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Situations Vacant: A Conceptual Framework for Commercial Real Estate Vacancy

Authors:
Situations Vacant: A Conceptual Framework for Commercial Real Estate
Vacancy
24th Annual European Real Estate Society (ERES) Conference
June 28 - July 1, 2017, Delft, The Netherlands
Dr Kevin Muldoon-Smith
Department of Architecture and Built Environment, Faculty of Engineering and
Environment, University of Northumbria, Sutherland Building, College Street,
Newcastle upon Tyne, NE1 8ST. E-mail: k.muldoon-smith@northumbria.ac.uk. Ph:
0191 349 5109
Dr Paul Greenhalgh
Department of Architecture and Built Environment, Faculty of Engineering and
Environment, University of Northumbria, Sutherland Building, College Street,
Newcastle upon Tyne, NE1 8ST. E-mail: paul.greenhalgh@northumbria.ac.uk. Ph:
0191 227 4593
Abstract
Commercial real estate vacancy is a key indicator of property market efficiency,
economic performance and urban resilience. However, there has been little
conceptual reflection into the abstract notion of vacancy beyond binary distinctions of
natural and structural vacancy. Although useful simplifying meta-concepts, neither
accounts for the internal complexity and imperfection that permeates real
commercial property markets. Consequently, the objective of this article is to outline
a conceptual framework that describes vacancy across the commercial real estate
building life-cycle from initial construction to final demolition and redevelopment.
The originality of the research rests in its utility as the first known holistic examination
of commercial real estate vacancy beyond that of an abstract economic factor, while
its value is explicit in the conceptual typology which can be used by researchers
interested in market imperfections and consequent interventions.
Key words: Natural Vacancy, Structural Vacancy, Commercial Real Estate,
Introduction and justification for research
Albert Einstein allegedly quipped that,
'If a cluttered desk is a sign of a cluttered mind, of what, then, is an empty
desk a sign of?'
In a slightly broader context, what do underperforming and empty commercial
properties (taken to mean office, retail and leisure and industrial buildings) tell us
about the cities in which they reside, the landlords who own them, the investors that
trade them, and the institutions of the commercial real estate markets which govern
them? One way of considering this situation, from the perspective of the commercial
office market, is that empty offices provide,
'A window into the soul of our shifting economy'
(Carter 2015, quoted in Sourcable.net 16 February 2015).
This analytical aperture directs the primary aim for this article. In order for
researchers to reflect on commercial real estate vacancy, they need to have a
conceptual framework (introduced in Figure 1) that can be used to reflect on the
material reality of vacant properties - one that moves beyond the binary distinction of
natural and structural vacancy and the broad notions of positive and negative
vacancy. In this article, natural vacancy is broadly taken to mean those properties
that efficiently clear respective property markets while structural vacancy is taken to
mean those vacant properties that no longer have a relationship with occupier
demand in their present use. Consequently, the primary objective of this article is to
develop a framework that can be used to examine vacancy throughout the building
lifecycle starting with the initial construction phase and ending with demolition and
redevelopment. The article is based on research into the commercial office market,
however, the resultant conceptual typology can be applied broadly to all of the major
commercial real property types (for example retail and leisure and industrial markets)
as long as the unique nature of each type of property is also considered.
Theoretical context
Various researchers have examined vacancy; those interested in obsolescence and
depreciation (Baum, 1991, 1993; Baum & McElhinney, 1997; Dunse et al, 2002;
Andrew & Pitt, 2006; Crosby & Devaney 2006; Crosby et al 2011); those interested
in the adaptation of vacant properties (Barlow & Gann, 1996; Beauregard, 2006;
Kincaid, 2002; Heath 2001; Geraedts & van der Voordt, 2003; Agre, 2005; Langston
et al, 2008; Remoy, 2010; Remoy and Wilkinson, 2012; Wilkinson and Read, 2011)
those who want to map the characteristics of vacancy (Myers & Wyatt, 2004;
Katyoka & Wyatt, 2008; Remoy H & Koppels, 2009); those who model the cyclical
behaviour of the economy and property (Ball 2003; Barras, 2009; Wheaton 1999);
and those who reflect on the medium to long-term rental adjustment process (Blank
& Winnick, 1953; Wincott, 1997; Voith & Crone, 1988; Crone, 1989; Grenadier, 1995;
Pissarides, 2000, 2005; Sanderson, et al., 2006; Miceli & Sirmans, 2013).
