COVID changed how many people work, and in a major disruption to the real-estate sector, where they work–particularly office workers. Hybrid and remote-working policies that have defined the post-pandemic era have resulted in significant challenges to the U.S. office market. Despite recent news of high-profile technology companies bringing employees back to their desks, availability rates in office buildings sit at all-time highs, according to Morgan Stanley Research.
In parallel, analysts estimate that the U.S. is facing a shortage of roughly 5 million to 6 million units of residential housing, based on the gap between the number of households formed versus availability of shelter.
“At first glance, the idea of turning office space into apartments has appeal: It could breathe new life into struggling downtown areas; boost city tax revenues; and increase foot traffic and tourism,” says Adam Kramer, Morgan Stanley Research equity analyst covering apartments and single-family REITs. “However, large-scale conversions face tremendous logistical and economic hurdles.”
For investors in both commercial and residential real estate, it’s important to gauge the feasibility of these plans. Here’s a closer look at what’s involved, including a deep dive on three potential markets where these conversions are underway and under discussion.
A Tiny Corner of the Market
One hurdle to office-to-residential conversion is simple math: steep conversion costs, combined with apartment rents at levels that would make it difficult to recoup the investments required. Nationally, average office rents stand at about $30 per square foot, compared with annualized apartment rents of around $29 per square foot. An analysis of recently announced office-to-residential projects found that conversion costs can vary depending on where a project is starting. For instance, acquiring a completed multifamily property costs about $600 per square foot and new developments run about $588 per square foot, on average. Meanwhile, the average cost of acquiring and then converting an existing office building is $685 per square foot.
Those calculations may explain why conversions have been limited to date. Figures on the number of conversions vary: According to CBRE data, 133 office-to-multifamily conversions have created more than 22,000 apartments since 2016, while the 169 projects either planned or under way are forecast to produce 31,000 more. Meanwhile, estimates from Yardi Matrix via RentCafe forecast 55,300 units in the pipeline as of 2024.
“While these estimates may diverge, they both show that new housing from office conversions amounts to less than half a percent of the total multifamily supply,” Kramer says. "So, while any additional housing is helpful on the margins, either way you cut it, this potential new supply will do little to solve the broader national housing shortage.”
Location, Location, Location
Along with economic hurdles, a dearth of suitable candidates for repurposing—in terms of location, vacancy level and physical features—could limit conversions.
Location: Walkability, safety, and proximity to transit and other amenities, such as schools and grocery stores, are all important factors. Outside urban centers, parking becomes an issue.
Vacancy: Generally, 30% occupancy is the maximum threshold for a conversion to be potentially viable, while a full conversion would require a building to be completely vacant. Because of the long duration of office leases, many office buildings don’t have sufficiently low vacancy rates.
Physical features: A building's architecture, design and location of utilities, distance between floors, and window placement, among other features, can affect desirability, viability and conversion costs.
Meanwhile, regulations can present obstacles. Zoning and building code requirements vary by region and can make any conversion project longer, more expensive and more complex. That said, local governments are uniquely placed to encourage conversions via tax breaks or other incentives. This could help recalibrate supply and demand for offices and housing in the short term, while boosting a city's revenue in the long term.
Digging Deeper
To examine how or if these developments can work Morgan Stanley analysts homed in on New York, San Francisco and Washington, D.C. All three cities have plentiful supplies of office space and a track record, albeit with varying success, in conversions.
New York City. The borough of Manhattan, which is the strongest office market in the U.S., accounts for about 10% of total U.S. office inventory and has a total market vacancy rate of more than 15%.
Analysts expect conversion opportunities to focus on the downtown Financial District, now reinvented as a residential neighborhood, fueled by a tax-incentive program that encouraged property owners to convert obsolete buildings into dwellings after the 1989-1990 recession.
As of the first quarter of 2024, 12 projects were either complete, under way, planned or announced, according to CBRE data. Meanwhile, the owners of 64 office buildings have approached New York City's Office Conversion Accelerator program, which helps developers navigate rules and building codes by connecting them to the relevant city agencies.
San Francisco. At 25%, the city's downtown office vacancy rate is higher than it was in the aftermath of the tech bubble, as the city's tech-heavy work force has been slow to return to the office, opting for remote or hybrid work. Companies continue to cut back on their space needs, and while there is hope that growing demand for artificial intelligence could reverse this trend, there are not enough tenants in this sector to make up for the decline in demand for premises.
Analysts expect conversion opportunities to face continuing challenges, namely a slow post-pandemic recovery for downtown property.
There is one potential bright spot for conversions in this market: In a bid to meet state-mandated requirement to create thousands of new homes, San Francisco voters recently backed a measure exempting office conversions from the city's transfer tax.
Washington, DC. The best conversion prospects are older office buildings bordering residential areas as well as the development of new residential clusters within the previously nonresidential central business district. Thirty-seven conversions are complete, underway, planned or announced in downtown DC, according to CBRE first-quarter data. The city enjoys strong government support for conversions in the central business district via the "office to anything" redevelopment program. This includes a 20-year tax abatement for residential conversions in a bid to revive a downtown hard hit since the pandemic.
"In these three markets, and others, conversions could work in specific instances, with specific buildings in specific sub-markets," says Kramer. "But nationally, the economic and logistical challenges limit the scope for wide-scale conversions."
For deeper insights and analysis, as your Morgan Stanley Representative or Financial Advisor for the full report, “Office to Residential: A Mismatch Made in Heaven?” (July 31, 2024).
