses including residential, student accommodation, aged care or hotel and it is likely that you will secure a bonus plot ration. It’s important to note though that if you have an older building where the plot ratio is already exceeded you may need to work harder, but generally the city is flexible and willing to entertain ideas which can be shown to yield public benefit.

Final thoughts

There is and always will be demand for office space. When overall supply gets close to or exceeds overall demand then generally the “easy” redevelopment options will not succeed and it becomes important to work a lot harder. A few key points to note:

  • Be clear on your target market;
  • Find ways to create symbiotic relationships between uses – both within your building and with the surrounding areas; and
  • Be smart about creating a place that provides a unique and attractive offering.

A few summary points to remember:

  • There is planning flexibility. Plot ratio bonus is available;
  • What’s the unique story of your offer? What’s the market?;
  • Explore a diversity of options;
  • Which option has the lower capital cost/m2 of NSA;
  • Optimal mix of uses to achieve development objectives;
  • Conversion involves risk, time and cost - is it worth it?;
  • Can you make your office compete?;
  • If you convert - will your new offer be able to compete?; and
  • It takes time - will your product be resilient to the cycle?

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