Far From 'Easy Money': Experts On The Hurdles Facing Office-To-Residential Conversions

There is growing consensus that there is pain ahead for a large chunk of the country’s office market, but widespread conversion of commercial buildings into housing isn't going to be the quick fix some hope for. 

“There are now potentially a lot of excited developers thinking that this could be some easy money,” Julie Whelan, CBRE head of occupier research for the Americas, said at the National Association of Real Estate Editors Conference this week in Atlanta. "But you have to understand location, and demographics of that location drive what the demand is in that particular area."

The complexities and the hurdles can be hard to overcome, Cross & Co.'s Ed Cross said. Cross is in a partnership planning to turn a 1929 office building in San Antonio called the Tower Life Building into hundreds of mixed-income apartments. That building is just 40% occupied, he said, and is no longer economically viable as an office.

Cross said on a panel that he has identified just five architects around the country who have experience in this kind of work. He added that the opportunities for conversions will be more prevalent in cities that have a significant number of commodity, midcentury buildings.

“Really, the percentage of buildings that fit this is going to be very small,” he said. “If I were to tell you where the great opportunity is, it's not historic buildings like mine. It's really in ... Atlanta, Dallas, Denver, Minneapolis — they have big inventory, '50s and '60s buildings that are functionally obsolete for office.”

The idea of conversions like these has captured the attention of real estate players across the country, and it is now being pitched as a potential solution to the housing crisis, which is largely driven by a supply shortage. With the outlook for many office buildings now uncertain, conversions are also increasingly being viewed as the answer for what to do with space that can't compete with new buildings.

CBRE research suggests that between 2016 and 2020 across the 25 largest markets in the U.S., there was an average of 35 office-to-residential conversions a year, and the pace hasn't increased, Whelan said. But looking at the next couple of years, there are twice as many conversions planned.

“If you add up everything that has been converted since 2016 or that is under conversion right now, or that is even planned to be converted in the books right now, it only adds up to about 2% of office stock,” Whelan said. “So that's why we say this isn't going to be a game-changer, this is going to be a factor in the equation of what the office market ends up being.”

The market is going to be a key part of how the conversions play out, Cross said.

“There's just got to be a capitulation on the part of both the owners and the lenders about the reality," he said. “I wonder if the federal government will allow the banks to extend and pretend again. … It will be real interesting in this cycle.”

For the most part, the issue of whether or not an office building is worth turning into something will come down to value and pricing. The value of the residential property needs to be around 50% more than an office for it to be worthwhile, Olivier Elamine, the CEO of Alstria, a European office real estate investment trust, previously told the Wall Street Journal.

But that hasn’t deterred some developers. Silverstein Properties and Metro Loft are turning 55 Broad St. in New York's Financial District, a largely vacant office building, into more than 500 apartments. Some half-dozen office-to-residential developments have started in Washington, D.C., in the last two years, while officials in Chicago recently released a plan to provide incentives to developers revitalizing the city’s iconic LaSalle Street, which is dealing with 5M SF of vacant commercial space. 

Panelists said the economics are important to consider too. Mortgage Bankers Association Research Vice President Jamie Woodwell said the difference in value between multifamily and office is going to be the biggest factor.

“A key question is whether you swing when a property has outlived its useful life, do you tear it down to the bottom and rebuild, or do you use its bones to sort of create a new one?” he said. “When you think about what's going on in the market right now, multifamily has been the hottest property and continues to be.”

That is largely because rents have been soaring, and while the pace of growth in U.S. home rents slowed to its lowest rate in 16 months in September, it is unlikely a meaningful price drop is on its way anytime soon. 

For Dougal Cameron — whose firm, Cameron Management, is aiming to turn a Houston office building into a mixed-used development he calls an "entrepreneurial village" — the key question of how overbuilt the world’s office supply is hasn't yet been answered.

“Right now, the jury's still out. Are we 20% overbuilt on office buildings worldwide or are we 50% overbuilt?” he said. “If you get an office building cheap enough, it's amazing the creative things you can do, like vertical hydroponic farming and all kinds of other stuff. And I'm sure with technology, we'll figure out some other cool things to do. But we were just talking about the fact that sometimes an office building is worth not just the dirt value but less than the dirt value.”

Whelan was quick to add that the office isn't dead, but this is all part of the evolution of the asset class. She said that there are developers who are interested in reimagining office buildings, but they are considering more than just good location, good pricing and strong market fundamentals.

“You're going to have to have the developer that comes with a really great idea, but also the government that is there willing to work with them,” she said, adding she recently spoke to a developer who said local leadership is a key factor in selecting locations for conversions. “The ease of doing business in these places for these developers is going to be critical to the success of their cities.”