The COVID-19 pandemic brought significant changes to American work and lifestyle, with far-reaching effects on the economy. Over a third of households now work from home more frequently than before, and employees spend about 3.5 days in the office, a 30% reduction from pre-pandemic norms. This shift has impacted the commercial real estate market, primarily office buildings but also encompassing hospitality and healthcare facilities. One of the biggest challenges in the real estate market, aside from the need for more affordable housing, is whether converting office buildings to apartments is feasible.
In the second quarter of 2023, commercial real estate investment volumes dropped by 64% year-over-year, and office vacancies hit a 30-year high at 18.2%. This surplus of vacant office space has led to a reduction in foot traffic for local businesses. In cities like New York City, the administration has tried to create incentives for getting people to go back to offices. The Biden-Harris administration recently unveiled an initiative to expedite the conversion of commercial properties into residential units, addressing this issue. A new initiative announced last week by the Biden-Harris administration helps accelerate conversions of commercial properties to residential use, presenting an opportunity to prevent such a loop.
Policymakers in cities like Washington, DC, New York, and San Francisco are actively working to revitalize their downtown areas through commercial-to-residential conversions. These conversions include vacant offices, hotels, and non-office commercial spaces, offering a solution to revitalize real estate and address long-standing housing issues, including housing shortages and affordability challenges.
As of the end of 2020, the housing market faced a shortage of 3.8 million units, resulting in the lowest rental vacancy rates in decades. Conversions also offer a means to combat climate change, as buildings are responsible for 29% of all U.S. greenhouse gas emissions. Rehabilitated structures can produce produce 50 to 75 percent fewer carbon emissions than new construction.
A new federal funding guidebook details how federal tools have been used to facilitate the development of affordable housing through conversions. Historically, cities have turned to conversion incentives during economic downturns. For example, New York revitalized Lower Manhattan post-9/11 through zoning reforms and tax incentives, doubling the local residential population by converting 20 million square feet of office space into housing. During the dot-com bubble, Los Angeles eased zoning restrictions for older commercial buildings, resulting in the development of 12,000 housing units over 20 years. In Philadelphia, conversions linked to 10-year property tax abatements led to the transformation of 8.2 million square feet of office space into housing, increasing the city center's population by 54%.
Commercial-to-residential conversion projects face significant physical complexities. Office buildings, especially newer ones, are designed with large floor plates for open concept workspaces, while residential units require features like exterior-opening windows, in-unit bathrooms, and kitchens. This necessitates changes in floor-to-floor height, window systems, heating, cooling units, sewers, and elevator access. Past conversion projects often focused on pre-war office buildings designed on smaller plates.
Additionally, converting commercial real estate into housing poses financial challenges. Office vacancies vary across building characteristics, and vacancy statistics don't account for multiple tenants with their lease terms. Zoning constraints, like density restrictions, parking regulations, and strict use guidelines, add to the complexity.
However, research suggests that 15% of office buildings in commercial districts across the 105 largest U.S. cities are suitable for residential conversion, with the potential to add 171,470 units. Developers argue that conversions can be completed more quickly and at costs up to 20% less than demolishing and rebuilding.
COVID-19's impact on sluggish office space demand is expected to continue into the next decade. The pandemic prompted a "flight to quality" in office spaces, with 10% of U.S. office buildings accounting for 80% of occupancy losses. High-vacancy rate buildings tend to be older and in downtown submarkets. Facilities with the right characteristics can provide much-needed housing and reduce emissions.
Several federal programs support commercial-to-residential conversions. The Biden-Harris Administration aims to facilitate these conversions further through its its Housing Supply and Action Plan. Programs like the Community Development Block Grant and Department of Transportation policies will make it easier to finance conversions. The Historic Tax Credit is also available, supporting over 47,000 properties and creating more than 150,000 low- and moderate-income housing units. This compliments other actions like HUD’s recently announced $860,000 in grant funds to study office-to-residential conversions undertaken since the pandemic.
According to a Zonda research study which interviewed new home shoppers throughout the country on what they are looking for next in a home, their top motivation was “location”, followed by “home design” and “price". "Office buildings hold some of the best locations in the country," says Mollie Carmichael, Principal of Advisory and Product Strategy at Zonda. "It is logical that the conversion of office to home could work very well for today’s investors. The key will be to keep a sophistication that meets a home quality and making sure the design meets what today’s consumers are looking for."
As the real estate landscape evolves, opportunities for conversions will continue to emerge.