Soaring Downtown Office Vacancies Pushing Developers Toward Apartment Conversions

The strategy of converting office buildings to residential has taken off in the suburbs and in some of D.C.'s emerging submarkets, but it has been difficult for developers to make conversion projects work in the city's central business district. 

That dynamic appears to be changing, some developers and experts say, as the elevated office vacancy in the downtown market makes conversion projects more appealing. 

"We've been asked to look at conversions in downtown more than we ever have," said Hickok Cole principal Laurence Caudle, an architect.

He said the shift has occurred over the last year. The District's office market last quarter reached a record-high 15.9% vacancy rate, according to CBRE, and it recorded 1.4M SF of negative absorption last year.

"There's concern that commercial office is softening and the net operating income might not be as high as it used to be, particularly in the downtown area," he said.

Even with the increased interest, turning an office building into apartments is a challenging and costly endeavor, and developers find it hard to make the math work in the area's most expensive submarket. Some are pushing the District to provide financial incentives to make the conversion projects feasible. 

In Northern Virginia, at least six office-to-residential conversion projects have moved forward over the last two years. Another project moved forward Monday, when PRP announced it closed the financing to convert the office building at 4900 Seminary Road in Alexandria into 213 luxury apartments. 

Developers have also converted vacant offices in D.C.'s emerging Buzzard Point neighborhood, where two development teams took old Coast Guard buildings and delivered them as apartments last year. 

"A lot of what I see is not in downtown, it's more on the outskirts of D.C. and in Northern Virginia," Caudle said. "I think it's because people still believe the downtown core office market is where they get the most money."

The conversion projects are more financially feasible in suburban and emerging markets than they are downtown, experts say, because of the lower cost basis of the land and the lower office rents. In Downtown D.C., rents remain high enough that it is still more profitable for developers to try to re-lease buildings as office, and values are high enough that residential developers have a hard time competing to acquire office assets. 

"The net operating income of office downtown has been higher than residential, so it requires a subsidy," Downtown D.C. Business Improvement District Director of Economic Development Gerry Widdicombe said. 

'Let's Get An Incentive Here'

The Downtown D.C. BID has been pushing the D.C. Council to adopt a pilot program to provide financial incentives for conversion projects that would help make the deals work downtown.

Widdicombe believes that the resulting tax revenues and public benefits from filling vacant office buildings with apartment renters will more than offset the costs of the incentives. 

"It doesn't do anybody any good to have a vacant building, whether in Downtown or NoMa or Capitol Riverfront," Widdicombe said. "The city isn't maximizing tax revenues. It doesn't add to the vibrancy of the city, and it's just sad to see an empty building. We're saying let's get an incentive here."

Douglas Development Managing Principal Norman Jemal, whose firm last year completed a conversion project on Buzzard Point, said he thinks it is in the city's best interest to provide financial incentives for these projects. 

"It would improve the tax base for the District of Columbia, it would make housing more affordable by sheer supply and demand, and I think it would be a win for the city," Jemal said. "The idea of having large vacant office buildings or a tremendous amount of vacancy is not healthy for the city. It's not good for the residents."

The Office of the Deputy Mayor for Planning and Economic Development last year formed a working group to explore the feasibility of office-to-residential conversion projects. DMPED Director of Real Estate Sarosh Olpadwala said that while the values for office buildings have made residential conversions difficult to pencil, the weakness of the office market could decrease that gap.

"These buildings are more valuable right now on paper, but after some period of vacancy, that value diminishes," Olpadwala said. "We've been working with the industry to understand what is the break-even point where the building has diminished value and residential is valuable enough that they can start to move toward conversion."

The District enacted a new tax abatement program last year for affordable housing development in amenity-rich neighborhoods that some conversion projects could take advantage of, Olpadwala said. He said DMPED is working with the Downtown D.C. BID to get more information on the conversion-specific incentive plan and hasn't taken a position on the proposal yet. 

Ward 2 Council Member Brooke Pinto, who was elected last year to replace former Council Member Jack Evans in the seat that represents Downtown D.C., told Bisnow in August she supports the idea of providing incentives for conversion projects. Widdicombe said the BID has been working with her on its proposal. 

"I’ve been very pleased to find in the last few months, in talking to buildings owners, that they are open to this idea," Pinto said in August. "A couple years ago, many of the building owners I spoke to about this were not as enthused about the prospect. They wanted vacancies to go to office. I think more and more people trying to address our affordable housing crisis, as well as the building owners trying to find some use for vacant spaces, many of them are in agreement that this is a really interesting model worth exploring."

Making The Projects Work

Office-to-residential conversions downtown are still few and far between, but one such project began moving forward last year that could provide a model for others to follow. 

Lincoln Property Co. in February acquired the 84K SF office building at 1313 L St. NW for $34.7M from a nonprofit that was vacating the property. 

