Opinion: Converting office to residential is not a business plan.
Main topic: “Opinion: Converting Office to Residential is not a Business Plan”
Converting obsolete or under-occupied office buildings into residential apartments is nothing new. Historically, as people moved to the suburbs, many central business districts lost their purpose, and large office buildings suddenly needed new life.
However, with COVID forcing employees out of cities and allowing flexible work schedules, downtown office occupancy rates have fallen, and office-to-residential conversions have become a popular topic of recent conversation.
Many discuss building conversions as the silver bullet to cure all the ills that plague cities, while others see conversions as the solution to the country’s housing shortage.
With so much attention drawn to the topic, it seems easy to simply convert millions of square feet of office space to housing to revitalize downtowns, relieve homelessness, increase state revenues, and ultimately solve the housing crisis. However, the reality is that conversions are an immense challenge and represent only a fraction of the available supply.
For the real estate professional, merely converting office to residential is not a business plan.
Theory vs. Reality.
Most discussions I’ve seen around the topic are purely academic.
There are a lot of statistical and schematic opportunities to misrepresent the ease of conversion without paying attention to the difficulty of execution. The problem with this approach is that these “studies,” “opinions,” and “academic exercises” have very tenuous ties to the work that goes into conversion projects. Few developers (if any) that have executed conversion projects are running statistics or writing papers on them.
The few writing articles or giving intervihttps://chicago.curbed.com/maps/historic-chicago-demolitions-senseless-buildings-lostews are not sharing the nuance of financing, the meticulously planned scopes of work, or the nitty-gritty on-site management that made their projects feasible. Some of this coyness is to protect trade secrets and valuable expertise, but mostly it’s a function of developers being too busy working on something extraordinarily difficult to pause and document their work.
Additionally, it is difficult for any project to serve as a universal example of how to execute an office-to-residential conversion when building codes are different in every jurisdiction, and each building is unique. Beware the algorithm.
The reality is that we (as an industry) prefer to build from scratch, either by demolishing existing structures or by finding vacant land. Which option we choose is typically determined by the age and density of the urban fabric of our chosen city.
For example, in Miami, the race to build taller and taller has mostly taken advantage of already-vacant land, while in Chicago (which had a denser urban fabric by the 90s as compared to Miami), even architecturally significant buildings have been torn down to make room for updated facilities with contemporary uses.
The Many Factors Needed for Office-to-Residential Conversion Feasibility.
The story is different in places where undeveloped land is tough to come by, to the point where land prices are extremely high.
Take New York, for example, where a 2017 study estimated an acre of land to be worth $5 million (compared with $600,000 in Chicago or $156,000 in Pittsburgh). The massive price tag on land is thus the first incentive to consider converting existing buildings.
Next, zoning laws, especially in cities with a limited supply of land, have contributed to conditions and incentives that promote converting existing real estate. It would be impossible to cover all of New York’s zoning changes and how they have impacted the city in a single article, but we’ll establish some context for the purpose of this discussion.
Early NYC Zoning and Impacts on Architecture
When developers built the Equitable Building at 120 Broadway in the early 20th century, it symbolized the urban ugly that would engulf New York if building massing regulations were not instituted. Residents and landlords alike were angry at the giant multi-acre shadows the building cast on the streets below.
The city responded with the 1916 Zoning Resolution, which established building height limits and required setbacks to allow light and air to reach the streets below. The resolution’s “setback principle” led to the creation of “wedding cake” art deco skyscrapers.
(You can find a thorough discussion of this here.)
With the changes in zoning, the Equitable Building, and others like it, were grandfathered into the new code. Compared to the wedding cake successors, the Equitable Building is taller and has more usable floor space because it does not have setbacks.
Changes like the implementation of the 1916 Zoning Resolution made overbuilt buildings extra valuable because by limiting future building volume, these legislative changes made it increasingly difficult to find land where it was possible to build enough floor area to justify the high cost of land.
The 1916 Zoning Resolution also encouraged manufacturing to coalesce around the waterfront and outer boroughs of New York City, primarily to reinforce industry requirements for proximity to transportation. This map of 1919 shows Lower Manhattan as an area of businesses and manufacturing. Later efforts to spur residential growth in Lower Manhattan were essentially efforts to undo this initial round of commercial zoning and building incentives.
