There is no question that, as Joseph Rubin, consultant to EisnerAmper’s financial advisory services group, puts it: “We are going through a long-term structural change in office usage.” As hybrid and remote work have become commonplace, tenants are realizing they can reconfigure and rationalize their space, and demand for office space is falling.
Additionally, tenants are demanding more from their office space – more light and better air systems, more amenities, the right location, and environmental and wellness certifications. “That leaves older buildings, which are most of the office inventory, behind. The dichotomy between more desirable and less desirable properties is quickly being more pronounced,” Rubin adds.
The ESG regulation factor is also crucial. Jim Gott, head of asset surveillance at loan servicer Mount Street, says: “This is a very considerable risk. We estimate that the amount of capital that is necessary to meet the regulatory requirements by 2030 is as much as £150 billion ($186.9 billion; €169.8 billion) in the UK alone.”
Peter Windmeißer, head of portfolio management at manager KGAL, sees something very similar in Germany. He says it is “increasingly difficult to sell older office buildings with a higher risk of becoming stranded assets.”
The US national office market vacancy is above 15 percent, observes Michael Steingold, director of private markets at Russell Investments. “Vacancy rates in downtown locations are even higher,” he says. “Some prime markets such as Chicago, San Francisco and Washington have more than 20 percent of the office stock sitting empty.”
Residential alternative
Alfonso Munk, chief investment officer of Americas at global management firm Hines, says he does not believe “the office is dead.” While one would hope not, the contrast to the booming residential rental market is striking.
CJ Slicklen, senior vice-president at Brookfield Asset Management, says: “Across Europe there is a housing shortage, with demand strongly outstripping supply. In locations where there are buildings that can be transformed and repurposed, we believe there is an opportunity to help provide high-quality, competitively priced housing.”
“There is far too little new residential construction taking place and the problem of affordable housing is becoming more acute,” agrees Windmeißer. “To find the repositioning/redevelopment of old office buildings [is] interesting.
“For example, if a building is over 50 years old and/or has not been refurbished for a long time, the options are to demolish and rebuild or to convert/reposition. From an ESG perspective, converting an office is often the more attractive alternative, as new residential construction generates significantly higher greenhouse gas emissions.”
In the UK, Pratap Singh, senior director at research and analytics group Acuity Knowledge Partners, states there is “a housing deficit of nearly 4.3 million homes.” It is hardly surprising the UK is giving conversion a push through its new permitted development rights policy to plug the demand-supply gap.
“From an ESG perspective, converting an office building is often the more attractive alternative”
Peter Windmeißer,
KGAL
According to one report published in 2022, nearly 30 percent of UK commercial real estate assets are earmarked to be repurposed. As Gott notes, “when the value of dated Mayfair offices is something like 20 percent of prime residential, then the pressure for conversion is clearly strong” as an alternative to disposal.
Likewise in the US, it feels as though today’s economic environment will see multifamily properties provide steadier income than offices. Steingold contrasts Russell Investments’ forecast of zero rental growth in offices over the next five years versus 12 to 15 percent in the residential market.
US investors grasp the lifeline
Indeed, there are no shortage of projects in the US. Silverstein Properties, one of the largest commercial landlords, has announced plans to raise more than $1.5 billion to convert unwanted office space into residential housing.
Singh cites numerous other projects, such as Park + Ford, the adaptive-reuse of the former three-building Park Center office complex into a 435-unit contemporary apartment community in Alexandria, Virginia. In the same city, there is also a suburban office building of 132,000 square feet where Urban Investment Partners (UIP) plans conversion into 112 apartments.
New York’s financial district, meanwhile, is home to 25 Water Street, which Singh says is “perhaps the largest ever office-to-residential conversion in the US.” The property is a 22-story, 1.1 million-square-foot office building that will be refitted to feature around 1,300 residential units.
In June 2022, Hines announced plans to embark on the transformation of South Temple Tower in Salt Lake City, the firm’s first office-to-residential conversion, which would involve the transformation of a 217,000-square-foot office building into a 255-unit luxury multifamily tower.
Europe treads water
Some Europeans are being bold. Windmeißer is considering conversions for KGAL’s new residential impact fund, including 150 apartments in a 1960s office building in the Netherlands that has not been renovated for more than 15 years. And Slicklen has ongoing examples in France and Germany “where we have taken class B properties that are close to transport hubs and repurposed them for residential.”
“We are looking at various conversion projects but, at the moment, we are not actively doing any,” says Simon Durkin, head of real assets research at BlackRock. One UK project has existing planning permission to redevelop industrial into residential, but Durkin says now “the numbers no longer stack up.”
Ben Pile, head of European residential investing at Barings, says his firm has not done any conversions yet, but has purchased other buildings after they have been converted. “We might consider it ourselves. But at the moment we have just not found the right opportunities.”
In Germany, Michael Peter, chief executive of P&P Real Estate, sees only problems. “Many existing properties need extensive investment to upgrade them to comply with the energy efficiency standards of the new Building Energy Act (GEG)… and floor plans and supply lines are not designed for residential units and need to be completely overhauled,” he says.
The conversion outlook
There are a number of difficulties concerning property conversions. Partly, these are down to economic circumstances.
Ashley Perry, investment director at manager Apache Capital, says: “Clearly given the cost inflation we are seeing, getting funding over the line for development sites is tricky but it is doable if you have the right product and partners – as our Great Charles Street scheme demonstrated.”
Sebastiano Ferrante, deputy head of Europe at PGIM Real Estate, also feels “conversions are challenging.”
First, it is very difficult to develop modern, affordable, sought-after living space in times when interest rates are rising and real estate values falling. Then, “developers must consider planning permission, time horizons and significant costs of residential developments.”
Amenities such as schools, supermarkets and public transport links are needed for residential areas but may not have been considered when building offices. Finally, Ferrante notes, “properties considered for conversion are often non-ESG compliant, which means the time and capital needed to bring them up to standards during a rebuild is huge, often with limited upside for investors.”
Richard Sykes, development director at London’s Patron Capital, agrees. “We have looked at a lot of schemes, but frankly, none have convinced us. The conversion costs are high, specifically if the existing facade does not meet future energy requirements, or the roof needs replacing.
“In most conversions you will need to replace the whole mechanical and electrical system internally. In addition, office layouts are often not conducive to conversion into residential property.”
This is a point with which Perry concurs. “We think carefully about access to daylight, views, floor-to-ceiling heights – you are limited in what you can do if you are converting an existing building.”
Singh sees these challenges too, but overall finds “conversion is generally cheaper than new construction from scratch” especially with attractive tax incentives. He notes at the UIP development “the estimated cost of conversion is $213 per square foot against $275 per square foot to build new construction.”
Indeed, a recent report from commercial real estate development association NAIOP notes that conversions are typically 15-20 percent less expensive than new apartment buildings, according to Munk, “with faster completion times, lower material and labor costs.”
Melanie Domres, managing director at BentallGreenOak, points out there “are increasing costs of getting a tenant into an office building because of the significant tenant improvements which are now required.”
However, she believes conversion can work. “It is important… to recognize that a poorly converted building will not be able to command the same level of rents as a purpose-built residential block,” Domres says. But “developers who are thoughtful in their approach and highlight the advantages of an office building (eg, windows, high ceilings and attractive common areas) will be able to avoid these pitfalls and produce a truly differentiated product that outperforms.”
There is a lot at stake. Durkin may be cautious, but he does believe “that conversion… to residential use could be part of a solution to the ‘donut effect’ which many cities are suffering. This could be the next phase in making our city centers and high streets vibrant again, bringing people back into cities.”
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