Our study determined that the establishment of the objectives was the single most influential variable in the development of alternate-use scenarios.  In the case of Eastern State the objectives were stated and specific; however, in the case of many historic properties the objectives are assumed or implicit.

Of all the factors effecting the conclusions of this study the establishment of the initial goals are of overriding importance.  The general conclusion of this study is that alternative use is a less effective strategy in achieving the goals set for Eastern State Penitentiary than investing the money required for conversion in an interest-bearing account.  This conclusion is not a condemnation of alternative use as an aspect of preservation theory or as an implementation strategy per se.  Other goals, however, will result in different conclusions.  If the goals were to retain fifty percent of the fabric or half of the cell blocks for interpretation, the conclusions and recommendations would be different. Although the conclusions of the study were less optimistic than desired, the single most effective adjustment of parameters to achieve a desirable outcome is the reestablishment of the goals.

The general experience of alternate use as a strategy for historic preservation and the previous specific proposals for Eastern State Penitentiary are of mixed success.  Most advocates of preservation recognize the compromises inherent in alternate use, namely reduction of fabric, reduced control, reduced access, and reduction of interpretive quality.  Because the preservation community often does not have the resources to independently determine the outcome of each and every historic property, a compromise is made between alternate use and apparent demolition or ruination.  Resorting to commercial development as a method of alternate use is not, generally, the first choice but the result of real or perceived necessity.

REAL ESTATE VERSUS PRESERVATION

The broadest objective of preservation is retention of fabric. Typically, the first choice for that property is one that treats the building more as an artifact than as real estate.  If the original fabric is not preservable, then we proceed to restore the fabric and so forth in the order prescribed by the Secretary of the Interior’s Guidelines.  We are also well aware that even displaying the building as an object, much less installing an alternative use, generates conflicts between authenticity and code conformance.

The building in question may be an eighteenth-century single-family residence.  To convert that property to a historic-house museum may entail conforming to the code requirements for group assembly.  The occupancy of an otherwise modest house, therefore, could be determined to be 100 or more people, but there is no fire-suppression equipment, second means of egress, or 100-pound-per-square-foot live-load capacity.

Such a situation is exacerbated if an owner is also required to amortize the capital improvements and compete in a market based on rents.  As exemplified by many historic tax credits in the early 1980s, the conflicts may not even be apparent for five or more years.  The objectives of preservation emphasize authenticity and durability whereas the rental market emphasizes amenity, image, and expediency.

The tax-act projects subscribed to the Secretary’s Guidelines to the extent required; however, the quality of the improvements were driven far more by the ability of the unit to fetch a rent than to endure over time.  Many of those projects were physically altered in ways that will prevent them from being reinterpreted in the future.

When Eastern State was presented to the commercial-development community, the proposals were perceived as less desirable than abandonment.  Among the development proposals for Eastern State the least destructive proposed that more than half the site be demolished.  Another developer proposed demolishing as much as ninety percent of the fabric.  One proposal required direct public subsidization of such a magnitude that exceeds the current costs of conversion to a museum.  All the proposals were presented, at least in part, as a means of preservation.

For Eastern State the motives and requirements of conventional commercial developments of conventional commercial development were not realizable given the gross-to-net square-footage ratio.  For every rentable square foot of Eastern State a developer has to renovate 1.6 gross square feet.  In the end the project would compete with equally desirable renovations in which the competing developer had to renovate only 1.1 square feet, which is typical of commercial renovations.  The extreme inefficiency of the complex made development feasible only by destroying so much of the fabric that the preservation community balked.  The history begs speculation as to the fate of Eastern State had it been eighty-five percent efficient instead of the sixty percent that it is.

As a consequence of the inefficient nature of Eastern State, it is inherently difficult to develop economically.  Generally, structures can be redeveloped economically when net-to-gross ratios approach ninety percent or the building can be altered in order to achieve such efficiency.  The consequences of such alterations may, and often do, result in major reconfiguration of interior volumes.  Depending on the original objectives, this may be unacceptable.