The new owner is working with Hickok Cole to design a project that will yield over 200 residential units. Caudle described it as a hybrid between a conversion project and a full demolish-and-rebuild development. The developer plans to tear down the building to the second floor and then build it back up to 110 feet, creating more residential density than what existed in the office building. 

Caudle said this property worked well as residential because it has light on three sides and didn't have as large of a floor plate as some office buildings. A building's floor plates can be among the greatest challenges of converting office buildings to residential, he said, as apartments must legally have light access in each unit.

The development teams behind the two conversion projects on Buzzard Point solved that challenge by cutting out chunks of the rectangular office buildings to form courtyards that brought light into all of the units. 

Creating these courtyards reduced the density of the buildings and was an expensive construction process, but the developers said it still made financial sense for these projects as they have been able to lease the apartments with strong rents. 

One of these projects, from Douglas and PTM Partners, delivered last year at 1900 Half St. SW. 

"It was expensive to build, but we ended up with 453 units with spectacular views of the waterfront," Jemal said.

Douglas is now working on the conversion of the Cotton Annex property, a former federal government office building in Southwest D.C., into 615 apartments. About 100 of the units will be in the adapted historic building, with the remainder in an adjacent, newly developed building. 

"You think about having a vacant piece of land there and a vacant old government building, as opposed to having hundreds and hundreds of residents there seven days a week through the weekend and evenings, it does a lot for the neighborhood and community," Jemal said. 

RiverPoint, the Buzzard Point conversion project from Akridge, Western Development and Orr Partners, yielded 480 apartments at 2121 First St. SW. Akridge Chairman Chip Akridge said the construction team ran into some unforeseen challenges that made the conversion strategy less beneficial. 

"It's not cheap to partially demolish a building, and you have to be very careful in doing it," Akridge said. "To be honest, we might have been just as well off cost-wise to demolish the whole thing and start over. We did save some time, but we probably spent the same amount of money."

For future projects, Akridge said he would likely lean toward a full tear-down strategy rather than converting an existing structure into apartments.

Akridge said downtown offices' relatively high values mean it is more profitable for developers that can successfully renovate and re-lease an older building, a strategy his firm has completed multiple times. But he said the weakness of the office market today is making residential conversions more feasible. 

"Office is still more valuable in the CBD, but it's not as glaring a difference as it has been," Akridge said. 

Monument Realty in February acquired a vacant Downtown D.C. office building at 1425 New York Ave. NW for $164K/SF, a deal Widdicombe pointed to as an example of office values coming down in a way that could make residential conversions more feasible. 

But in this case, Monument hasn't pursued a residential conversion because it has a deal in the works to re-lease the building to the General Services Administration, Monument principal Michael Darby told Bisnow. He said the building is also located in the middle of a block, making it less feasible for a residential conversion. 

Darby said he is looking at a potential D.C. office acquisition, the details of which he declined to disclose, that Monument could turn into a residential project. But he said he would go with a full tear-down and rebuild effort, as he believes the conversion strategy has proven to be too expensive. 

Monument completed one conversion project in the District in 2005, the transformation of a 1960s-era office building at 1414 22nd St. NW into 36 condominiums. Darby said this project was successful because of the high-end nature of the condos, but he said the numbers don't make sense to convert office buildings into today's market-rate apartments. 

"It's very, very hard to make these things work," Darby said. "The main reason is buildings in D.C. are worth too much ... The biggest problem above that is you've got a building in most situations that's not the optimum shape."

Darby said he thinks some developers underestimate the costs associated with conversion projects, and he said the cost savings from retaining the existing structure typically don't outweigh the risks.

"I'd much rather build ground-up to get it right and not take the risk on the conversion," Darby said. "You have to have a very special situation to make it work. You never really get as much value for the existing structure as you want."

Darby said he doesn't think the District should provide incentives for office-to-residential conversions because it would create a competitive disadvantage for ground-up apartment developers that don't receive a similar subsidy. 

"I don't know that we should be diverting our attention away from a product that's already working to try to create more of the same product that would increase competition in ways that I guarantee people like me that are building residential would think would be unfair," Darby said.

Another vacant Downtown D.C. office building that hit the market in the fall is receiving strong interest from residential developers.  

Stream Realty is representing S.C. Herman & Associates in selling the vacant office building at 1125 15th St. NW. The brokerage firm is marketing to office investors and to developers interested in converting it to residential, Stream Realty Managing Director Matt Pacinelli said. 

"The interest has been quite strong, particularly from the residential side with institutional and experienced capital leading the way," Pacinelli said. 

He said the team decided to take the approach of marketing to residential developers in part because of the challenges the office market faces today. He also said the building's location near Midtown Center provides a host of retail amenities that appeal to apartment renters. 

"With the escalated vacancy rates at this point, and the demand for multifamily assets given the risk profile relative to office in downtown Washington, it seemed logical to pursue this approach," Pacinelli said. "The market had evolved to a point where it felt that the location was ripe for multifamily."