Commercial real estate developers are well aware of the national housing shortage. To meet current demand, the nation needs to add 4 million to 5 million new homes.
Housing development is at the epicenter of the problem. The construction rate began to slow in 2000. By 2020, 5.5 million fewer homes were delivered compared to the average rate of delivery from 1968 to 2000. That number correlates closely to the number of homes needed today. It’s a problem that doesn’t have a clear solution. Simply ramping up the speed of new construction is no easy task due to high construction costs, land pricing, and (now) the higher cost of capital. Plus, there’s a shortage of viable housing development sites in populated areas. As a result, developers are struggling to find opportunities to bring new homes to the market.
Office-to-apartment conversions are offering one solution. The popularity of remote work following the pandemic has decreased the demand for office space. Now, there’s an excess of underutilized office space in many areas where there’s also a housing deficit. The dynamic could provide an unusual opportunity to transition vacant real estate into for-sale or for-rent housing. While the proposition is exciting, the reality is much more complex.
Here is a deeper look at the office-to-residential conversion trend and its complexities.
A Solution to the Nation’s Housing Crisis
There are good reasons why office space is a contender for housing conversion projects. Office districts are built in populated areas near existing housing with proximity to essential amenities. The spaces are also largely underutilized in today’s market. At the end of 2023, the office market vacancy rate was near 20%, with expectations that there will be 330 million square feet of excess office space by 2030.
It seems like a no brainer to look at that much empty space and determine housing is the higher and better use. Governments agree, too. Several states have created tax incentive programs to encourage developers to pursue office-to-residential conversion projects. California, Washington, and New York are all examples of states that have funded programs to incentivize developers to convert office or other non-residential real estate into housing. Plus, the Department of Housing and Urban Development is researching similar opportunities to launch supportive programs.
It isn’t all talk, either. This year, more than 55,000 apartment units will be converted from office space, according to a report from Rent Café. That is four times the number of conversion projects that took place just a few years ago in 2021. Washington DC, New York City, and Dallas are the most popular markets for conversion opportunities, making up more than 10,000 of the new units created this year from former office properties.
Not Every Office Can Be Converted
Although underutilized office space presents an attractive prospect for office-to residential conversion, the reality is much more challenging. As a standard, most office buildings have floor plates that are not easily transitioned into apartment or condo units, plus foundations, mechanical systems, and venting are often incompatible with standard apartment construction. In other instances, the zoning may not align with residential uses. Developers must do a building-by-building in-depth analysis to determine if an office property is a candidate for conversion. Most often, developers will find obstacles that are too prohibitive for the project.
As a result of these obstacles, Moody’s Analytics does not expect to see a widespread conversion trend. “Finding an obsolete office building at the right price and asking rents, with high vacancy and the right floor plates to convert into an apartment building is great in theory, but very hard to execute in today’s market,” according to Moody’s. The most attractive conversion opportunities, according to the outlet, will mostly come from small B- or C-grade properties that lose the sole or primary tenant. In New York City, Moody’s found that only 3% of office properties—or 35 total properties—would be viable conversion candidates.
Making the Numbers Work
Developers that find an ideal candidate for conversion—one with adaptable floor plates and an ability to comply with zoning regulations in a populated city—will then have to find the profit margin, which will likely be narrow on an office conversion. The cost to transition an office property is $100 to $500 per square foot, according to CBRE. Moody’s model assumes an average development cost of $150 per square foot. According to its model and factoring in a 15% profit margin, a developer would have to buy an office building for $262 per square foot to make the deal work. Luckily office prices are also falling, which could increase opportunities. Nationally, office values fell to a low of $196 per square foot in 2023, down from $280 per square foot in 2022. Pricing is highly market-specific, however. In Los Angeles office values have fallen 41%, the sharpest drop in the nation, to $244 per square foot, while assets in New York City are trading at around $300 per square foot. So, the opportunity will depend on the market and the value of the asset.
To help vet the financial potential of a prospective conversion project and ensure it remains profitable, developers can utilize modern real estate development software like Northspyre. The innovative program uses predictive analytics to determine the future financial performance of a project, arming developers with information to make data-backed decisions and produce more predictable outcomes. In addition, the platform creates financial forecasts and tracks budgets and spending to ensure the project stays on or below budget and reduces overages. With this software, developers can ensure conversion projects come in on time and on budget, and that’s a win-win for everyone.
Curious to learn more? Watch our On-Demand Product Launch Video to learn more about how Complex Capital Management and Portfolio Analytics Plus can help your real estate development team deliver predictable outcomes and higher returns at scale.
