Municipal authorities in US cities where home prices have soared are increasingly seeking to convert outdated and unwanted offices into apartments. That can be a welcome development for a commercial real estate market that is still licking its wounds from the pandemic, changing commuter patterns and persistently high interest rates.
Today, municipal incentives and property value resets have aligned sufficiently to justify the cost of conversion. For commercial property investors and lenders alike, it may add up to attractive opportunities to capitalize adaptive-reuse projects—the repurposing of old or obsolete buildings for new uses.
Reuse offers a potential solution to two major challenges facing many American cities: soaring office vacancy rates, which have nearly doubled since the pandemic, and an acute housing shortage—aggravated by high interest rates—that has put homeownership out of reach for many.
The low valuations of older office buildings and the expected savings on demolition and other development costs can increase the attractiveness of conversion. But in most cases, it often comes down to this: the cheaper the purchase price of the obsolete office building, the more realistic the adaptive reuse opportunity.
We’re starting to see a clustering of opportunities in dense gateway cities like New York, Chicago, Los Angeles and San Francisco, where much of the office stock is 60 years or older and no longer fit for purpose. Incentives for conversion, including tax abatements and zoning changes, can speed the process.
Overcoming Challenges with Conversions
Adaptive reuse isn’t without complications. Conversions can be notoriously difficult, especially with older buildings. Many come with environmental issues, such as asbestos or lead, that require remediation and have deep floor plates that necessitate “light wells” to let in natural light. Another complication: most offices have poured concrete floors strengthened by rebar grids with structural integrity that can be put at risk by too many penetrations or poorly thought-out drainage layouts.
In many cases, it is easier to simply demolish an unused office and build a modern, fit-for-purpose multifamily residential tower in its place.
But with rising prices and interest costs, the cost-benefit analysis is starting to change. Investors who can buy a sufficiently devalued office tower are increasingly finding that it may be more cost-effective to convert than to build from scratch. This may allow developers to save time and money on demolition costs, while also improving a property’s environmental profile. A sale of an empty office building also provides sellers another way to move a potentially obsolete asset off their balance sheets.
In most cases, profit potential in conversions for developers and investors is likely to be greatest when functionally obsolete properties can be acquired at a deep discount.
Cities increasingly embrace these conversions, too. They can help address housing supply shortages, reinstate lost tax revenue, and bring life back to neighborhoods that have become less vibrant. For the right projects, municipalities will often promote conversion with expedited zoning and tax incentives.
The Evolution of Office: A Case Study
When done well, we believe conversions can benefit multiple stakeholders and provide attractive return potential for real estate equity and debt investors.
Consider a 50-year-old office building in a prime location in a major East Coast city that lacks the amenities today’s office tenants require. In this case, a private equity sponsor might want to reposition the building as a top-quality Class A office tower. But in recent years, rising interest rates and the pandemic’s shift to remote work would have quickly unraveled that vision, leaving the lender with a pressing question: What next?
As the building enters foreclosure, several bidders step forward, each eager to pick up the asset at a discount to the sponsor’s original purchase price. Their proposals share a common theme: transforming the obsolete office into a highly amenitized multifamily asset that would better match market demand. Another bidder, with a tenant in tow, steps in with a plan to build a brand-new “trophy office,” complete with high ceilings and state-of-the-art features designed to attract top-tier tenants.
Does this mean the market for office space in US cities is roaring back to life? Not quite. But for well-located properties, opportunities for real estate investors still seem attractive. Vacancy rates in the top echelons of buildings are typically less than 10%, creating a viable market for office.
Dollars and “Sense” in Conversions
As long as a building can be bought cheaply enough to repurpose—something that was rarely possible a few years ago—there’s a chance that experienced developers can convert it, with the potential to do good for the community and do well for investors.
It’s unclear whether this environment marks the start of a new cycle in commercial real estate activity. But a gradual increase in conversions may be evidence of the first green shoots.
We think that’s good news for investors who know their way around complex business plans and conversions.
