Conversions of obsolete office buildings to multifamily use have been going on for some time, but investor interest in these projects is accelerating due to anemic demand for office space in many major U.S. cities. However, the trend is not nearly as widespread as some in the industry have predicted it would be post-pandemic.
The latest newcomer to the strategy is New York City developer Silverstein Properties, which has launched a new fund aiming to raise $1.5 billion to acquire and convert older offices buildings in Manhattan that are experiencing growing vacancies and debt burdens. Marty Burger, the firm’s CEO, told Bloomberg that this is just the start of what could be a “$10-billion-plus” opportunity, as the effort could potentially expand to other markets, including Washington, D.C., Boston and the West Coast.
Silverstein has already acquired a 30-story office tower in Manhattan’s Financial District at 55 Broad St. and partnered with Metro Loft, a long-time specialist in apartment conversions, for this project.
Besides Silverstein, various institutional and private investors, including Invesco, recently allocated significant funds to increase their exposure to this strategy, according to Peter Nicoletti, managing director, head of capital markets—New York, with commercial real estate services firm Colliers.
Developers are also underwriting conversion opportunities, then raising money to fund them, notes Michael Muldowney, executive vice president, capital markets, with commercial real estate services firm CBRE. The most popular fundraising strategy employed by private developers for this type of project has been crowdfunding, according to him. Or at least, “it was before interest rates skyrocketed and regulators shut down the big banks for constriction lending,” Muldowney adds.
Currently, there are 125 office conversion projects underway nationally, according to Jessica Morin, CBRE’s Americas head of office research. Of that number, about 30 percent are multifamily conversions, while 50 percent are conversions to life sciences space, and the rest are conversions to hotel and other uses.
Getting a loan
There also appears to be some appetite for financing conversions. For example, Bisnow reported that Brookfield Real Estate Financial Partners in August provided the Vanbarton Group $273 million to convert a 24-story office tower at 160 Water St. in New York City into a 30-story multifamily project.
But large banks are mostly out of this market right now or have fully allocated for 2022, according to Justin Glasgow, senior vice president, debt & structured finance, with CBRE. The most active and cost-effective construction lenders today are the regional and local banks, he says.
The catch is that these smaller banks are typically constrained on loan size and favor deals with existing borrowers, low overall leverage and often have some partial recourse requirement, Glasgow notes. Debt funds are active at higher leverage, but the all-in cost of the debt is often cost-prohibitive.
“In addition to basis and overall location, lenders want to see the ‘right’ physical attributes to the building, such as column spacing, appropriate finished ceiling heights and market amenities in common areas,” he notes. “And they are very focused on the sponsor’s track record in converting to residential. Lenders view conversions as riskier than ground-up development and loan term will reflect that.”
The number of conversions to multifamily is expected to accelerate next year and beyond, as state and local jurisdictions with dire housing shortages try to create incentives to stimulate residential conversions, which provide a quicker, more sustainable solution than ground-up development. For example, California Gov. Gavin Newsom signed two bills into law in September that open districts zoned for commercial use to residential conversions for both affordable and market-rate projects and streamline the entitlements process for affordable projects.
Additionally, California's 2023 budget allocates $400 million in grants for office-to-multifamily conversions; Denver's budget provides funds to study the matter; and Washington, D.C. Mayor Muriel Bowser is calling for a 20-year tax abatement tied to these kinds of conversions.
The city of Baltimore recently reauthorized a High-Performance Market-Rate Tax Credit that incentivizes both new multifamily construction and conversion of commercial buildings to apartments, notes Muldowney. The city of Chicago has also proposed an initiative to repurpose high-vacancy buildings in its downtown financial district into homes, offering tax credits and incentives, along with financing tools.
But while city would like to see such projects create more workforce housing, Morin notes that most of the office buildings are being converted into luxury units with the rents high enough to make the projects pencil out. Nicoletti concurs, pointing out that with the cost to convert on top of acquisition price ranging from $300 to $400 per sq. ft,, market rate rents are the only way to get the returns investors expect.
This is not because the cost to convert is high, but rather because rents for workforce housing aren’t high enough to get a return on cost investors will accept, says Muldowney. The expected returns for such projects range from the high-teens to low-20s.
The cost of converting an office building into apartments is estimated to range between $100 and $200 per sq. ft., plus the cost of recent inflation, according to Jeffrey Havsy, commercial real estate industry practice lead for Moody’s Analytics. In New York City, for instance, a developer would need to acquire an office property at $262 per sq.ft. or less, which only applied to 20 percent of New York City’s office buildings in 2021, to realize a profit on a conversion, he notes.
“A lot of low-hanging fruit has already been completed or is in the pipeline,” notes Muldowney. It will take time for office owners and lenders to accept pricing that is low enough to have conversions make economic sense for the buyers, he says. “If the building cannot deliver an 80-percent net rentable area, it will be difficult to get to pricing that an office seller will expect.”
A similar situation can be found in Los Angeles. The city’s adaptive reuse ordinance, which has been in play for more than 20 years, streamlined the overall approval process for residential conversions downtown, cutting the timeline from years to months, according to Tim Mustard, principle and director of business development with Southern California-based TCA Architects.
This ordinance is responsible for one-third, or about 12,000 of the 37,000 new residential units created in downtown Los Angeles over the last 20 years. The city is expected to update the ordinance this year to provide developers with financial incentives and expand it to areas outside of downtown.
But Mark Tarczynski, Los Angeles-based executive vice president at Colliers, notes that a lot of the most “viable” buildings were converted to apartments back when this ordinance was adopted in 2001.
In the details
The most efficient floor plates for housing have single-loaded or double-loaded corridors; otherwise, the project would require cutting in an atrium, notes Muldowney. New York state’s multiple dwelling law, for example, requires bedrooms to feature windows of a certain size that open out onto the street.
New York City has established an Adaptive Reuse Task Force that's expected to recommend regulatory changes by the end of the year that would spur conversions of obsolete office buildings. Real estate trade association REBNY estimates that a "conservative" conversion rate of 10 percent of New York City’s lower-tier office buildings could generate approximately 14,000 new apartment units.
New York City office buildings built prior to 1961 are allowed to convert and are exempt from the city’s Uniform Land Use Review Procedure, which takes about a year to complete, according to Nicoletti. He notes that buildings with light and air exposure or a center core, which are mostly found in Lower Manhattan and in Manhattan’s Third Avenue corridor, are the most adaptable for apartment use and attractive to investors.
“The best candidates are not mid-block buildings, [but] preferably free-standing, with light on four sides, and really cheap,” adds David Webb, Washington, D.C.-based vice chairman of capital markets and leader of the Mid-Atlantic debt and structured finance group with CBRE. Most projects will require the building to be gutted down to the concrete, he notes.
Right now, office-to-apartment conversions are mostly happening in markets with a scarcity of developable land and/or with a good concentration of “meds and eds” who “need a place to crash,” says Muldowney. In addition to New York and major California cities, these include Philadelphia, Pittsburgh and Washington, D.C.