Concurrently, professional practices regularly also use relative vacancy levels
(alongside absorption and take-up, rent and yield) to monitor the performance of
local markets (see quarterly updates from international commercial real estate
companies, CBRE, Colliers and Cushman and Wakefield, BNP Paribas, Jones Lang
LaSalle).
Historically, it is the latter research into rental adjustment and professional practice
that have given most attention to vacancy, although recognition is given to the more
recent emphasis on understanding vacancy in order to assist adaptive re-use. Much
of this traditional research has specifically focused on the natural rate of vacancy
rate and the prime markets. Typically, this language has borrowed from neo-classical
economics, particularly its cyclical nature, and surveys of the labour market. This is
most clearly seen in the parallel utilisation of the natural rate of unemployment and
property vacancy and the utilisation of initial, cyclical and frictional categories of
unemployment and property vacancy (outlined by Kerris and Kopells, 2006).
In the study of employment, initial vacancy is taken to mean those potential
employees who are recently qualified but yet to find employment. The parallel
example in commercial real estate are those commercial properties that have just
been constructed but have not been filled yet. Cyclical unemployment occurs in
parallel with the economic cycle; for example, when the economy is in decline
unemployment will rise and vice versa. A similar process takes place, although
lagged, in commercial real estate as the property cycle oscillates over time.
Furthermore, frictional unemployment is a result of the movement of employees
between firms and the consequent time taken to hire and refill vacant positions. This
same process takes place in commercial real estate as businesses expand and
retract. While structural unemployment is the consequence of a permanent change
in the composition of the economy which leads to mis-matches between the
requirements of business and the available employee skills and training base to fill
these positions (for a rare discussion of structural property vacancy see Remoy,
2010).
The central argument in this article is that while commercial real estate is most
certainly linked into the economic cycle it deserves its own conceptual framework
that recognises the unique nature and imperfections associated with property
markets. It is work noting that initial, cyclical and frictional concepts of vacancy
implicitly assume that the market process will correct itself over time as the market
clears. It is only structural vacancy that considers the other side of this situation,
those properties that do not clear the market. On a certain level, the existing set of
terminology covers both sides of the commercial market, those properties that are
temporarily vacant and those that are permanently vacant. However, under closer
scrutiny this argument starts to fall apart when we consider that the natural rate of
vacancy, which by most estimates only accounts for 4-10% of stock, has received
the majority of academic attention. The rest of the vacant commercial stock, that
considered structurally vacant, is relatively unexplored (Lausberg, 2008). This article
responds to this situation by setting out a conceptual framework that delves under
this situation, particularly, the transition from natural to structural vacancy and
reveals the operation of sub-optimal variants of vacancy which have received less
attention in academia and practice. It achieves this aim by introducing two other
commercial property ingredients into the discussion, the commercial property
descriptions ‘prime’ and secondary. In this paper prime property is taken to mean the
most recent additions to, and most desirable segments of, commercial stock. In
contrast, secondary property is taken to mean older stock in relation to the
traditionally more desirable prime stock. The secondary focus is vindicated in the
vacancy typology, when it becomes increasingly apparent that a simple bifurcation
between natural and structural vacancy does not exist. Secondary vacancy
transcends both positions, indicating the ambiguous and dynamic nature of
commercial vacancy.
It is worth noting that it is not the aim of this article to criticise existing research into
vacancy, indeed, it is the basis for many of the econometric pillars of commercial real
estate thought. Rather, the article argues that the current nature of commercial real
estate necessitates a more detailed engagement with vacancy which in turn will help
those engaged with a more resilient built environment. This extended debate also
has the potential to inform new econometric analysis into less efficient parts of
commercial real estate. The conceptual output of this article, the vacancy typology, is
informed by a 3-year research project into office market obsolescence, depreciation
and vacancy in the UK. While conducting this research, primarily based on an on-
going interview process with industry professionals, it quickly became apparent that
the traditional language used in academia and practice to describe vacancy was not
adequate to express or explain the various manifestations of vacancy present in the
commercial office market, nor its variability and change. The typology builds upon
the traditional concepts of initial, frictional, cyclical and structural vacancy, in order to
better reflect the full extent, and process, of commercial vacancy.
Situations vacant
Some commercial vacancy is a ‘necessary’ attribute of property markets. The
efficient operation of the commercial markets, reflected in churn and filtering of
businesses (Greenhalgh et al., 2003; Greenhalgh, 2008) up and down the property
ladder cannot happen without a certain degree of vacancy. This type of vacancy can
be understood as that part of stock that efficiently clears in response to the needs of
occupier demand. This process of vacancy is generally referred to as initial, frictional
or cyclical in nature (Kerris and Kopells, 2006). However, this perspective does not
tackle those properties that do not efficiently clear through the market mechanism.
