Are office conversions a feasible solution to the housing shortage?
Intro
With a glut of empty commercial real estate, conversations about office-to-residential conversions have been extensive over the last few months. With so many offices sitting vacant and an affordable housing crisis, investors, politicians, developers, architects, engineers, lenders, construction companies, property managers, agents and residents are all asking the same question; can underutilized offices be converted to housing?
In this article we’ll take a look at these projects from the real estate owner/operator’s perspective. We’ll discuss whether conversions have “legs” in general, and then address whether they can provide a legitimate solution to the national housing crisis. Spoiler alert: These questions have two different answers.
The context
The idea of converting one type of property to another is hardly new, with adaptive reuse being a frequently-used strategy for decades. With rising interest rates, inflation and lack of new construction, attention to the housing crisis in the United States has come into focus. Despite recent downturns in both home prices and rents, the number of cost-burdened renters hit an all-time high in 2021, according to Harvard University’s State of Housing report from earlier this year. Houselessness also reached record highs in 2022.
Because office real estate has been experiencing a major downturn since the pandemic, the nature of remote and hybrid work has fundamentally changed. Vacancy rates are now in the 20% ballpark, meaning numerous “ghost” office buildings, particularly older Class B and C assets, are sitting vacant around the country.
Two case studies in NYC
What do a couple of successful conversion projects look like?
25 Water Street - underway
This property, which was previously tenanted by J.P. Morgan and the Daily News, will be converted to ~1,300 residential units. The project is achieving its lighting and ventilation requirements by building a large courtyard in the center of the building. It does not offer affordable units, and was originally built in 1968. It shares one side with another building, and has two sides of street exposure. A fourth side overlooks the Vietnam Veterans Memorial Plaza Square. Windows on this side of the building do not qualify the space for bedrooms, but the developers are marketing these units as office/bed extra rooms.
One Wall Street - completed
This is a mixed-use tower offering 566 apartment units. While One Wall Street didn’t add an interior courtyard, it concentrates its elevators and mechanical systems near the center of the building. This property is substantially taller than the buildings around it, and residents have more access to light and fresh air, than on blocks where buildings are back to back. Most of the building opened in 1931, while the southern annex opened in the 1960s.
The economics of conversions
As the case studies indicate, the best candidates for conversion are often older buildings, or else buildings with favorable exposures, not necessarily the typical mid-block, mid-rise. With that in mind, let’s explore the core considerations and economics of office conversion projects. First, we’ll look at what the ideal conversion candidate looks like, and then we will cover costs and what is likely to happen in the future.
What hurdles do successful office conversions need to clear?
Any office conversion project needs to clear a number of hurdles to be successful.
Pricing and Economics
For the conversion project to make financial sense, the office building in question needs to be generating rents on a per square foot basis significantly below multifamily attainable rents. This can work in some cities with high multifamily rental rates, such as New York, where average one-bedroom rents are $82/square foot and average Class B and C office rents are in the $40/square foot range. In other cities, like housing-undersupplied Denver, average one-bedroom rents are $31/square foot and the average all-class office rent is ~$35/square foot. Whether you already own the property or will be acquiring your conversion candidate, this represents a significant impediment to conversion.
Beyond just pricing numbers, you’ll also need to consider the logistics of your conversion process. Unless the building you’re working on is completely empty, you may encounter significant difficulties getting access to occupied spaces during the mechanical buildout phase.
Zoning
When considering development on any parcel, office converters need to consider whether the property is zoned properly, or whether rezoning can be feasibly achieved. Even if the economic requirements of the project are satisfied, not every commercial parcel is zoned to allow for residential, particularly in downtown areas where office space is usually concentrated.
Building characteristics
It takes a particular type of building to make a solid candidate for conversion. Many articles and case studies will mention that pre-World War II buildings are better suited for conversion than newer properties. One of the main reasons for this is that newer buildings simply have wider floor plates, with greater depth from window to core. Converting these buildings means finding creative ways to use that inner space, whether for mechanical systems as is the case at One Wall Street or for other uses.
Another issue stems from facade design typically used in buildings from the 60s on. The exteriors are more frequently concrete, monolithic, and without operable windows. Each of these issues presents challenges due to regulations requiring daylight penetration, ventilation, and crucially, windows in each bedroom.
Another challenge comes from the building’s mechanical systems. While offices need relatively minimal plumbing systems on each floor, every single apartment unit will need to be fully plumbed for a kitchen and at least one bathroom. These pipes need to go under the floors in conversions, presenting yet another obstacle. “It used to be that we tried to keep the core building elements in place, but more often than not we need to move them, because they’re stealing some really valuable space,” says John Cetra, FAIA, co-founder of CetraRuddy, an architectural firm that has built a strong reputation for office conversion projects.
