For building conversion strategies, it is all about pricing

Most change-of-use projects are not economically viable, but falling prices, looming debt maturities and potential government assistance could change that.

The office-to-residential conversion is the value-add play everyone is talking about but almost no one is making, at least not yet.

Interest in the strategy has skyrocketed in the post-pandemic era among investors, managers and lenders alike, not to mention elected officials. The core concept is simple: by converting underused office properties into much-needed housing supply, investors and managers can reinvigorate their portfolios, rebalance the commercial real estate market and revitalize city centers still stuck in covid-induced malaise.

“We’ve heard predictions that anywhere from 10-15 percent of these ‘have-not’ office buildings will be converted to residential,” says Sondra Wenger, head of CBRE Investment Management’s Americas commercial operations division. “Yet, while conversion activity is rising, it’s not enough to have a material impact on occupancies for office.”

Like most quick-fix propositions, the office-to-residential conversion panacea has proven to largely be too good to be true.

Just 1.7 percent of office square footage in the US was undergoing some kind of conversion as of April 1, according to CBRE’s advisory arm. This represents an increase of 10 million square feet since the third quarter of 2023, but still just a sliver of the overall market.

Cyndi Thomas, a managing director for RCLCO Fund Advisors, says the idea of conversion has been explored by many of her clients, most of whom are pension funds with large direct investment portfolios. Yet, despite broad interest in conversion projects, the conclusion they have all reached is that these projects are not economically viable.

“From the investors’ point of view, they just can’t pick these opportunities up at a cheap enough basis to make the numbers work,” Thomas says. “The way through this will be slow and painful, with probably fewer conversions than we would all like to see.”

Too much to carry

Still, at some point, addressing the issues in the office sector will become imperative. Nationally, office vacancies have continued to climb, clocking in at a record 19.7 percent last year, according to commercial property advisory services firm Cushman & Wakefield, with large markets such as Midtown Manhattan and San Francisco seeing rates of 21 percent and 32.5 percent, respectively.

These high levels of vacancy are not sustainable for office owners, many of whom financed those properties with variable-rate debt, says Josh Zegen, managing principal of New York-based debt fund and private equity firm Madison Realty Capital. Because interest rates have risen significantly in recent years, the cost of servicing debt in today’s market with reduced income has become more difficult for owners.

“Office properties carrying floating rate debt are going to have a much harder time servicing that debt,” Zegen says. “It’s not like in a zero-rate environment, where the carry is less.”

Another motivating factor for current owners to part with office properties at prices that could potentially accommodate conversion is a looming wave of loan maturities. Across all commercial property types, including apartments, some $2.8 trillion of debt will come to term between this year and 2028, according to analytics firm Trepp, a reality that will force many owners to realize losses on devalued properties.

Cities stepping up

On the other side of that dynamic are the cities within which these properties are located. Zegen explains continued deterioration of office markets will eventually spur government action on the issue. “Tax revenue is going to be majorly impacted if office just completely dies,” he says. “Cities and towns throughout the US need to figure out how to supplement what was once a very significant source of tax revenue, or incentivize developers to do something more, to protect their tax bases.”

Wenger says that CBRE IM estimates most conversions will require current prices to fall between $50 and $100 per square foot, with higher cost markets necessitating great discounts. This could come from buyers and sellers coming together on valuations, or a combination of government subsidies and market adjustments.

“Whether it’s a city subsidy or pricing just falls, it has to come from somewhere,” says Wenger. “Cities do not want a bunch of zombie buildings creating a real estate doom loop. A lot of cities recognize this and are taking steps to help make these projects economically feasible.”

In Chicago, officials have discussed using nearly $200 million of improvement funds for conversion projects. Washington, DC, has launched a $2.5 million, 20-year tax abatement for downtown property owners who add at least 10 housing units. California has set aside $400 million for office-to-residential incentives and, federally, the Biden Administration is championing office conversion as a means for addressing the national housing shortage. It has even floated the idea of subsidizing loans for projects near transportation hubs.

Similarly, New York has relaxed zoning restrictions and offered resources for aiding the conversion process. This is an important development for making projects pencil out, as delays in the permitting and building of change-of-use projects can add significant costs.

The accounting firm Deloitte projects that the various government actions combined with market dynamics will result in office-to-residential conversions becoming broadly profitable by 2027.

Meanwhile, for groups that can identify office properties that lend themselves to repositioning in the current environment, securing private financing is no obstacle, says Alex Staikos, director, capital markets at international brokerage JLL.

“When a building is viable for conversion, there’s plenty of capital to get behind it,” Staikos says. “So, as we get deeper into this new dynamic and the delineation between office that’s working and office that isn’t working, I expect there to be more movement in this space.”

On the capital formation front, launching dedicated conversion vehicles is an increasingly popular topic of conversation, primarily among office managers with track records in office conversion, says Stuart Baldwin, a partner at capital advisory Hodes Weill & Associates. “While many people think this is a new strategy, these types of conversions have been happening for a long time,” Baldwin notes. “There are groups who have experience, who know how to underwrite the actual redevelopment costs that go into these projects.”

Finding a way

Since 2016, 133 office-to-residential conversions have been completed, resulting in 22,000 new apartments coming online, according to CBRE. Though substantial, the numbers are a mere drop in the bucket for the housing sector, which is by some counts between two million and six million units short of where it should be.

“When a building is viable for conversion, there’s plenty of capital to get behind it”

Alex Staikos

Still, despite the various challenges, the number of change-of-use projects in the works is on the rise. CBRE projects 119 office conversion projects will be completed this year, well above the annual average of 52 over the past five years. More than 60 percent of those deliveries will be apartment buildings.

To execute these projects, Mark Plechaty, a principal at New York-based engineering firm DeSimone Consulting Engineering, says one of the biggest hurdles is ensuring that the newly created units have sufficient light and access to windows to meet legal requirements.

Plechaty explains: “As these floor plates get deeper, those interior spaces don’t work, so we’ve seen the center portion be walled off and abandoned. We have also seen projects where people are seeking to cut a hole in the middle of the building, allowing light to come in, and then taking that floor area and stick it on top of the building.”

Because offices are required to have higher load-bearing capacity than residential properties, Plechaty said many conversion projects are made economically viable by adding new floors on top of the existing building. “There are also things you can do to make the new floors lighter than normal,” he adds. “There’s a little uptick on that cost, but the savings down below are huge. That’s a part of our equation.”

Others say the key to a successful office conversion is to target small properties. Matan Kurman, head of operations and underwriting at the New York-based manager S3 Capital, says his firm targets low- and mid-rise properties.

Kurman adds that these properties tend to have large windows and relatively small floor plates, helping them avoid some of the logistical complications of larger properties. While these assets are often sold for less than $100 million, making them suboptimal for some institutional investors and funds, they are prime for conversion in secondary Sun Belt markets such as Atlanta, Charlotte and Nashville.

Whatever the scale, conversions are a capital- and risk-intensive proposition. But Baldwin says that is not necessarily an issue for institutional investors today.

“Conversions bring more risk than a traditional value-add strategy, but less than a true opportunistic approach… but that fits the current moment,” Baldwin adds. “A lot of investors have said their return expectations have gone up the risk-return curve, toward value-add and opportunistic, given the anticipation of further dislocation.”