This type of vacancy is not just a problem for commercial property landlords; it is
also a problem for every nearby small business owner who depends on workers for
daily trade. Each empty desk or shop represents one less person spending money in
town, city and regional centres (Carter, 2015).
Underperforming and vacant buildings offer a powerful mode of reflection in relation
to societies most wasteful practices. Increasingly, commercial buildings engage
consumer demand for relatively fleeting moments in time, yet, endure for long
centuries in the built environment. Reflecting this situation, following the opening of
the Frank Gehry designed Facebook headquarters in California, Marc Kushner
(2015) heralded the potential end of the office, arguing that social media is changing
the way we consume the built environment. This statement is not necessarily as
hyperbolic as it may first appear, technology is increasingly pervasive. However,
Lausberg (2008) indicates that this situation, the precarious nature of commercial
property, is little known in contrast to traditional perspectives of market efficiency.
Reflecting the importance of this omission, Wilkinson et al (2014) attest that the
continuing use of existing commercial real estate stock is a universal concern.
They argue that,
'There is a need for greater knowledge and awareness of what happens to
societies buildings over time and how we might adapt them sustainably. This
action includes avoiding premature destruction through finding new uses for
buildings that have become unwanted or obsolete. While new development
must also be sustainable, there is insufficient time for us to act unless
proactive intervention into the performance of existing building stock becomes
a priority'
(Wilkinson et al., 2014:5).
Summarising this situation, Lausberg (2008) indicates that it is relatively easy to
estimate natural vacancy (associated with initial, cyclical and frictional vacancy) from
available market data. However, he indicates that there is a knowledge deficit in
relation to structural vacancies, which he generally equates with obsolescence and
location. He argues that not understanding this situation places commercial property
and associated locations at significant risk.
The implications of this situation are disquieting. Instead of focusing on what is not
known and working to remedy this situation, market actors and academics focus on
the comfortable reality of the 'prime' market which can be equated with the historical
'natural' rate of vacancy. Consequently, the narrative of vacancy is beset by what
Pickety (2014:2) calls,
'An abundance of prejudice and paucity of fact.'
Which results in a potential risk, where,
'We overestimate what we know and underestimate the value of the unknown'
(Taleb, 2010:140).
A Typology of commercial vacancy
Orthodox thought suggests that commercial vacancy can be separated into two
broadly distinct tiers, that of natural vacancy and that of structural vacancy. This then
interacts with the realities of commercial property practice, which in itself, is
separated into the prime market and the secondary market. However, these
bifurcations do not run contiguously. Each vacancy tier, natural and structural, has its
own characteristics, and although both part of the same commercial market, operate
and manifest themselves quite differently.
Figure 1, the Typological Model of Vacancy, and the proceeding narrative explain
this situation. Figure 1 should be read from left to right and top to bottom. The
horizontal dimension describes the operational variation inherent in commercial
property vacancy, running from the macro to the micro level. This is denoted by the
horizontal arrows which pass through Column 3. The vertical dimension represents
the property ladder, the filtering process of tenants as they move between buildings,
and the building life cycle. The best properties are added to the top in a funnel like
system and the worst ones eventually drop out of the bottom depending on their
contingent circumstance (following the vertical arrows in Column 3).
Figure 1: Typological Model of Vacancy
Segmentation
The Market
(towns, cities
and regions)
Vacancy Processes
Natural Vacancy
Premium Vacancy
Prime
Cyclical
Frictional
Initial
Auxiliary Vacancy
Secondary
Churn
Hidden
Strategic
Structural Vacancy
Evolutionary Vacancy
Inefficient
Inertial
Transformational
Final Vacancy
Physical
Planning
Economic
The first column describes the respective tiers of vacancy, natural vacancy and
structural vacancy. Natural vacancy describes those properties that efficiently clear
through the classic supply and demand mechanism, while structural vacancy
describes those properties that no longer clear through the supply and demand
mechanism (Column 1 describes the macro level description of the vacancy
process). This bifurcation can then be sub-divided in order to reflect real market
segmentation. The natural rate can be sub-divided into premium and auxiliary
vacancy. Premium vacancy, as the name suggests represents the very best
buildings that are on the market and is associated with the familiar initial, frictional
and cyclical vacancy (Kerris and Koppells, 2006; Lausberg, 2008). Auxiliary vacancy
describes those vacant secondary properties that still have a role to play in the
commercial real estate market. Auxiliary vacancy describes non-prime secondary
properties that are held in reserve in order to 'fill in' prime supply shortages. The
concept of 'filling in' is, by its very nature temporary. This is because it presumes that
once new prime buildings are constructed, tenants will move to higher specification
accommodation. Filling in is most likely to take place in buoyant areas with tight
supply conditions and during and following times of recession when speculative
construction has abated resulting in lagged development.
