Commercial real estate faces a significant challenge as office vacancies reached historically high levels in 2023, driven by remote and hybrid work models. Conversely, residential rental properties have reached all-time lows in many major cities. While converting unused office spaces into residential units seems like a logical solution, experts caution that this process is far from simple.
Office-to-residential conversions pose considerable complexities and costs. A recent Goldman Sachs report indicates that office acquisition prices would need to drop nearly 50% for such projects to be financially viable. Despite a surplus of unused office space—projected to reach 1 billion square feet by the end of the decade according to Cushman & Wakefield—only a fraction of these spaces are suitable for residential conversion. Factors such as building age, cost, and redevelopment challenges limit the feasibility of conversions.
Zoning restrictions and layout issues further complicate the conversion process. Not all buildings are suitable for residential use, and even those that are may require years of planning and significant investment to complete. John Walkup, co-founder of UrbanDigs, a real estate data-analytics company, highlights the lengthy and risky nature of conversion projects compared to new ground-up developments.
In summary, while the idea of repurposing unused office space for residential use appears appealing, the reality is that such conversions are often impractical and financially challenging, requiring careful consideration of various factors and significant investment.
Goldman Sachs defines a “nonviable” office space as one located in a suburban area or central business district, constructed before 1990, lacking renovations since 2000, and experiencing a vacancy rate exceeding 30%. Surprisingly, these “nonviable” office spaces are considered more suitable for conversion projects because they are typically almost entirely vacant. According to Goldman Sachs’ analysis, converting such nonviable office spaces at their current price levels would result in a loss of $164 per square foot. This implies that office prices would need to drop by 50% for developers to fully cover the costs through discounted future revenues.
In essence, developers are unlikely to recover their investments in conversion projects unless there is a significant drop in prices.
Ran Eliasaf, founder of real estate private equity firm Northwind Group, emphasizes that aside from zoning and regulatory hurdles, conversion projects face substantial expenses and must overcome structural and financial obstacles. He notes that building housing from scratch is often more cost-effective, and successful conversions are limited to certain types of buildings.
In summary, while nonviable office spaces may seem suitable for conversion due to their high vacancy rates, the financial challenges and structural limitations associated with such projects mean that developers may struggle to recoup their investments unless office prices undergo a significant decline.
Office-to-apartment conversions are a ‘fringe trend at best’
Despite the significant challenges and lengthy timelines associated with office-to-residential conversions, some projects are still progressing. A study by Deloitte released in July 2023 identified 217 conversion projects in the immediate pipeline for completion. However, while there were indications of a “conversion wave” in the immediate post-pandemic era (2021-2022), Moody’s Analytics cautioned in its 2022 study titled “Why Office-to-Apartment Conversions are Likely a Fringe Trend at Best” that executing and profiting from such conversions is more challenging than theorizing about them.
Before the pandemic, only about 0.4% of office space was converted to multifamily space annually, a figure that increased to just 0.5% in 2023, according to Goldman Sachs. At this pace, it would take another eight years to convert the 4% of offices categorized as nonviable by Goldman Sachs. In many cases, it may be easier, cheaper, and quicker to construct entirely new apartment buildings rather than undertake complex conversion projects.
Factors that play into office-to-residential conversions
Richard Whitney, vice president of architecture, interior design, and sustainability firm FitzGerald, highlights several key factors to consider when contemplating office-to-residential conversion projects. With experience in completing over 100 conversions and renovations to historical buildings, Whitney’s firm understands the complexities involved in such endeavors.
One crucial aspect architects must consider is the existing building infrastructure. This includes factors such as the floor plate size, which dictates the usable square footage of each floor. Determining the floor plate size is essential for designing floor plans that comply with building codes and provide adequate light and ventilation to each residential unit. However, this task becomes more challenging when original drawings or floor plans of the building are unavailable.
Additionally, designers must account for the condition of existing HVAC, electrical, and plumbing systems, especially in older buildings where these systems may require replacement. The uncertainty surrounding historic buildings and the potential lack of original drawings can make some stakeholders hesitant to pursue conversion projects. Without access to original drawings, it can be difficult to understand how the building was constructed, potentially leading to unforeseen challenges during the conversion process.
Whitney emphasizes the importance of considering these unknown factors when planning conversion projects, as they can significantly impact the project’s feasibility and success. Being prepared for potential challenges and hidden obstacles is essential for navigating the complexities of office-to-residential conversions.
Government incentives
In late October 2023, the White House launched a multi-agency initiative aimed at encouraging states and cities to repurpose empty office buildings into apartments. Transportation Secretary Pete Buttigieg announced that there would be “over $35 billion in lending capacity” available to provide below-market rate loans to finance housing construction and conversions near transportation hubs.
According to Richard Whitney, this type of government involvement in office-to-residential conversions is crucial. He explains that construction costs are high, and real estate developers face significant challenges with financing. Projects are more likely to be financially viable if city governments provide incentives and subsidies to alleviate costs.
Several cities, including Boston, have initiated their own incentive programs for office-to-residential conversion projects. Boston’s program, announced last summer, offers property tax waivers of up to 75% for up to 29 years. The program aims to increase downtown housing units and boost foot traffic to support downtown businesses.
Arthur Jemison, the city of Boston’s chief of planning, emphasized the goal of incentivizing partnerships between lenders, property owners, downtown stakeholders, and the state to increase housing production in the downtown core.
Whitney believes that incentives like these will significantly contribute to bringing more affordable housing to cities. Moreover, established programs can streamline approval processes, reducing project completion times. He stresses that shorter approval processes are crucial for the success of conversion projects, as prolonged delays can hinder progress and viability.