Changing Demographics and New Conversion Possibilities
Fast-forward to the 1970s when the Financial District experienced massive development, which included a deliberate introduction of some multifamily buildings. In 1973, the World Trade Center was completed, delivering nearly 10 million square feet of office space. On its heels, the city used material excavated from the World Trade Center sites to create Battery Park City— a planned community that would boast parks, housing, and social infrastructure.
This heralded the beginning of a demographic change that would take decades.
In 1978, architect Joseph Pell Lombardi purchased the Liberty Tower when it was two-thirds empty and made it one of the first office-to-residential conversions in the country. The architects introduced residential units to the Financial District by converting the 175,000 sq ft building to 89 luxury apartments with retail on the first floor.
It’s unclear why the Liberty Tower had such a high vacancy rate. However, we know the demand for office space had fallen due to the dual recessions of the early 1970s and a growing focus on developing Midtown over Lower Manhattan.
(The Liberty Tower (like many other conversions) also benefitted from a J-51 tax abatement program that offset some of the high repositioning cost. Unfortunately, for those looking to take advantage of this tax incentive, the program expired in July 2022. Unless the legislation is updated, the tax benefits that came with it are no longer available.)
The New York Times described the Liberty Tower conversion as part of a “market reversal” in which people moved to Manhattan because of “the gas situation” that made commuting expensive and “the tightness of the apartment market uptown.” These new residents were “pioneers willing to sacrifice or overlook various amenities of more established residential communities such as movies, restaurants, and laundries — for the sake of being close to work.”
In the face of these changing neighborhood demographics, voices of opposition soon followed, adding another layer of complexity to the history.
Concerned about “threats to [Manhattan’s] architectural heritage,” the New York Landmarks Conservancy purchased buildings to maintain their historical integrity and lobbied local commissioners to create a special Landmarks zoning district.
This movement made demolishing certain existing buildings in New York City very politically difficult, even in the 1970s. Add strict zoning, shifting demographics, and a scarcity of land, and you have a market where building conversions begin to look like a reasonable option (and land prices then were not yet as steep as they are now.)
Market Shifts leading up to and After 9/11
To further break down and identify the conditions that promote office-to-residential conversions, we’ll look at New York more recently, focusing on Manhattan’s Financial District (FiDi) leading up to and after the 2001 attacks on the World Trade Center.
The ratio of office to residential buildings in FiDi began to shift alongside changes in financial markets that coincided with the rise of the Internet and the ability to execute monetary exchange trades online.
For example, in 1992, E*Trade launched as the first online brokerage. Before then, a trader needed a broker physically on Wall Street. Now an online brokerage could be headquartered anywhere worldwide, reducing demand for FiDi office space.
A few years later, in December 1998, the SEC approved electronic trading systems. Before these technological shifts, financial services firms benefitted from co-location in centralized districts. With trades executing online in real-time, large Wall Street firms could now move to other parts of the city or the country where rent was less expensive.
At the same time, areas surrounding FiDi were becoming more residential. In the decade of the 90s, Lower Manhattan added 4,900 housing units.¹
Before the 2001 attacks, the World Trade Center campus had approximately 30 million square feet of office space, with 100 retail stores below.
After the attacks on the World Trade Center towers destroyed the site and heavily damaged the area, the shift from primarily commercial to mixed-use accelerated sharply.
According to USA Today, “the financial district lost about 45% of its best office space,” Along with the physical destruction, many jobs were also lost.
Economists with the New York Fed estimated in 2002 that the September 11 attacks were responsible for a net loss of jobs in the range of 38,000-46,000 in October 2001 and up to 49,000 to 71,000 by February 2002. According to this same study, “the number of jobs in the securities industry fell by 12,000, or 7 percent, in October 2001…and the banking industry saw a net job loss of 8,000, or 8 percent, in October.”
The terrorist attacks also led to policy changes that discouraged having a centralized financial district.