Auxiliary vacancy is more permanent in those areas with adverse economic
conditions, where it is difficult to justify the cost of development. In these locations it
is important to safeguard viable secondary space in order to fulfil the requirements of
occupier demand and economic development (in such areas auxiliary vacancy is
closer to premium vacancy).
In turn, structural vacancy can then be sub divided into evolutionary vacancy and
final vacancy. Evolutionary vacancy describes those properties that could still have a
future in alternative use if adapted. Final vacancy, as the name suggests describes
those properties that no longer have a future either in their present or alternative use
and should therefore be removed from property supply altogether. The first two
columns can then be related to the overall commercial market (column 3), which, for
simplicity, is divided into prime property and secondary property. The prime market
only intersects with premium vacancy, while, secondary vacancy accounts for
auxiliary, evolutionary and final vacancy.
It is this part of the model that lays out the disparity and non-alignment between
natural and structural vacancy, and the prime and secondary market (they are not
one and the same). Demonstrating the influence of the secondary market, this model
indicates that it is, in part, included in both tiers of vacancy, natural and structural, as
it also forms part of the auxiliary layer of vacancy. It is this non alignment that
exposes the myth that all secondary vacancy is bad and that the natural rate of
vacancy only contains prime property. The third column, representing the property
market (and its contingent location), forms the spinal structure of the model. The left
hand side (of which) considers the segmentation of vacancy in market locations,
while the final column to the right, considers the processes of vacancy that take
place in these locations. It is these processes that reflect and make sense of the
dynamic change and movement that takes place within and between the respective
segments of commercial vacancy.
This is because the final column describes the micro level vacancy interaction.
'Cyclical', 'frictional' and 'initial' vacancy are relatively well known in the international
literature (Kerris and Koppells, 2006; Lausberg, 2008; Remoy, 2010). These
concepts are typically associated with the 'natural' rate of vacancy, market clearing
and concepts of equilibrium and premium vacancy. By themselves they are an
efficient means of describing premium vacancy as its level oscillates around
equilibrium (cyclical), as it facilitates the movement of firms (frictional) and as new
property enters the market (initial). All three types of vacancy are helpful as they
facilitate the efficient operation of the property market and are therefore presumed to
be temporary in nature.
Moving down Column 4, churn, hidden and strategic vacancy describe those types of
commercial vacancy that taken place within auxiliary vacancy. Churn vacancy is a
variation of frictional vacancy, describing this concept after it has begun to filter down
the property ladder. Churn vacancy takes place when the push and pull factors of
new development at higher specification are constructed and cause existing tenants
to filter up the property ladder through a 'flight to quality.' It is different to frictional
vacancy because it leads to a downward revision in rent, capital value and yield
(without significant property improvement) and takes place more regularly. In itself, it
is not a negative attribute of vacancy, (this type of filtering and absorption is directly
related to new start-ups and small businesses), however, it is a signal that such
property is no longer a prime investment. Hidden vacancy describes that portion of
vacancy that is difficult to detect, often consciously so. It includes those properties
that are taking shelter from empty property taxation (but are vacant to all intents and
purposes) and those properties considered grey space (those properties that are
leased but are surplus to tenant requirements).
Strategic vacancy is a potentially negative attribute of the commercial market. It
describes those instances when landlords forcibly evict or coerce tenants to leave
their buildings in pursuit of higher values associated with alternative building use
even though they are still relatively viable in their present use (hence why it sits in
the auxiliary segment). Strategic vacancy is particularly prevalent in England,
following planning changes which have incentivised landlords in certain locations to
target more profitable use (the advent of relaxed planning regulation, through
permitted development rights, has been seen to favour office to residential
conversion due to the higher economic value of the latter). All three of these
concepts are still part of natural vacancy but are also associated with degrading
performance and an increase in void space.
