Why Lenders Are Competing To Finance Office-To-Residential Conversions In The D.C. Region
Kennedy Wilson is one of many commercial real estate lenders that sees a strong investment thesis in new multifamily construction in the D.C. region — a market that has achieved steady rent growth and experienced a sharp drop in new supply.
But being bullish on multifamily projects in the D.C. area today means jumping headfirst into the most active segment of development: office-to-residential conversions. As momentum builds behind these projects, the market for financing them has become extremely competitive.
“We're aggressively pursuing all of the deals that we like, and because of the abatement and other factors, a lot of those deals are conversions,” Kennedy Wilson Managing Director Craig Lockard, who is based in D.C. and works on loan originations across the eastern half of the U.S., told Bisnow.
The Beverly Hills, California-based firm is financing two large conversion projects that are under construction in Alexandria. It provided an $84M loan to Carr Properties’ 237-unit project at 425 Montgomery, and it made a $96M senior construction loan for Community Three and Whitaker Investment Corp.’s 234-unit TideLock project on the waterfront.
It has tried to finance conversions in the District, but Lockard said it lost out to other lenders on two of the projects underway downtown: Duball’s 161-unit conversion at 1201 Connecticut Ave. NW, which Eaglebank financed with a $54.5M loan, and National Real Estate Development’s 157-unit project at 1625 Massachusetts Ave. NW, which Bank of America financed with a $62.8M loan.
“We competed very hard to win that deal and lost it,” he said of the 1625 Mass project.
“So, yeah, it's competitive,” he added. “Those two projects were great because they had three sides of really good light and air, and the floor plates and the ceiling heights all were very functional for a conversion.”
Meanwhile, the firm is looking at two more conversion projects in Alexandria and Arlington.
It’s not that the firm is especially interested in conversions. In fact, Lockard said Kennedy Wilson is more selective on those opportunities, given the particular challenges that come with turning an old building into a new use.
“We see a lot of conversion proposals that are very, very challenging,” he said.
“Conversions are difficult, more difficult than I think most people give credit to, and we are very selective about what the floor plans are going to look like when the units are done, what the rents that those units can command will be and the feasibility of the construction project in general.”
But the number of projects Kennedy Wilson has financed or competed for in the D.C. region reflects the relatively prolific nature of the conversion strategy, compared to a near standstill in traditional ground-up multifamily.
The greater D.C. area ranks No. 2 in the nation, behind only Manhattan, for the most office conversions, according to a CBRE second-quarter report. Eighty conversion projects in the region are either complete or under construction, totaling 9.2M SF. That far outpaces cities like Boston and Los Angeles, which each have just 1.2M SF.
In D.C., conversions are some of the only new multifamily projects moving forward. New multifamily starts last year plunged 79% from the prior year, a drop developers attribute in part to local housing policies that have discouraged investment in the city.
But the underlying fundamentals of D.C.’s apartment market have remained strong. Last quarter, rents were up 3.1% year-over-year in the District and 3.9% in Northern Virginia, according to Newmark.
Lockard said the region is at the nexus of multiple factors that work in its favor: Office value depreciation, height limitations in D.C. that create lower-lying office buildings — a factor that Alexandria also benefits from — and D.C.’s 20-year office-to-residential conversion tax abatement.
“I'm not seeing a lot of other opportunities outside of D.C. where they offer abatement,” Lockard said. “When you get a 20-year full abatement of taxes, you can just pretty much underwrite that as the expenses of the property.”
The city has awarded abatements to eight conversion projects poised to deliver 1,745 units. The latest to get underway was The Bernstein Cos. and Stonebridge’s 435-unit redevelopment of 1990 K St. NW, which broke ground earlier this month.
Alexandria doesn’t offer the same abatement as D.C., but Lockard said the deals the firm did there worked because the value of the offices had been “significantly eroded, and the functionality of the buildings was good for conversion.”
And with many lenders circling the same few deals, competition is heating up. Lockard expects “intense competition” for the Alexandria and Arlington conversion opportunities.
“It's always been a little bit more competitive than the average market,” he said. “And now, with fewer deals and with the banks being active, it is as competitive as it’s ever been.”
