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Are office-to-residential conversions a new trend or a transitory niche in troubled waters?

Conversion projects grow in popularity due to office-sector headwinds

Office-to-residential conversions are starting to become increasingly common due to limited housing supply and the stark headwinds facing the U.S. office sector. Is it this the start of a big new trend or simply a niche opportunity?

Yardi Matrix recently cited a few examples of conversions currently underway. Five buildings in Dallas, for example, are in the midst of the conversion process and are slated to deliver an estimated 1,500 units upon completion in the next few years, according to Yardi. Meanwhile, Midtown Manhattan’s McGraw-Hill Building is converting more than 20 of its floors into apartments this summer, with the top two-thirds of the 33-story tower being turned into 224 luxury apartments.

Washington, D.C., has been the most active market for office conversions, with 2.5 million square feet reportedly set to metamorphose into residential space. But from 2020 to 2021, there were only 1,147 units added to the D.C. market through office conversions, according to Yardi subsidiary RentCafe.

Several practical hurdles exist when it comes to converting office space into livable housing units — starting with location, location, location.

A building potentially earmarked for conversion needs to not only be in an area zoned for residential living but also in a neighborhood that people actually want to and can afford to live. A building’s configuration is also a roadblock as offices and apartments have different fundamental configurations. Office-space floor plates — the footprints of leasable square footage on individual office floors — are often configured with offices around the perimeter surrounding an open area of desks or cubicles. Apartments, on the other hand, usually need windows to be attractive, or in many cases, conform to local code.

Furthermore, office floors usually have too few kitchens or bathrooms to be easily converted into residential units without expensive renovations or retrofits. Office heating and cooling systems can be unsuitable for practicality or residential building codes. Residential fire codes may be incongruous with how an office is laid out. The list is large and can often amount to a laundry list of pricey structural changes.

Add it all up, and for an investor to profit, a majority of converted units often have to turn into luxury units for a project to pencil out.

In a separate study of office conversions for First American Financial Corp., senior commercial real estate economist Xander Snyder wrote that it’s useful to compare costs for repurposing to those of ground-up development.

“While repurposing costs vary considerably depending on building quality and location, some estimates put office-to-multifamily conversions at between 15% to 25% cheaper than ground-up development,” Snyder said. “That’s certainly less expensive than a fresh build, but it implies that office owners may be forced to take significant discounts in a sale for a conversion project to be profitable.”

And with only a 20% difference between repurposing and starting from scratch, this leaves a narrow price margin that a few cost overruns during a project could easily wipe out, Snyder added.

All told, it’s unlikely that such conversions will come to pass for a significant amount of existing, obsolescent office stock over the next few years, Snyder predicted. CBRE data shows some 43 million square feet of office space set for conversion by 2025, which equates to 0.8% of the lower-tier Class B and C office stock that make up most office-conversion candidates.

For conversions to progress past niche status, government incentives will be needed to make such projects worthwhile, according to Yardi. It’s already happening in some part of the country: California’s 2023 budget, for instance, includes $400 million set aside for conversion grants, while Baltimore reauthorized a tax credit that provides a conversion incentive. Government involvement can be expensive, Yardi noted, but with so much of local budgets coming from commercial property taxes, letting real estate values fall could also wind up being costly to municipal coffers.

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