THE REAL ESTATE MARKET

As preservationists we often look at an abandoned building in a state of impending demolition or collapse and conclude that we can save the building if we can find an appropriate use.  The premise is that if we persevere and are clever, we will find a perfect use that will save the building and serve the occupant.

A general theory of rent, however, suggests that by the time the building has reached the point of demolition or abandonment, the market has effectively conducted just such a search.  An abandoned building is the real estate market’s way of telling us that it has tried to find a fit at virtually any and all rents and failed to come up with even a $1-per-square-foot option.  There are many buildings that pass through the market and into abandonment every day, but only a few of them are objects of preservation concern.  The real estate rules are the same for all property, historic or not.  When we adopt such a building and begin the search for the saving alternative use, we are ignoring the original message: The market does not currently value this property.

The operative term in the former paragraph is “the market.”  A market is an open exchange among buyers and sellers in which both parties are acting out of perceived self-interest and with equal bargaining positions.  This definition paraphrases Paul Samuelson’s classic text on economics, and little has occurred to change the definition.

The definition is relevant in that it points out that markets are made up of individuals, not machines or computers, and that collective judgment is a major factor in interpreting market behavior.  Another important point is that a market will change based on perception.  Having a better mousetrap is of little value unless the buyer perceives the value of the improvement.  The relevance to historic properties is that while we perceive value of historicity, the market will respond and buy based on the sum of individual buyers’ perceptions of value.  The market will bid down rent, which is a measure of value such that at any given time a property is returning its highest and best rent for its condition, type, and location.  If a property can through reinvestment return a higher rent, then development will occur with or without the intercession of the preservation community.  The factors effecting either the currently realizable rent or the prospect of reinvestment include the building type and its condition, but far more important is its location, efficiency, zoning, and scale.  In other words, much of the value of a given property is dependent on factors that are unrelated to the architectural style or historic value of the building.

As preservationists we tend to view the life cycle of a building in quite physical terms related to condition and maintenance.  The market views the building in terms more of utility and function.  While we view alternative use as a special condition of preservation planning, the real estate market continually evaluates each and every property in the inventory for alternative-use potential on a revolving basis.

An exception to this occurs when an owner perceives the value of the property to lie in its appreciation rather than its rent.  In Philadelphia such a situation may currently exist with respect to the Victory Building and the Naval Home. Both properties are privately held, both are vacant and abandoned, and both are deteriorating to the point of condemnation.  The respective dollar values of the sites may be increasing simply as time goes by.  In other works, the sites are a form of land bank.  Their respective values may not be appreciably different whether they are rented or vacant.  By waiting and doing nothing the properties may be condemned and demolished; but because the investment value in the properties is in appreciation to begin with demolition may actually enhance the value.

In an effort to tilt the market toward preservation, we have used incentives to reduce the risk of development and encourage certified rehabilitation.  The historic tax credit is such a device.  In the early 1980s a developer could receive as much as a twenty-five-percent tax credit for investing in and developing historic buildings or buildings contributing to a historic district.

The response of the development sector was slow at first, but caught on rapidly and produced a flood of tax-act development projects.  The standards were tightened each year as the reviewers became more suspicious of developers’ motives and tactics but the genie was out of the bottle.

Among the early compromises with the developers were that seventy-five percent of the exterior wall needed to be preserved and that the interiors of the buildings were not as significant as the exteriors.  In mildly hyperbolic terms the message was that the developer could do virtually anything on the interior as long as most (seventy-five percent) of the façade survived.

In the case of Old City, a district in Philadelphia, a typical consequence of these policies was that an open loft building that was occupied at a rent of $2 per square foot was bought and renovated in the name of preservation.  Such projects resulted in virtual destruction of the interior fabric.  The provision for saving seventy-five percent of the exterior wall was intended to allow developers to replace significantly deteriorated portions of the wall.  The application of this provision authorized developers to demolish as much as twenty-five percent of the exterior wall whether it was deteriorated or not in order to provide courts and light wells.  Rents increased to $10 per square foot, but with the tax credit the effective rent was close to $12 per square foot per year.

