Despite Costs, Developers Pursue Rehab Opportunities for Detroit’s Historic Buildings

by Kristin Harlow

By Steven Phillip Siegel

Mies van der Rohe. Yamasaki. Kamper. Kahn. Portman. Gyllis. Some of the biggest architects in the world have a presence in Detroit. Motown’s exceptional confluence of architects and designers earned the city a UNESCO City of Design designation, the only city in the United States to receive the UN’s award for design excellence. However, beginning in the early 1970s, many of the city’s finest architectural works slowly sank under a weakening market amid tenant (and residential) flight to the suburbs.

In the aftermath of the Great Recession, developers, led by Dan Gilbert’s Bedrock, began slowly redeveloping Detroit’s architectural gems. Historic properties like downtown’s David Stott Building or New Center’s Fisher Building saw massive capital investments in recent years. Yet, many city residents and tenants find it hard to comprehend why rents on these new projects are so much higher than the rest of the market. The narrative of Detroit’s architectural gems — and the financial Jenga it takes to make them succeed — tells the story of the city’s modern-day renaissance.

Steven Phillip Siegel,
Lutz Real Estate
Investments, Q10 | Lutz Financial Services

“To us, it’s a passion project,” says Brett Yuhsaz, Bedrock’s director of construction, who has worked on some of the city’s most notable historic rehabs, including architectural gems like the David Stott, Shinola Hotel and Book Tower. “These buildings are iconic to Detroit, especially when you look at some of the amazing architectural talent that was here in the 20th century, and we’re all about restoring these gems back to their original design,” says Yuhsaz.

Associated challenges

Notable challenges exist with rehabbing historic structures. Older buildings tend to use more “natural” materials, including terracotta, limestone, ornate brick and copper, which are not widely used today for modern construction due to the excessive cost. Finding trades to work on these vintage materials adds significant expense to projects. Even so, Yuhasz says “the level of craftsmanship in metro Detroit and Southeast Michigan shows the passion of the contractors. It’s not always about the lowest bidder but finding the right people who are truly craftsmen.” 

Additionally, retrofitting older structures for modern building code and tenant demands is excruciatingly difficult and expensive. Floor plans and infrastructure from the early 20th century were not designed with modern-day boilers, water heaters, elevators and tech AV in mind. “It’s a giant puzzle,” explains Yuhsaz. “We’re constantly investigating and studying every nook and cranny in these buildings and how to fit in these modern systems for great functionality and modernity.”

Besides material and utility challenges, there is the inherent troubled state of older buildings and their inefficient floor plates. Detroit-based Kraemer Design Group, an architecture and design firm with expertise in historic rehabs, knows these challenges well. “One of the reasons rents are higher [downtown] is because they are inefficient buildings,” explains Bob Kraemer, principal and founder.

“If you build a brand-new apartment building, your percentage of rentable area is higher than if you converted an old building. In a new building, it’s 85 percent of total square feet whereas in a rehab it’s 75 percent. You’re backwards from day one.”

Cost structure

With less rentable square feet available for rent, developers need to charge more than projects in the suburbs. Add in costs associated with retrofitting properties for modern utilities, upgrading historic natural materials and demoing crumbling structures, and a picture begins to emerge of the high costs associated with these historic rehabs.

The numbers bar this out. According to Don Selvidge, MAI & senior managing director at Integra Realty Resources, costs have been escalating drastically for rehabbing historic structures. Total costs for historic rehabs can get into the high $300s per square foot. Hard costs for rehabbing historic buildings range anywhere from $220 to $300 per square foot, while soft costs can be $40 to $80 per square foot. Meanwhile, a typical four-over-one wood frame ground-up project has hard costs of $150 to $175 and soft costs of $20 to $40 per square foot. Taking rough averages (before land), the basis for a 100,000-square-foot suburban development would be $19 million, while the same size urban project would be $30 million.

How to make the math work

To make development projects financially viable, developers target a spread between the exit cap rate and return on cost, typically around 150 to 200 basis points. This “developer spread” allows them to hit risk-adjusted returns that are attractive for equity investors. Exit cap rates in suburban Detroit are similar to downtown Detroit projects. With significantly higher costs downtown, a ground-up project needs a higher net operating income (NOI) to warrant the cost. And therein lies the crux: the only way to get a higher NOI is to charge higher rents. As such, downtown Detroit and Midtown have the highest rents in the entire metro area. 

However, even with Class A rents in downtown/Midtown approaching $2.50 per square foot, achieving the 150-basis point developer spread has become more difficult due to hard costs approaching $300 per square foot. Without the various incentives offered to developers, including brownfield TIFs and tax abatements to help boost NOI, historic tax credits or Michigan Economic Development Corp. public/private capital to lower investor equity, historic rehabilitation projects would not be able to compete with capital that can go to the suburbs for a higher (and less labor intensive) return.

As a result, many of these gems would sit empty, as they did for decades until demand returned for downtown living. Kraemer sees restarting the state’s Historic Tax Credit Equity program as critical to future historic rehab projects. “It’s a pretty sizeable credit,” he says. “It gets the banking institutions more excited and it’s almost the exact same paperwork [as applying through the historic preservation societies].” 

Despite the sizeable financial and physical challenges associated with historic rehabilitations, projects like the Shinola Hotel or Ford’s Michigan Central Station prove that developer appetite remains flush and Detroit’s prospects high. While discussions of abatements, brownfield TIFs and other public/private incentive programs have recently garnered media attention, a bird’s eye view of the numbers indicates how critical these programs are for making historic rehabs financially viable for developers.

Even so, many developers in Detroit are driven beyond purely financial means. Brian Hughes, vice president at Northern Equities Group, says he relishes the opportunity to update the Albert Kahn in a way that preserves its integrity and gives it new life. “At the time it was built, the Fisher Brothers said it was to show ‘a practical demonstration of our continued and steadily growing faith in the future of Detroit,’ which resonates with me because we are doing the same with this project today.”

Perhaps what these developers see in these historic properties is that the greatest value in real estate is beauty.

Steven Phillip Siegel is vice president with Lutz Real Estate Investments and Q10 | Lutz Financial Services. This article originally appeared in the July 2020 issue of Heartland Real Estate Business magazine. 

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