Office-to-Apartment Conversion Not Necessarily a Win-Win

There is often palpable excitement around the idea of converting underperforming office space into multifamily housing. It’s a strategy that screams “win-win” for many involved.

However, a panel on Tuesday at the National Association of Real Estate Editors in Atlanta spoke much more cautiously, if not pessimistically about how this could be a game-changer or even the lifesaver for office space.

Julie Whelan, CBRE; Dougal Cameron, Cameron Management; Ed Cross, Cross & Co. and Jamie Woodwell, Mortgage Bankers Association, addressed the issue with Biznow’s Jon Banister as moderator.

Cross pointed out that he’s only identified five architects in the country who have experience in this niche. He said Texas has just three contracting companies that have done the work.

He spoke about construction challenges such as discovering that many of these buildings aren’t plumb, and establishing proper mechanical systems is difficult.

“The construction industry is in turmoil right now with the mechanical systems side of things being the worst of it,” Cross said. “There aren’t enough contractors or equipment, and these developers can’t give us pricing because the price of materials keeps changing.”

In Need of Office Market Capitulation

Office conversion to apartments today comprises a tiny portion of real estate today, but it is growing, Whelan said.

CBRE found that from 2016 to 2020, converting office buildings into anything occurred about 35 times per year. However, in 2022 alone, the country is on pace to do 35 office-to-apartment conversions, she said.

“In 2023 and 2024, based on what’s in the planning stage right now, we see that number doubling,” Whelan said. “Even still, that is just 2% of the entire office stock, so it’s not going to solve for the US housing shortage by any means.”

Cross said that what is stalling and could continue to stall progress is real estate sales.

“We need a capitulation of the office market, and right now, office transactions are mostly silent,” he said.

He said his market of San Antonio is a prime example: it’s 83% leased, but only 20% occupied. “In a few years, the percentage of leased buildings will go to 50,” he said.

The quest to find offices ideal for conversions is tricky, according to the panel.

Cameron said some offices are worth less than their price of dirt because they can’t be torn down for another five or six years, based on their lease terms. “After that time, you have to wait to see what the lender is going to do with it,” he said. “Then, you really have to get creative with your design to pull it off.”

Whelan said there are plenty of factors that make the entire process difficult.

“You have to find the right location, one suitable for a conversion, and even then, it’s not an easy process.”

Defining the Ideal Office Building Candidate

The panel concurred that buildings constructed in the 1950s and 1960s are ideal in their ability to be converted. They mentioned Minneapolis, Seattle and Denver among those markets ripe with that stock. Whelan said CBRE determined that Cleveland might have the best of those to offer.

Whelan said that over the past few years nationwide, the average building age for conversions was 81 and average size was 175,000 square feet.

The ability to work with local governments can make or break any deals.

“Cities won’t let office buildings go empty because then that area becomes desolate, and they don’t want that,” Whelan said. “Creating public-private partnerships will be very important to get this done, but we see that when you start talking about residential, in a lot of areas, things can get touchy. Eventually, these cities are going to have to be compelled to do the right thing.

“I recommend you look for areas where the local government shows good leadership and can help you to get your deal done.”

Incentives and Legislation In Sight

Cross said that Houston is the ideal model for a major city addressing housing crises because there’s no zoning there and “you never hear about housing affordability or a homeless problem.”

Cross mentioned that currently there is legislation moving through Congress that could create a 30% break on companies who do these conversions.

He mentioned Calgary, where that city sees it could lose $6 trillion in office value because of the work-from-home movement there.

“It’s offering $75 per square foot in subsidies, to be paid at the time of completion,” Cross said. “Markets are going to have to start running their numbers and see what the work-from-home movement is going to do to them and respond.”

Woodwell said this could become the next big test for the commercial real estate market, which “has gone through its two biggest ever, just recently – the Great Recession and the hotel challenges after things shut down at the start of the pandemic.”