The Hard Reality of Property Conversion

New York Gov. Andrew Cuomo recently called for a change in regulations to permit commercial property owners to convert their buildings to residential uses. Lost in the fanfare of his announcement, however, was the hard reality of the many challenges facing redevelopment. Real Capital Analytics’ Jim Costello points out that cutting red tape isn’t the only factor limiting conversions. Repurposing a building is costly, and the only real way to make it pencil out is to buy the asset at a discount.

“A redevelopment that prices an office building at the discounted value of future rental income for the building just cannot get off the ground,” Costello writes. “The times when it has made sense in the past to remove office buildings from market inventory for redevelopment are generally when the price cycle moves against the office sector.”

When plotting sales of office buildings in Manhattan sold for redevelopment purposes versus Manhattan office sale prices as measured by the RCA Hedonic Series, Costello saw a clear lag where redevelopment became popular after prices fell.

In the mid-2000s, there was an office redevelopment wave underway in the city. When prices peaked in 2008, things had already cooled. Eventually, they fell 30% after the peak. From 2009 to 2015, 15.6 million square feet of office space was sold for purposes of redevelopment.

In the most recent runup, office prices peaked 2017 as Chinese investors began to depart the bidding pool. Even before COVID-19 hit, a slow correction was underway. Office prices fell 10% by Q3 2020, according to RCA.

Costello anticipates that the office market will change in the future as people have become accustomed to working from home. But he says it is uncertain whether that changes the income potential for buildings and what investors are willing to pay..

With a clear picture of the office market in the future, buyers and sellers are still far apart on asset pricing, according to Costello. That uncertainty is only one obstacle for developers, though. If 30% price declines appear, redevelopment could occur. But Costello points out that if office prices dip that much, there may not be that much of a demand for residential in New York.

The market is not close to that point yet and despite the rising vacancies many people believe that the office sector will come back. “We probably can get through this pandemic without a major impact to urban office,” says Paul Fried, head of equity capital markets at Greystone Capital Advisors. “Most tenants have continued to pay and have not picked up stakes and left.”