In other words, a provision designed to salvage threatened buildings stimulated the taking of functioning buildings in the name of preservation.  This occurred even though the buildings were doing precisely what they were designed to do as loft buildings, albeit at $2 per square foot.  The loft buildings were modified in such ways that the interiors were destroyed and the perimeters altered in ways that their original uses can never be reinstalled, regardless of what the market may do in fifteen or twenty years.

These same properties were subsequently up for resale; the original investors had collected their tax credits and wanted to move to other investment opportunities.  From the mid-1980s to the mid-1990s, however, the market for property in Old City had declined to $8 or $9 per square foot.  Before the development community could stop the process so many units were in the pipeline that Old City was glutted with one-and two-bedroom apartments.  The projects were going bankrupt one by one.

The phenomenon of Old City is a contrived market founded upon a form of subsidization.  When the subsidies expired the market started sending rents in Old City back where they were before intervention.  In twenty years, barring any movement in the basic demand for space in Old City, the properties will decline to meet the market.

The point is that the under occupancy or lack of occupancy of a property at a given time is not so much a consequence of potential renters overlooking a jewel as much as the bidding process at work.  When we meddle with the mechanism we have not to date been able to predict the long-term ramifications.  If we resort to incentives, we can almost surely expect to have to sustain those incentives indefinitely.  If we compromise the fabric we may very well restrict future development potential resulting in pre-mature demolition.

The fundamental problem of subsidization or other form of market manipulation is that the moneys are applied indirectly to the objective with the consequence that the outcomes are not necessarily reliable of desirable.  The use of tax credits to achieve preservation first and foremost enriches the developer, which will encourage the developer, which will encourage the developer to preserve the building.  It follows that the incentive evaporates with the termination of the subsidy, which in the case of historic tax credits is no more than five years.

Regardless of the form or mechanism, incentives and subsidies are disbursements generally from public funds that are designed to provide value to the public.  In the case of a typical historic tax-credit development in Old City, the amount of the tax credit was $1 million.  If we had awarded a $1-million grant to the original owner of the same loft building, would we or the building be any worse off today.

The temptation to intervene in the market on behalf of our sacred cow is almost irresistible, if not for preservation then for some other motive.  On March 19 of this year The Philadelphia Inquirer reported a proposal by Myles Tannenbaum, “a Wharton lecturer and longtime principal in commercial real estate ventures,” to deal with the soft Class B real estate Market.  The plan is to establish a publicly funded authority that will purchase and demolish buildings with low occupancies.  By reducing supply, rents will rise and enhance the surviving properties while the owners of the demolished properties are reimbursed for their “losses.”

Tannenbaum and developers not unlike him are the same partners in alternative use whom we are relying on for the sensitive and enlightened preservation of our buildings.

THE ALTERNATIVE USE FORMULA

The basic formula for real estate development is quite simple: Will the property return more money than it costs to develop?  The methods for predicting the outcome of a given venture are far from certain.  The consequences of being right or lucky may result in substantial profits and such ventures certainly derive considerable publicity; however, many do not realize profits and some are outright financial disasters.  A major factor in assessing a development project is the analysis and management of the risks.  A typical objective of the development of a property is to double the equity investment upon resale, although the reality of investment is that very few projects double their equity investment.  The negative picture is assumed to be that the investor loses the original investment.  In fact, a project that goes sour can be much worse than that.

The worst-case scenario for a project is that halfway through construction the contractor goes bankrupt, leaving the developer with a huge debt, no building, breached rental agreements, and a panicked lender.  The losses can easily exceed the value of the investment.  For all of these reasons – combined with Samuelson’s first law of perceived self-interest – developers not only approach a project to turn a profit but to turn the maximum profit possible on a given property.  We now have a situation in which a property has the potential to derive increased rent through reinvestment.  If the building is currently producing $2 per square foot and we can get $10 by investing $40, we have a twenty-five percent return on investment per annum.  If the developer determines that these ratios are favorable, why would he or she deliberately invest $50 or $60 per square foot for the same return?  In other words, given the nature and risks of ventures why would anyone increase risk in an already inherently risky business?  Not only is it unlikely that a developer will invest more than is required but he or she is unlikely to deliberately restrict rental return.