Keenan and Gong explain that “the location strategy of financial services firms also changed from the urban corporate campus model, where a firm has major corporate functions concentrated in several buildings close together, toward a split-operations model in which two or more active sites provide backup for one another, one site can absorb some or all of the critical work of the other for an extended time.’” ² This geopolitical shift lessened the likelihood that office demand for financial services in the Financial District would rebound above pre-9/11 levels.
While businesses moved out of Lower Manhattan, people moved in.
According to Keenan and Gong, “The household population increased one-quarter, from 34,700 in 2000 to 43,700 in 2005. This growth dwarfed the overall population increases in the rest of Manhattan and New York City, which grew 3 percent and 1.7 percent, respectively.
An examination of the components of population change shows that 2000-2005 saw a net inflow of 6,900 persons into Lower Manhattan. Thus, Lower Manhattan not only recouped its initial population losses in the aftermath of 9/11 but saw a significant net inflow as measured between 2000 and 2005.” ³
This increased residential and decreased office demand trend continued well into the decade after the September 11 attacks. The New York Fed states that “even within New York City, many thousands of jobs moved from downtown to Midtown…Between 2000 and 2003, the number of employees at businesses in the zip codes south of Canal Street tumbled by 17 percent. By 2014, employment had rebounded quite a bit, but not to pre-attack levels. But keep in mind that in 2000, more than 10 percent of Lower Manhattan employees worked in the World Trade Center, which had its own zip code” (emphasis added).
As mentioned before, Midtown, and some suburbs, absorbed the office demand left by the void of the World Trade Center.
(This article does a great job showing the changes and redevelopment of the Financial District since 2001.)
¹Joseph J. Salvo et al., A Pre-and Post-9/11 Look (2000-2005) at Lower Manhattan. New York: New York City Department of City Planning, 2007.
²Hongmian Gong and Kevin Keenan. “The Impact of 9/11 on the Geography of Financial Services in New York: A Few Years Later,” The Professional Geographer 64, no. 3 (2012): 370-388. https://web-s-ebscohost-com.eresources.cuyahogalibrary.org/ehost/detail/detail?vid=3&sid=3f6eb80a-208b-4f25-873e-1368a081b2f3%40redis&bdata=JnNpdGU9ZWhvc3QtbGl2ZQ%3d%3d#AN=77270562&db=aph.
³Joseph J. Salvo et al., A Pre-and Post-9/11 Look (2000-2005) at Lower Manhattan.
A Feasible Conversion Candidate?
Fast forward to today, and we have One Wall Street—a notable office-to-residential conversion located in the Financial District that is nearing completion (depending on how you measure completion).
The building is a New York City Landmark and part of the Wall Street Historic District.
Macklowe Properties purchased One Wall Street in 2014 and is set to “offer 566 condominiums with 176,000 square feet of amenity space.”
The history contained in this Art Deco landmark alone makes it especially appealing for conversion.
More significantly, the conversion of this historic building is a display of the unique macroeconomic, geopolitical, and demographic factors that needed to come together over decades for conversion to make sense (whether One Wall “makes sense” is yet to be determined, but I wouldn’t bet against it).
After the previously discussed migration of companies to midtown because of the negative sentiment that followed the 2001 attacks, New York began to rebuild the World Trade Center site and its surroundings. Gradually, non-finance companies moved into the new commercial spaces (Spotify in 2013, Condé Nast in 2015).
As FiDi recovered, the sentiment changed, and beautiful buildings from a previously booming time remained, looking for a new purpose. As residential demand outstripped available supply, developers like Macklowe began reimagining the place.
Despite some of the demographic and economic tailwinds, and the beauty of the historical conversion, we cannot assume the economic feasibility of a project like One Wall Street. From start to finish, the project took nearly a decade. So much has changed since 2014, and COVID was a uniquely unexpected risk.
In the excitement to find a golden opportunity within an office conversion, we must remember the inherent risk of real estate development. Time of execution is a known development risk, and while existing structures can provide some schedule advantages, they’re not guaranteed.
