Multifamily Conversions Are Penciling Despite Challenges

Conversions of non-residential forms of commercial real estate to multifamily units is not only possible — it appears to make financial sense much of the time, according to a new report from the National Multifamily Housing Council and ULI.

Noting that such conversions have become “a mainstream development option, and perhaps even a specialized niche sector,” the report finds that local, regional and national developers alike have honed the skills necessary to convert non-residential buildings to residential ones, and both institutional and private capital are actively pursuing investment opportunities in that regard. And “many of those interviewed (for the report) indicated that this was their first or second conversion of CRE to multifamily, having a track record already in ground-up development or investment in office and/or residential properties, while others have long specialized in revitalizing old buildings,” the report states.

Overall, such conversions appear to be financially feasible in a broad range of markets, from small cities to large metros, as well as across a spectrum of original uses, building conditions, and other circumstances. What’s more, occupancy does not seem to be an impediment to the process “and complete vacancy is not an absolute requirement,” accordion to NHMC.

Some developers polled by NHMC say they purchased buildings that were operating in the office market without pricing discounts, despite a softening in the office market overall; one such developer said while the building was almost fully occupied at purchase, it was known that the anchor tenant would be vacating soon and the developer then negotiated lease terminations with over 20 remaining tenants. Another said their purchase price was “fair,” given the building’s status as a Class B office property with 50-60% occupancy that required negotiated lease terminations.  Other developers who described their purchase price as “cheap” typically were in the market for properties that were vacant or unused with significant deterioration.

NHMC also translated hard and soft conversion costs (excluding acquisition costs) into per-unit costs to provide a comparative metric across the projects they profiled: of the 21 projects for which they were able to develop this metric, the median cost per unit was $255,000, with an additional five projects within +/– 10 percent of that figure. There were also five projects within +/– 20 percent of the median, ranging from $209,000 to $300,000 per unit.

But nearly half of the projects had per-unit costs much lower and much higher than those ranges. “The apparent driver behind the particular costs is sometimes easier to identify, such as those with small units and low per-unit costs ($176,000 per condominium unit), and large luxury condominium units with the highest cost per unit ($1.07 million per unit),” the report notes. “As a group, though, they prove the unique way that target markets and converted buildings come together. One developer added this perspective: ‘You go with the flow of what the building is telling you it wants to do or can do,and then merge that with your financials.’”

As for financing, developers who converted buildings not yet qualified for historic tax credits– generally define as buildings constructed from the mid to late 1960s — “experienced little, if any, challenges,” describing their experience as “essentially easy.”  The lower risks associated with bypassing the excavation and framing stage were noted as reasons for more flexibility in the debt markets for an adaptive use project as well. Several 1960s-era buildings “came of age” during the study and utilized financing that ultimately included federal and state historic tax credits, federal New Markets Tax Credits, and state restoration tax abatements, “all of which combined to make the project more attractive to private capital.”