None of these obstacles are insurmountable; where there’s a will, there’s a way. According to Robert Seldin, managing principal of Madison Highland Live/Work Lofts at developer Madison Marquette, “We never have a problem with daylight penetration. We look for buildings where we are able to find and unleash the most intrinsic value.” As in other investment strategies, much of the profit from conversions is made during the purchase.
Assessing the opportunity
With these factors in mind, how many office buildings across the United States stand as potential office conversion candidates? In a review of 300 buildings across North America, architectural firm Gensler found that around 30% of assessed properties would make good candidates for conversions, based on their physical characteristics. Moody’s, in a general analysis, reviewed how many NYC buildings could be good conversion candidates. They looked at properties with high vacancy rates, low rents per square foot, and under 14,000 square feet to a floor plate (the rough figure Moody’s considers the upper end for a feasible apartment conversion). The researchers found that only 3% of NYC offices fit the bill.
Neither of these analyses are necessarily more accurate than the other. What’s clear is that a small portion of buildings make good candidates for conversion, and they will be concentrated in markets with particularly high apartment rents. There’s another angle to the housing solution story, too. All this logic is based on renting out the finished product for the maximum rates possible. Consequently, these archetypal projects won’t directly add affordable units to the market. However, even new market-rate housing is empirically demonstrated to reduce rents in general, as this research from Fannie Mae shows.
How common will conversions become?
Data already shows that conversions are increasing in frequency. However, the availability of suitable properties limits how widespread these projects can get. According to data from RentCafe released at the end of 2022, office-to-residential conversions increased by 43% from 2020 to 2021. CBRE data backs up this trend, with the firm estimating an average of 39 projects completed per year, with 217 planned or underway at the end of 2022.
Nonetheless, market forces will limit how common conversions can really get. Until the inventory of Class B and C offices becomes enough of a drag on portfolios to see a substantial downward price adjustment, it may take more creative measures to see conversions become widespread. Developers interested in these projects certainly have opportunities, in expensive housing markets, but it is up to them to get the ball rolling. “The developer needs to be the expert and guide the consultants,” Robert added. “We focus on the developer needing to be the knowledge center…how do you create value with these assets? In our experience it's decidedly not trying to fit the standard.”
Role of incentives - preservation tax credits; conversion-specific incentives
One way to spur more conversion activity is to introduce incentive programs that reward developers for turning offices into housing. Governments at different levels are already establishing incentives of various types to maximize the potential of office conversion projects. Various states and municipalities are currently offering solutions such as TIF financing, interest-free loans, direct grants, and other solutions to nudge the numbers.
While this will absolutely affect how many projects “pencil,” it remains to be seen if jurisdictions will offer substantial incentives to truly affect the course of the housing crisis. Many office buildings aren’t just marginally unqualified for conversion, they’re completely unsuited to become housing as-is. Consequently, incentives need to be more than just the cherry on top if they’re going to have a significant impact.
For their part, lenders too need to come around to the fact that sometimes, conversion projects might be the best choice for older, lower quality offices facing economic obsoletion. “I’m getting the sense that the real estate story here is that some of these office mortgages are predicated on rent escalations that are not happening,” John said. “There has to be a realization. Bankers will have to accept that the expected returns aren’t there, and we need to reset the value of these properties.”
The verdict
Asking whether or not office conversions are a feasible solution to the housing shortage is not the same as asking whether or not conversion to housing, as a concept, is a feasible business concept. Clearly, there is validity to the idea of converting underutilized office space to a new highest and best use, much like previous adaptive reuse projects converted old industrial buildings into housing or, indeed, offices. However, converting ketchup plants or cotton mills into attractive lofts is very much an opportunistic game, and so is converting offices to housing. Some acquisition firms may specialize in conversions, amassing the skills and connections needed to make these projects consistently successful. In other cases, office owners may realize that they are positioned to convert their own buildings, that without the costs of an acquisition to worry about, the margin is sufficient to allow the project to come to fruition.
Unfortunately, there are simply not enough buildings with the right size and construction, performing poorly enough as office, located in expensive enough rental housing markets, to make the 330 million square feet of vacant office expected by 2030 a solution to the housing crisis. While incentives and changes to local zoning ordinances may substantially expand the band of suitable property candidates, providing commensurable housing for the nation will require more than just conversions to fix.
