Obsolescence To Opportunity: Conversions Blunt The Crisis Of Too Many Offices

When a building's last tenant walks out, it usually spells trouble. For a growing class of investors, it's an opportunity.

Office conversions continue to pick up pace as a cadre of buyers bet they can breathe new life into well-located assets. Each cubicle-turned-apartment is less empty space for an office sector that has spent years digging out from the work-from-home era, and core commercial real estate markets are increasingly relying on conversions to eat away at office vacancies. 

“We're getting to that point where you see vacant buildings or very low-leased buildings hit the market for conversion, and there's a more active market for those,” said Daniel Vickerman, the head of commercial investment research at Heitman. “That will continue to be a trend.”

The total amount of office space in the U.S. tracked by Avison Young declined by more than 2% quarter-over-quarter. Roughly 111M SF was removed from inventory, and while not all of that decline comes from conversions, all of it helps landlords at the negotiating table contend with a 22% national availability rate.

The number of residential units planned as part of an office conversion jumped 28% year-over-year to 90,300 apartments, with office conversions now accounting for 47% of nationwide adaptive reuse projects, according to RentCafe. 

In the meantime, office users continue to abandon older buildings and push into high-quality spaces. In gateway markets, 81% of first-quarter leasing volume was in Class-A properties, with 39% going to just a handful of buildings at the top of each market. 

There is roughly 1B SF available for lease out of the 4.7B SF tracked by Avison Young, some of which is effectively obsolete. That isn’t a pandemic-era development, as the sector has always had some amount of space that was too old, poorly located or otherwise unsuitable for tenants. But the pace at which properties become outdated has been accelerated by shifting tenant priorities and the promise of artificial intelligence. 

Prime residential conversion targets — properties with great locations, corner lots, lots of windows and relatively slim floor plates — are at the top of the list and have been snapped up in core markets. 

That has left another group of investors and developers to push conversions beyond apartments and condos.   

“It's more than office to resi. It's office to something else — office to anything,” said Harry Klaff, a principal and president of U.S. operations at Avison Young.

Some defunct offices are finding new life as data centers while others have become self-storage hubs.  

Landlords got a sense of their property's prospects as the pandemic reset occupancy patterns. The work-from-home era presented an early opportunity for the sector to get ahead of the obsolescence, but the Federal Reserve’s decision to begin raising interest rates tightened debt availability and kept conversions from getting off the ground, Vickerman said. 

“We would have expected more conversions in 2021 and 2022 than otherwise happened given the demand destruction. That’s because a lot of these buildings didn't have the rent rolls in the right place to convert at that time,” Vickerman said.

A landlord with a half-empty building still has half a building worth of tenants with valid leases that cost money to terminate.

Office buildings ripen for conversion as leases for the tenants that hung on expire and they move out, often into better-appointed space. The push to identify conversion opportunities in prime corridors has led some buildings to be gutted that likely had a future serving office tenants with relatively small investments, Vickerman said.

“We're starting to see some office that arguably shouldn't be converted,” he said. “It's being converted because it's actually just completely vacant at the right time.”

Chicago is one of the country’s most challenged office markets, with a 30% availability rate and 305K SF of negative net absorption in the central business district in the first quarter alone, according to Avison Young. It has also become a popular market for conversions, with a pipeline of more than 5,000 units, the third-largest in the country, behind Manhattan and Los Angeles. 

A 98-year-old building that once hosted Esquire magazine is slated to become 252 apartments, with the first 12 floors of the 25-story building set to open to tenants by July. The quick development timeline — Mavrek Development and Acres Commercial Realty Corp. secured the financing for the project last September — is part and parcel of what draws investors and developers to conversions more broadly. 

In New York, a Billionaires’ Row office tower is set to switch to mixed-income residential by leveraging a new statewide tax incentive package. In Washington, D.C., the fourth-largest market for office-to-residential development, with a pipeline of 4,167 units, lenders are fighting to finance projects. 

For core markets, where older buildings in downtown commercial districts may be half-vacant but adjacent to a fully occupied gleaming tower, there is some expectation that conversion demand will be enough to absorb obsolete office buildings in relatively short order. 

“Not every single market in the country is going to be that way. But for D.C. proper and for the top 20 markets where office is historically thought of, it’s going to be fine,” said Marc Dubick, the president of Duball LLC, a merchant development firm working on two conversions in the nation’s capital. 

Washington’s office sector has been hit especially hard by government downsizing that has helped leave more than a quarter of office inventory up for lease and tenants huddling in a handful of properties. 

The vacancy rate for trophy properties in D.C. was 9.5% at the end of the first quarter, less than half the 19.2% Class-A vacancy rate, which started to decline last year, and the 23.7% vacancy in Class-B properties, according to Avison Young.  

Duball lost bids on projects to developers looking to capitalize on the deep market bifurcation by planning new luxury builds and betting that they can fill them with firms that are looking for but struggling to find top-class space.   

“We've competed for two projects in D.C. that have gone to a very well-known, respected office developer who's going to tear these old office buildings down and build trophy office,” he said.