What to Know Before Pursuing a Change of Use

The pandemic disrupted real estate demand, creating ample opportunity for change-of-use redevelopment projects. Now, office spaces are becoming lab space to accommodate life science demand, extended-stay hotels are a starting point for apartment communities and big box retail can be transformed into warehouse and distribution facilities.

While demand has been redistributed, achieving a change of use isn’t always easy. David Reina, a partner in Morris, Manning & Martin LLP’s hospitality practice, who has seen several hotel-to-multifamily conversions, says that zoning is the top consideration for investors pursuing these deals. “When contemplating a change in use, the first consideration for a buyer is whether it will require a re-zoning or some similar approval from a governmental agency,” Reina tells GlobeSt.com. “In a number of urban jurisdictions, existing zoning may allow for hotel or multifamily use, with the change from one to the other requiring no approval or only an abbreviated or of-right application process—that is ideal.”

There are also instances when re-zoning approval is required, according to Reina. “Depending on market dynamics and the whether the relevant zoning board or city council has indicated its support of adding housing units, it might still be a good deal,” says Reina, advising that investors in this situation would need to engage land-use counsel that has experience and a positive history with the zoning board.

Once the zoning challenges are overcome, investors will need to assess if the property configuration will lend itself to the new use. This includes everything from potential construction challenges, like the addition of knock down walls to meeting ADA and other building code requirements. “These considerations need to be addressed prior to even negotiating a PSA, as the PSA is going to have to include, for example, an extended time period for closing to allow for the entitlements approval process to unfold, if such an approval is needed,” says Reina. “And of course sellers need to be on board with the deal falling apart if the approval is not obtained—that’s sometimes more risk than a seller, even a seller of a distressed asset, is willing to take.”

On the financing side, Reina advises working with a lender that understands the change-of-use process. “You’ve got to work with a lender who understands what is happening with the change in use, and that there may be a short period of time from closing on the purchase to when the asset is up and running as apartments,” says Reina. “Most loans will also include a small construction component to fund renovations.”

For extended-stay hotel-to-multifamily conversions specifically, Reina says that there is likely to be a hold-over tenant. “The pandemic saw a marked increase in the number of holdover tenants in extended stay products, particularly after the federal eviction moratorium was enacted,” says Reina. “However, most conversion renovation plans require that for at least some period of time the building be fully vacant—for example, if electric or water systems need to be upgraded.  As a result, buyers are requiring that sellers deliver their hotels fully vacant at closing.” To accomplish this, sellers may need to provide cash incentives to hold-over tenants. In these conversion projects, buyers will also need to ensure that hotels are delivered at closing free and clear of hotel franchise agreements.

Conversion deals inherently come with extensive due diligence as compared to a standard deal or redevelopment project. “Sellers are also much more sensitive about confidentiality in these deals,” says Reina.