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How obsolescence risk is a fundraising opportunity

Retrofitting existing assets to meet current ESG or tenant requirements will call for managers to raise new pools of capital.

Mitigating obsolescence risk will come at a cost to real estate owners. But for some industry players, this means a potential fundraising opportunity.

“There is going to be obsolescence resulting from the huge amount of stock which was built between the 70s and 90s, where it’s no longer fit for purpose,” says Damien Smith, managing partner at real assets advisory firm Sera Global. “Communities have changed, demographics have changed, the requirements of occupiers have changed in that area, and I see that as both a risk and an opportunity.”

The risk relates to existing owners that try to lease an obsolete building in its current state, without investing in the asset. “Occupiers are becoming increasingly selective on their ESG and staffing needs and will leave to find modern space in better locations,” Smith explains.

The opportunity, however, comes from “a whole raft of the asset management community” that is not being proactive about keeping their properties up to date. “If they don’t plan for and hire the best talent to be able to drive more active asset management and invest in these assets to modernize them, then assets will be sold to someone else that is raising capital to do that,” he remarks. “There are pools of capital being raised today to remediate these assets.” In Europe, for example, Smith is aware of three managers that are launching funds for the purpose of retrofitting properties to meet current ESG or tenant requirements.

Seeking obsolescence

Smith points out that this fundraising activity around updating obsolete assets is not focused on owners seeking to make improvements to their existing portfolios. Rather, “people who I speak to are saying, actually we’re going to raise a new fund to do this with new assets. We’re going to go out and find obsolescence in the market and buy that and then fix it rather than fixing what they already own,”‘ he notes.

One of the few real estate funds known to focus on value-add   refurbishment in the name of carbon reduction is Columbia Threadneedle Investments’ Threadneedle Carbon Neutral Real Estate Fund. The UK-focused office fund was originally launched as the Low Carbon Workplace Trust in 2010 before being renamed in 2020 after the fund’s portfolio was certified as operationally carbon neutral.

“Evolving investor criteria and the regulatory landscape related to embodied carbon may reduce investor and occupier demand for ground-up development and make refurbishments more desirable and economically feasible than in the past – particularly those that move buildings from non-compliance to compliance with new and evolving environmental standards,” notes Will Robson, head of global real estate solutions research at MSCI.

Funds focused on retrofits may appear very similar to more general value-add funds, except that the retrofits would need to adhere to environmental standards, Robson adds: “It’ll be interesting to see to what extent these strategies become concentrated in specific specialist funds versus spread across all portfolios as ‘just a thing that needs to be done in real estate.”‘

Fundraising around retrofits would likely be concentrated  with managers that would not shy away from complex assets. “I think you might find some managers become particularly skilled in understanding these costs and efficient at undertaking the refits as this landscape evolves,” Robson observes. “If that does happen, then maybe it’s more efficient for some investors and managers that don’t have as much capability or a lower risk tolerance to identify the most challenging assets to transition and transfer them to such managers.”

Smith does not believe that most owners will have difficulty getting access to capital. Open-end funds, for example, typically have entry queues of capital, which can be used to either buy new assets or retrofit existing assets within the portfolio, Smith observes.

Fellow Sera Global partner Zaahir Syed also notes that increased retrofitting activity to address accelerated obsolescence could also lead to more fund recapitalizations. For an asset that was built 10 years ago but now is considered outdated, “if you have it in a closed end fund, you exercise these measures to retrofit and you can see longevity of that asset for a long period of time,” he says. “You can recapitalize that into an open­ end fund or into a longer dated vehicle with a like-minded capital partner, and you can get that income stream that you’re looking for. So it can align well and be attractive for investors, while at the same time, meeting the demands for ESG considerations.”

That said, Smith believes that raising new funds to making existing assets more relevant is only part of the solution to addressing obsolescence risk. “If you consider the Open End Diversified Core Equity fund industry in the US, with a couple of hundred billion dollars of assets under management, many of the constituent funds already have significant queues of capital and the assets within their portfolios,” he says. “I think it’s important that there’s new capital being raised for groups that are forward thinking, but for existing asset owners, there’s an onus on them as well to be more aspirational in terms of doing a better job.”

Reproduced with permission from PERE.