Commercial office building conversions are widely discussed but rarely acted upon.
Leases on roughly 11% of office space in the U.S. are set to expire this year and leases on an estimated 900M square feet of office space nationwide are set to expire by 2025 according to a study by JLL (Sisson, 2022). Many tenants will seek to decrease their square footage as more employees work remotely or on a hybrid schedule.
With office vacancies on the rise and an increasing need for residential units, especially affordable housing, office-to-residential conversions are often offered as an easy solution.If commercial rents and vacancies continue to trend negatively, building owners may need to repurpose the properties out of necessity. While such conversions may make sense in certain situations, widespread conversions don’t appear feasible in the current environment.
What are the challenges owners might face in commercial to residential conversions, and what solutions and opportunities make these projects more viable?
Challenges
Converting office space to residential faces many potential challenges.
Governmental Challenges
- Zoning – Repurposing of buildings can often involve a lengthy rezoning process.
- Building codes – Residential building requirements often contain specific requirements that would be difficult to achieve in an office conversion.
Economic Challenges
- Rental premiums – In many markets, office space has a rent premium versus residential. This results in office buildings, even those with 30% and higher vacancies, returning higher overall rents than residential.
- Conversion period – Conversion from office to residential takes time, and during the conversion process, the owner will have no revenue but will continue to pay carrying costs.
- Conversion cost – Conversions cost money and building owners already have a substantial capital investment. Conversion to housing will require an additional investment, and that investment might not create an equivalent increase in the value of the property. Will capital be available to complete these conversions?
- Comparable cost – In many areas of the country where land is relatively inexpensive, it is less expensive to build housing from scratch than to convert old office buildings.
Physical Challenges
- Lighting – Office buildings often have very wide floor plans with the center of the building being used for storage or other functions that don’t need much natural light. Residential space, by contrast, needs light throughout. Parts of a residential building that are too far from natural light may not meet code or the expectations of potential residents.
- Plumbing – Plumbing in office buildings is generally very focused on one or two areas toward the center of the building. Residential will require plumbing in every unit, often towards the outer portions of the building where most bedrooms would likely be placed.
- Electrical – Electric work would need to be rerouted and essentially re-wired from scratch.
Solutions
While such conversions face numerous challenges, there are potential solutions that may make them more feasible and lead to an increase in office-to-residential conversions moving forward.
Local Government Solutions
Municipalities can aid in the process by simplifying the approval process for rezoning. Building codes can be revised to provide property owners greater flexibility.
Local Government Funding
Governments will continue to evaluate the lost revenue from commercial properties, which could lead to budget deficits. Certain municipalities may find it economically feasible to invest in office-to-residential conversion projects through public-private partnerships, tax credits, or affordable housing incentives.
Federal Government Funding
The federal government could introduce incentives to assist in the process. Legislators in both houses of Congress introduced a bill to create a tax credit to convert unused office buildings into residential, hotel or mixed-use properties. The Revitalizing Downtowns Act (S. 2511), which has not yet been voted into law, would create a 20% tax credit for expenses to convert obsolete office buildings, which are defined as structures that are at least 25 years old.
Industrial Use
In place of residential, certain property owners could turn to office-to-industrial conversions. Urban offices are attractive to e-commerce companies due to their proximity to where people live. Multi-level warehouses are common in densely populated areas in other countries. The trend has begun to show up in the United States as developers have transformed obsolete office buildings into warehouses; however, this trend has limited viability.
Opportunities
While widespread office-to-residential conversions may not be feasible in the near term, certain conversions offer opportunities. For example, some older commercial office buildings have construction details that new construction could not economically replicate. Examples include high ceilings, ornate décor, and locations where new construction of residential units would be very expensive.
Office-to-residential conversions will continue to be a widely discussed topic in the near term. Certain municipalities may look to be aggressive in encouraging such conversions through government incentives or public-private partnerships. Select contractors may emerge as experts in conversion projects. Real estate investors will seek conversion projects that offer the highest possible returns.
Sisson, P. (2022, June 16). With 900M SF Of Office Leases Expiring By 2025, Owners Are Getting More Aggressive. Bisnow. (https://www.bisnow.com/national/news/top-talent/great-cliff-or-slow-fade-in-ailing-office-market-rising-renewals-are-key-113403)
Contact Us
Property owners looking to convert their commercial office building should contact their Withum advisor to discuss potential benefits and incentives.