Inefficient vacancy, transformational vacancy and inertial vacancy take place in the
evolutionary vacancy layer. These types of vacancy can be considered on a
progressive redevelopment spectrum and chart the transition of commercial property
into potential new use. Inefficient vacancy describes those properties that are
inefficient in terms of operational cost, holding cost and embodied carbon. These
properties are functionally and economically obsolete and are ready to transition into
alterative use (or potentially within use following major improvement). Inertial
vacancy describes the regular impasse between operational use (in original form)
and transformation (into new use). It does not happen in all cases but can be a
consequence of restrictive tenancy covenants, planning negotiations and financial
due diliegence. As the names suggests, transformational vacancy describes those
properties going through new development, and details the final transition between
inefficient use, and such properties leaving supply altogether (and entering another
property market with additional attributes).
Physical, planning and economic (often interrelated rather than separate categories)
vacancy processes make up final vacancy. Planning vacancy includes those
properties that cannot be adapted into alternative use (but are no longer viable in
their present use) because they are constrained by planning regulation that places
restriction on alternative use. Physical vacancy describes those properties that have
either depreciated beyond repair or have restrictive designs which do not lend
themselves to re-use. Economic vacancy describes those properties that are not
supported by viable local rental levels. In other words, the underlying rental levels
that underpin such buildings do not cover existing running cost or the cost of
development. The only way these buildings can be re-used is through the
introduction of subsidy.
The segmentation is not a static model. There is a great deal of transference
between the fuzzy boundaries of the four segments, especially between auxiliary and
evolutionary vacancy (and increasingly between market segments as the boundaries
between use dissolve). The model will also vary between locations depending on the
prevailing market conditions in those locations.
Conclusion
This article has explicated a conceptual framework for commercial vacancy that
moves beyond the positive facets of vacancy, such as initial, frictional and cyclical
vacancy types (Kerris and Koppels, 2006) and the general approximation of
structural vacancy. This thread of enquiry builds upon the initial work of Kerris and
Koppels (2006) and sets out a conceptual framework that considers natural and
structural types of vacancy, highlighting an additional set of vacancy concepts. The
theoretical argument suggest that commercial vacancy can be separated into two
distinct tiers, that of natural vacancy and that of structural vacancy.
Natural vacancy describes those properties that efficiently clear through the classic
supply and demand mechanism, while structural vacancy describes those properties
that no longer clear through this mechanism. This distinction then interacts with the
commercial market, which in itself is separated into the prime market and the
secondary market. However, these bifurcations do not run contiguously. Not all
secondary vacancy is structural; for example, auxiliary vacancy captures those
secondary properties that still clear the market and are held in reserve to support
and fill-in for the prime market in certain locations.
Each vacancy tier has its own characteristics, and although part of the same
commercial market, operate and manifest quite differently. To demonstrate this
situation, the horizontal dimension of the vacancy typology describes the scale
based variation inherent in vacancy, running from the macro to the micro level. The
vertical dimension represents the property ladder and the temporal building life cycle.
The best properties are added to the top in a funnel-like system and the worst ones
eventually drop out of the bottom dependent on their contingent circumstance. The
originality of the research rests in its utility as the first known holistic examination of
commercial real estate vacancy beyond that of an abstract economic factor, while its
value is explicit in the conceptual typology which can be used by researchers
interested in market imperfections and consequent interventions.
However, in order to begin to understand commercial vacancy, it is necessary to
qualify the research findings in this paper. First, the UK focus of the research reveals
the need for some cautionary words in relation to the context and content of the
findings and conclusions in this paper. We must be careful of over generalisation and
simplification. Each location in the world contains a variety of comparable but highly
specific real estate markets which are contingent and socially produced in each
context. It is therefore likely that the operation of vacancy will be different in
alternative market contexts. Therefore, it is hoped that the conceptual framework set
out in this paper is used as a framework for discussion rather than rigid structure.
Similarly, in taking such a wide view of commercial vacancy, some of the finer details
of the different types of property and vacancy been dealt with in cursory fashion. This
paper has only provided general descriptions and drawn broad conclusions, a great
deal more research will be needed to fully understand the specific nature of
commercial vacancy. Finally, by focusing its research on the UK, the paper is
Anglocentric in its conceptualisation and understanding of commercial real estate,
which will most certainly add a degree of bias to the judgements contained within.
Despite these caveats, we consider that the material within provides a conceptual
framework through which a more comprehensive picture of commercial vacancy
begins to emerge. Above all, the message is clear: we misunderstand contemporary
commercial real estate, if we believe that commercial vacancy can be reduced to a
simple bifurcation of natural and structural vacancy.
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... What is new, however, is the rate and regularity of obsolescence and vacancy (Muldoon-Smith and Greenhalgh, 2017;Armstrong et al., 2021). Traditionally, a typical office lease would be 20-25 years long with full repairing and insurance obligations placed on the tenant. ...
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