Office to Apartment Conversions
This is the second post in our series on multi-family conversions, a popular and fast-growing trend in commercial real estate. In our first post, we looked at how the Covid-19 pandemic and on-going US housing shortage are propelling the multi-family conversion trend, the history of multi-family conversions and the plusses and minuses. In this post, we take an in-depth look at office to apartment conversions. Over the past decade, office buildings have emerged as the most popular type of multi-family conversions, for numerous reasons.
Location, Location, Location
First and foremost, office buildings have emerged as the most popular type of multi-family conversion due to their highly desirable location. Many converted office buildings are located within a city’s central business district, enabling tenants to live close to where they work and giving them quick, easy access to public transportation, restaurants and entertainment and the city’s cultural attractions.
There’s traditionally been a dearth of housing in city centers because most of the buildings located there are office buildings. Office buildings’ prime downtown location, coupled with a lack of apartment inventory, drives up demand and rents for converted apartments, which in turn drives up profits and investors’ returns.
The Right Size and Layout
Office buildings’ layout and size often make them prime candidates for conversion, especially pre-World War II office buildings with their smaller floor plates, high ceilings, abundant windows and smaller inner cores. The Wall Street Journal estimates that there are nearly 1,000 newer office buildings in the US that are prime candidates for conversion to multi-family, based on them being built since 1980; 100,000 square feet or larger; and currently at least 50% vacant18.
Sizing Up A Building
When it comes to multi-family conversions, however, not all office buildings were created equal. Some offices lend themselves well to conversion, others do not. Some of the deciding factors are:
- Size and shape of the floor plates: on average, floor plates in multi-family buildings run 65-70 feet deep19, while the average floor plate of older office buildings measures 120 feet deep20. If a building’s floor plate is too deep, the apartments created will be awkwardly sized or shaped and won’t have many windows or natural light. Which brings us to the second deciding factor…
- Proximity to natural lighting: there’s an unwritten but closely adhered to rule that any space in an apartment should be no more than 30 feet from a window21. So, if a building doesn’t have many outside windows, or the size and shape of its floor plates would make it difficult or impossible to create apartments with ample natural lighting, it’s probably not a good candidate for conversion. One option is to create a light well down the building’s center, but that’s expensive and in many cases may not be structurally feasible.
- Size and shape of the inner core: most office buildings have an inner core, usually down the center, for mechanicals, like elevators, electrical and plumbing. If the core is too expansive, or the corridors that would be created around the core would be too big, there will be a lot of wasted space in the building and/or the size and layouts of the apartments will be awkward.
- Closely related is the building’s lease span, the distance from the façade to the elevators. NYC-based architectural and design firm Cetra Ruddy found that in general, the larger the lease span, the harder it is to successfully convert a building to apartments22.
- Landmark status: some older office buildings have been granted landmark status, in which case there are strict rules about how the building can and can’t be changed that can have a major impact on design, construction, costs and upkeep. At the same time, the idea of living in a historically significant building with original features and fixtures can be very appealing to tenants, so apartments in landmark buildings are often in high demand and command higher rents.
- Age and condition of the building: It’s not uncommon for older office buildings to have hidden problems, like mold, asbestos, lead paint and damaged concrete, or structural problems. All can drive up the cost of and amount of time needed for the conversion, which is why a thorough physical inspection of the building before committing to a conversion is a must.
The Right Market Conditions
In most office to multi-family conversions, older B and C class office buildings are converted to Class A apartments. In order for the project to make sense from a financial standpoint, several conditions must exist:
- Obviously, the cost of acquiring and converting the building should be less than the cost of new ground-up construction. When calculating the cost of new construction, the cost of demolishing the building and clearing the site should be considered.
- The current vacancy rate for Class A multi-family apartments in the market should be lower than the current vacancy rate for Class B and C office space, indicating higher demand for apartments than for Class B and C office space.
- Net absorption trends for the two sectors. Net absorption for Class A apartments should be projected to remain higher than for Class B and C office space. If net absorption of office space is projected to outpace net absorption for apartments, a conversion probably does not make long-term financial sense.
- Current asking rents for Class A apartments in the market must be higher than asking rents for Class B and C office space. If office rents are below or equal to apartment rents, there’s little or no financial incentive to convert.
- Class A multi-family rents should be projected to grow, while Class B and C office rents are projected to shrink or remain stagnant. If office rents are expected to outpace multi-family rents in the long-term, again, there’s little financial benefit to the conversion.
- Prevailing cap rates for the two sectors. The average cap rate for multi-family properties in the market should be lower than the average cap rate for office buildings, indicating there’s greater demand for and less risk with a multi-family building.
The Pandemic’s Impact on Office Demand
In the early days of the pandemic, office buildings and entire cities were shutting down, leading to a huge increase in the number of people working remotely or on a hybrid work schedule. The National Association of Realtors (NAR) estimates that after many US cities went on lockdown in March of 2020, nearly 50 million US office workers were working remotely23.
Many companies found that employees’ productivity did not drop when they worked outside the office, so they started reassessing the amount of office space they needed and how that space would be utilized, with an eye on downsizing to save money on rent.
Class B and C Office Buildings Hit Hard
In addition, NAR estimates that about 518,000 office jobs lost during the pandemic24 have yet to be recovered, further reducing the amount of office space companies need. Class B and C buildings, which tend to be older and more obsolete, were hit particularly hard, as companies sought to move to newer and nicer buildings to entice employees back to the office and to help recruit and retain talent.
Remote and Hybrid Work Are Likely Here to Stay
As the pandemic has shown signs of subsiding and Covid-19 vaccines and effective therapeutics have become widely available, many cities and employers have made concerted efforts to coax employees back to the office. Even so, it appears that the remote and hybrid work trends are here to stay, at least for the foreseeable future.
The National Association of Realtors reported that as of the end of September 2021, approximately 20.3 million office workers were still working remotely, more than double the 8.9 million in 201925. A recent survey by Deloitte found that just 7% of companies surveyed plan to require their workers to return to the office full time26, while another survey from PWC found that nearly 1/3rd of executives surveyed believe they’ll need less office space in the next three years due to an increase in remote work27.
A Return to City Living
Another factor fueling the office to apartment trend is the continued popularity of city living. Before the onset of the pandemic, urban multi-family was one of commercial real estate’s hottest segments, as Gen Z, millennials and baby boomers all embraced the live-work-play ethos, flocking to apartments in cities to be near work, shopping, dining and entertainment, cultural institutions and everything else big and mid-sized cities have to offer.
The pandemic briefly reversed that trend, causing many renters to leave bigger cities for less densely populated and less expensive areas, especially secondary and tertiary markets. But, with the pandemic seemingly subsiding and the lifting of pandemic-induced lockdowns and restrictions across the US, the appeal of city living has returned and with it an increase in the demand for apartments in urban areas.
Up Next: Factory and Hotel Conversions
That wraps up our look at office to multi-family conversions. Next, we’ll take an in-depth look at factory and hotel conversions, the second and third most popular types of multi-family conversions over the past decade.
About The Author
Terry Banike is Realogic’s marketing manager. Over the course of his career, he has worked in marketing, communications, journalism and public relations, and has written numerous news stories and feature articles for newspapers, trade publications, newsletters and blogs. A rabid reader of anything and everything on commercial real estate, Terry closely follows commercial real estate news and trends and frequently posts about real estate on the Realogic Blog. He can be reached at firstname.lastname@example.org.