Commercial real estate debt investors are taking a cautious look at a fast-growing trend in 2023: financing office-to-residential conversions. The interest comes as a handful of high-profile office to residential conversions are getting underway in New York, including a pair of pending transactions in New York’s Downtown submarket. In mid-March, Vanbarton Group inched closer to moving ahead with its planned residential conversion of 160 Water Street via a $272.5 million construction loan. The manager is hoping to create 588 new units of market-rate housing.
Just down the road from the Vanbarton project is 25 Water Street, a planned 1,300-unit residential conversion which is the second-largest transaction of this kind to get underway in New York. New York-based advisory Newmark in December arranged a roughly $538 million loan on behalf of the sponsors. Only the conversion of nearby One Wall Street, completed last year, was larger.
“We definitely see the conversion of office buildings to residential as a bigger trend,” Christopher Kramer, senior managing director of debt and structured finance at Newmark tells Real Estate Capital USA. “Some office buildings just do not work well as an office building anymore – so convert its use.”
Projects like these highlight the vast inventory of obsolete office buildings in central business district locations including in Chicago and New York.
Rising office vacancy rates are one of the two main driving factors for office-to-residential conversions, according to CBRE.
In its latest paper on the topic, CBRE found office vacancy rates in the US reached a nearly 30-year high of 17.1 percent in Q3 2022. These are worrying figures when compared with the US multifamily vacancy rate, which stood 3.9 percent in the same period with average rents increasing 10.4 percent to $2,143 per month, market participants say.
The country’s ongoing housing shortage is the other main driver.
“Amid concerns over the US housing supply, office conversions are bridging the gap between housing supply and demand,” says Matt Vance, senior director multifamily research, at CBRE. “[Conversions] have brought much-needed residential options to important high-density neighborhoods with barriers to new development.”
Multifamily has been the most common reuse for outdated office buildings, with CBRE tracking around 90 completed office-to-multifamily conversions across 26 major US office markets since 2016. The projects collectively reduced office inventory by 16.4 million square feet and added more than 14,000 apartment units.
Pandemic-induced remote working continues to affect the office market, says Jeffrey Fine, global head of real estate client solutions and capital markets at Goldman Sachs Asset Management. “In New York, we are over-officed compared to tenant demand.”
Still, conversion projects need careful consideration.
“There are many complexities when you when discussing this sort of adaptive reuse sort of an adaptive reuse,” says Kramer. “People need to consider the unknown of what’s behind the walls.”
Considerations include the floor layouts, location and lighting.
“Having enough natural lighting and minimizing the loss of floor area ratio are two key concerns that come straight to mind,” adds Goldman’s Fine. “It is also hard to core out a building to create that light well, and it’s very expensive. Another consideration is pricing, and how it adjusts when buying an office building to convert to alternative use. Some buildings do not lend themselves well to conversion [for these reasons].”
Challenges include long term office tenancy, floor plates or zoning issues, adds Matt Salem, KKR’s partner and head of real estate credit. “Some places you can convert floor by floor, [and are] pretty liquid for conversions,” he says.
“It is a very illiquid world right now – some portfolios can take illiquidity, and some can’t. We know office will not be illiquid forever, but [we need to figure out] what the long-term demand is.”
The obstacles do not stop with the physical practicalities of undergoing a conversion. “A buyer could be looking at acquiring a building that could be a good conversion opportunity, but they need to buy it and then justify all the costs it will take to convert and have a reasonable equity return,” says Newmark’s Kramer. “The seller may say, ‘Well, my debt is $400 per square foot, so I can’t sell it to you for $200 per square foot,’ and the lender may not be willing to play along and work with them in that scenario.
“This is [an example of] the obstacles from an opportunity set standpoint that would slow this [trend] down a bit.”
Goldman’s Fine points out another variable: “What do I have to generate for the building to get a positive return, and if it does not create a number a seller wants today, who is paying for the carrying cost of the building while leases run out and it gets repurposed?”
These variables include the length of time it takes to input the business plan. “It works if there is no incumbent debt and it is an empty building, but it could be a decade-long journey to go through if the latter,” Fine says. “It might be better to knock down and build new. Cities are having to subsidize to make the economics viable, tax relief, to pay to buy the site.”
The critical questions keep coming. “Who is replacing these loans; and what type of lenders are seeking out this type of renovation most?” he adds.
According to a spokesperson for 160 Water Street’s developer, Mayor Eric Adams is looking to the project as an example in his push to remove legal hurdles standing in the way of
Kramer believes this is what is needed – fewer hurdles and more incentives. “There could be the opportunity for more incentives from the municipalities to make the economics make a little more sense for developers to go find more opportunities that work and make sense to actually convert.”
According to a report from the Commercial Real Estate Finance Council, items in New York governor Kathy Hochul’s proposed $227 billion budget aim to increase the number of apartment units in the state. This includes incentivizing developers to convert New York City office buildings to apartments as long as at least 20 percent of the units are deemed affordable. In exchange, the developers would get a 19-year property tax exemption. The proposal would be geared toward buildings constructed prior to 1991.
As part of this, there would be rezoning around neighborhoods with good transportation links and extend the city’s 421a Affordable Housing Incentive, which allows for tax abatement for new developments. That program expired in June 2022, but Hochul’s proposal aims to extend the completion deadline for these projects to June 2030.
The idea to convert office to residential is not new and has existed for some time. “But the last two years has jump-started more of a consistent trend that has to pick up pace – it is a requirement for a lot of these CBD locations,” Kramer says. “Unless office demand picks up, these obsolete office buildings need to find a new path, and conversion is it.”