The hard costs of an alternative-use scheme consist of three parts: the land, the infrastructure, and the amenities.  The land is a fixed value regardless of what the scheme is.  The costs of infrastructure are remarkably similar for offices, stores, apartments, or bowling alleys.  The variable hard costs are the amenities, which constitute between fifteen and twenty percent of hard costs, a modest portion of the construction costs.

The amenities of the project are what distinguish a warehouse from an amusement gallery; an office from an apartment.  If the project provides no amenity, the space is referred to as shell space.  As a fraction of overall project cost, amenities are approximately five percent of the total project budget.  In other words, it is that five percent that distinguishes a raw, unimproved loft from an upscale, deluxe apartment.  The difference in rent in Philadelphia is approximately 1,000 percent ($1 versus $10 per square foot per year).  Given the option, why would a developer put ninety-five percent of the money at risk in order to reduce income potential by ninety percent?

Allowed to operate in the market, alternative uses will move to the upscale option.  The upscale option, in turn, is by definition the use furthest removed from the current use in terms of rent.

The upscale options also result in the maximum insult to the fabric.  Among feasible redevelopment options the highest return on investment option is one that reconfigures the property more than lesser uses.  If a building was originally constructed as a factory and manufacturing remained the highest and best use, then the market will keep it manufacturing and the property is not a preservation problem.  If there is no economically feasible option the property will pass out of the inventory.  If redevelopment occurs, the property must be enhanced in terms of use in a substantially different way than its current condition or it would already be in that use group.

The Budd plant on Allegheny Avenue in Philadelphia is a legitimate piece of industrial Americana.  It is not an object of preservation concern because Budd is still using it as a factory.  The Midvale-Hepenstall steel mills around the corner from Budd were summarily demolished because they were no longer valued as mills and no one – including preservationists – could convince young professionals to want apartments in the middle of the Hunting Park industrial area.  The loft buildings in Old City were developed as apartments, a configuration as radically removed from open bays as possible.

There are three fundamental scenarios of commercial development: stay the same, demolish and rebuild, or partially demolish and renovate.  In the case of the latter, the partial demolition will move to the extreme of the financially feasible options.  The wider the potential margin, the greater the alteration.  The development proposals for Eastern State Penitentiary are prime examples of this principle in action.

CAPITALIZATION VERSUS RENT

To bring Eastern State Penitentiary to the real estate market as potential rental space requires investment in the form of site and building improvements.

For a given business operation there is a limit to the overhead that can be carried.  Very simply, if the rent is too high to be covered by the revenues, the business moves to a location with a lower rent.  The ability of an operation to pay rent, therefore, is tied to the ability of that operation to realize revenue.  The same thing is true of the ability of that same business to amortize debt.  Whether income pays rent or pays down debt is academic.

In the scenarios presented for Eastern State, we determined that given the uses we investigated, the site can render rent at an average of $2.75 per square foot or approximately $600,000 per year.  The cost of bringing the site to a state of improvement in order to realize that income requires the investment of approximately $12.5 million plus approximately $300,000 in additional annual expenses associated directly with rental operations.  We have also concluded that those funds must come from sources that will not require repayment of principal or of interest – i.e., appropriations, donations, or grants.

The net return is, therefore, $300,000 per year on $12.5 million or approximately 2.4 percent.  It is on this basis that we suggest that a more appropriate use of the money would be to invest the money in a guaranteed fund of from eight to nine percent, which will return $1,000,000 per year net without the risks and damage of the alterations.

One response to this finding was a question regarding the ability of tenants to carry more of the capital expense.  The scenarios developed in the study assume that the tenants will, in fact, bring an additional $15 to $20 per square foot in fit-out costs to the rental space.  Over the approximately 200,000 rentable square feet that means that the tenants are providing an additional $3 million to $4 million in capitalization on top of the $12.5 million provided by the landlord. 