The increased complexity of a conversion can magnify typical development challenges to the point where the project is no longer feasible. This is why relying on purely academic thinking to pursue a conversion project is irresponsible and foolish. And while a deep understanding of the history and the laws that affect our built environment is not necessarily required, it sure helps when it comes to pursuing complex projects (and not just conversions).
Everything’s Bigger In Texas…Including the Office Vacancy Rates
While the appetite for office-to-residential conversions may be growing, I’m hesitant to jump on the bandwagon to think these projects will become the norm or bring a significant amount of supply online in the next decade.
In analyzing the changes in New York’s Financial District over the last 30 years, it’s easy to see how many factors need to align to compel mass redevelopment that significantly changes the mix of an area’s building stock.
For the most part, converting office to multifamily is not a business plan. Business plans require a general understanding of an asset’s market, jurisdictional requirements, and physical condition. These circumstances can vary significantly among buildings.
I would not be changing the strategy of my brokerage, construction company, or consulting firm to focus only on this type of work. (For example, at MADDPROJECT, we see office-to-residential conversions simply as complex development projects—the same way we look at restaurant or boutique hotel renovations.)
For one, the rate of conversion has been overstated. Adding up all conversions in the U.S. since 2016 and assuming that all planned projects will be completed accounts for only 2% of the total U.S. office inventory.
According to CBRE, “conversions are concentrated in coastal and northeast markets with relatively older office stock. San Diego, Boston, Manhattan, Cleveland, and Philadelphia have the most underway.”
This makes sense since these areas have many obsolete office buildings protected by historical designations, which makes tearing them down nearly impossible. Moreover, given that these coastal cities are also dense, they provide adequate market conditions where there is demand for luxury apartments, which command the required rents to justify complex project feasibility.
COVID sparked abrupt domestic population migration, mainly benefitting sunbelt states like Texas, Arizona, and Florida. In addition, office demand has plunged across the country with increased work-from-home capabilities and flexibility. These demographic shifts have pulled some conversions into the pipeline where they may not have otherwise made sense.
Take Houston, for instance. Texas has been the leader in population growth since 2018, with Houston being its most populous city. The five leaders in population growth (Texas, Florida, North Carolina, Arizona, and Georgia) have ample land for new development, and in Texas, an acre of land costs about $4,000. In Houston’s Harris County, an acre costs about $21,000.
According to Colliers, Houston currently has a 23.5% office vacancy rate (vs. ~17% nationally), translating to 56 million square feet. For comparison, all office-to-multifamily conversions in the United States since 2016 have reduced office inventory by only 16.4 million sq. ft. Despite this glut, another 2 million sq. ft. of office space is being built in Houston.
With all that office space available for conversion, only three are underway in Houston (compared with three in Manhattan alone, nine in Philadelphia, and twelve in Washington, D.C.). If conversions were easy, feasible, and the solution to housing shortages, I would expect market forces to quickly wave a wand and fix the imbalance in Houston’s supply-demand equation.
The reality is that conversions are an especially risky endeavor. (I will cover some risks to look for in a future newsletter).
In Conclusion…
Conversions are complex, costly, time-consuming, and require better planning and execution than ground-up development.
Before considering a building for conversion, the stars need to align in terms of favorable zoning and building code, low going-in basis, consistent rental demand at a high price point, tax benefits or government subsidies, and scarce land. If most of these factors are in your favor, then you still need a strong business plan, including a clear path to turning the floor plate into a plan that accommodates the required unit mix and maximizes efficiency.
In the next couple of newsletters, I will discuss conversions in greater detail to distill the circumstances where a conversion is warranted, and I’ll cover some tactics I use to assess a building for conversion potential.
Stay tuned!
The Takeaway
Office-to-residential conversions are some of the most complex development projects. Not many developers have the interest, expertise or balance sheets to take on million-square-foot/billion-dollar projects.
Major economic and demographic changes take time, in most cases decades. Therefore, legislation aiming to promote any type of real estate development should consider that. We should absolutely make big plans for our cities, and the time horizons expected should reflect that.
If given a choice, it is easier to build from scratch. While conversion projects will still happen, even if they occur in greater numbers than in the past, they only account for a tiny percentage of the overall supply. We will most likely demolish many obsolete buildings, just like in the past.
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