In order for the businesses to carry more than that amount of debt will require a reduction in rent.  As a general rule $1 in annual income can carry $10 of debt; therefore, if we cut rent by $100,000 per year the tenants could carry an additional $1 million in debt.  If we eliminate rent, the tenants could carry an additional $6 million to the project in improvements.

As amazing as it may sound, even if the penitentiary gives away free space, it will cost someone an additional $6.5 million for improvements mostly in the form of infrastructure and code compliance items.  There are also scenarios beyond free rent (the landlord pays the tenant to stay on the property, thus theoretically enabling the tenant to absorb even more of the capital costs).  the point is that there is an interplay between rent and capitalization; for a given operation, the lower the rent, the greater the debt the tenant can carry; the higher the rent, the more capital the landlord must bring to the project.

As absurd as it may seem, there are situations in which free rent is appropriate.  There are historic properties that exchange rent for no other reason than the added security that comes with occupancy.  There are situations in which rents are subsidized in order to provide housing to low-income groups.  The establishment of the relative contributions to capitalization are a reflection of the project goals and objectives.

THE PRESERVATION PROCESS

The minimum essential elements of preservation for a project can be developed from the goals set for a project.  These elements are both general and specific characteristics without which the project is not worth the effort.  (One such goal for Eastern State was to keep the perimeter wall intact.)  From this list emerge those items that are non-negotiable and those that are.  if the list becomes a detailed way of saying that everything will be kept intact then that property is not a good candidate for alternative use.

The next step is to develop a financial plan to support the preservation objectives.  In the case of Eastern State, one scenario is to develop the site as a managed ruin.  If that becomes the accepted goal, the financial plan is far less demanding than a scenario in which one or more cell blocks are restored to a pristine state of repair.

In the course of conducting this study we learned a great deal about the museum business, namely that it is a business with the identifiable characteristics of any other business.  Interpretation and revenue are inextricably intertwined, and fund-raising is as integral to an operation as historic interpretation.  The goals of the museum evolve and are rarely fully developed when the institution opens its doors.  The plan, therefore, must be progressive and constantly evolving.  There may never be a point at which the interpretation or the preservation plan is “finished.”

The financial plan is, therefore, a rather flexible tool that has one objective: equilibrium.  If there is an operating shortfall, alternate use is not the only means by which to reestablish equilibrium.  Given the irreversible nature of conversion, alternative use may even be considered the tool of last resort, but without clear goals we have no comparison for other options.

The broader message to the preservation community is that an early step in the preservation process should be, in fact, be the financial plan.  A common assumption is that the preferred first step in the preservation sequence is a historic-structure report, but we are suggesting that before such a report there must come a clear statement of goals and objectives and a financial plan supporting them.  A historic-structure report is an expensive undertaking in itself and may or may not be necessary if the financial feasibility does not exist.

The idea is to find a use that fits the building rather than fitting the building to a use.  We discovered that most developers bring a preconceived use to a project because the use is the part of the development formula with which a given developer is familiar.  Very few developers are comfortable approaching a project without a preconception of what the project will be.  In other words, if we ask a developer who has always done apartment conversions, we should not be surprised that his or her solution for the project is apartments.

The consequence of such predispositions is that developers typically evaluate a property relative to a preferred type of use.  If a given property does not appear promising for that developer’s use type, the developer will alter the building in question or abandon the site and move on to one that fits the criteria rather than change use.

An analysis of these factors leads to the conclusion that while commercial development may bring capital investment to a project, it also brings its own agenda and requirements, which are not generally compatible with preservation.  The degree of incompatibility may not be immediately apparent, as seen in historic tax-credit projects.  Subsidies and incentives are indirect interventions in the market with untoward and unpredictable outcomes.

The success of alternate use as a preservation strategy is considerably more dependent on the establishment of the global objectives for the property than the subtleties and vagaries of the real estate market.  Without introspective and open expression of the preservation objectives we naively risk surrendering the fate of the property to the motives and objectives of the market.

Samuel Y. Harris

--S. Harris & Co. Comprehensive Project List--