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CompStak took a closer look at one of the hottest topics in real estate, office-to-residential conversions, utilizing office transaction data along with multifamily data from CompStak’s partner, RealPage. With suppressed office demand threatening the health of central business districts across the United States, many city governments are now debating how to enact zoning or policy changes or incentives to further encourage office to residential conversions. In this week’s analysis, CompStak evaluates office and multifamily performance in four key markets where this debate is well underway: San Francisco, New York City, Washington D.C. and Chicago.

Gateway Cities Propose Conversions

The triple threat of housing shortages, empty central business districts, and looming budget shortfalls have caused municipal leaders across the US to rethink their cities’ urban fabric. And on the surface, the prospect of converting office space to residential & mixed uses offers a way to attack all three problems at once. 

Policy proposals for office-to-residential conversions are coalescing around a few key ideas, not limited to: 

Some of America’s largest urban cores are the subject of the proposals:

CompStak took a high-level look at office and residential market performance in these areas.

Key Submarkets Dominated by 1960-1990 Office Stock

One key lesson from Lower Manhattan’s Post-9/11 transformation was that conversion of office space was far more likely to occur in pre-war buildings and in Class B/C offices with smaller floorplates. This is a challenge for cities and office markets where larger floorplate buildings or post-war buildings are struggling to retain tenants or are knocking at the door of obsolescence, but also are not ideal candidates for conversion.

This spells particular trouble for a few targeted submarkets in the four cities analyzed. For example, among those submarkets under consideration for conversions, between 45% and 55% of office space in each submarket was built between 1960 and 1990, with the exception of Times Square South (only 4.0%). The average built year for office stock in three of the five submarkets analyzed ranged from 1957 to 1965. Less than 25% of office space in each submarket was constructed after 1990 with the exception of Central D.C. (34.7%), which has an average built year for office space much higher than its counterparts at 1980.

 

New York City’s Times Square South submarket (which encompasses the Garment District), boasts the greatest percentage of pre-1960 buildings, while the city’s other targeted submarket, Midtown East, contains the greatest share (92.3%) of office product built before 1990 altogether.

These submarkets have been discussed as prime for conversion because much of their office stock is older and tenants are increasingly drawn to new or renovated product, especially since the pandemic began. How has leasing trended in these submarkets especially in older Class B/C product over the last few years?

Effective Rent Growth Lags

Lower demand for office space in these submarkets is reflected in the trend in effective rent growth. Marginal positive rent growth can only be seen in pre-1960 and post-1990 office buildings in Midtown East Manhattan and Central D.C. 

In Manhattan’s Times Square South and SoMa in San Francisco, effective rents declined in every built year category between 2019 and 2022. The same would be the case for the Chicago Loop absent a small positive increase in effective rents in mid-century buildings over the same period. Pre-1960 offices, making up 36.0% of space in SoMa, had the sharpest decline in rents overall (-20.0%).

WALTs below 6.5 Years for Older Buildings

There’s also an extra expense to consider in office-to-residential conversions. While buildings considered are likely to be underperforming especially because they have high vacancy, any remaining active tenants would still need to be relocated or bought out of their leases prior to construction. This has been noted by many developers as a substantial obstacle and one that supports the call for supplemental government incentives. 

CompStak’s data shows that Weighted Average Lease Terms (“WALT”, which measures the average remaining lease term of tenants with active leases), are highest in every submarket for post-1990 buildings. But buildings built between 1960 and 1990 have the lowest weighted average remaining lease term in three of the five submarkets analyzed.

Tenants in buildings built before 1960 in SoMa San Francisco have a weighted average lease term of just under four years, the lowest among potential markets for any age cohort. WALTs for all building types were under 8 years with the sole exception of post-1990 built offices in New York’s Midtown East. When developers are targeting buildings, they are likely to hone in on those that are vacant or have the lowest WALT.

Residential Rents Surpass Pre-Pandemic Levels

Successful (read as “profitable”) conversions are predicated on the ability of new residential spaces to command high rents (in other words, their ability to recoup the costs of financing and construction). Data from CompStak’s multifamily data partner, RealPage, gives some insight into the state of residential rents in those submarkets targeted for conversions.

New York’s submarkets are characterized by high rent growth exiting the pandemic, reaching peak year-over-year growth of +31.8% in Midtown West (nearly coterminous with Times Square South/ Garment District) in March 2022.

Rents there now exceed their pre pandemic level: average effective rents increased $588 between December 2019 and December 2022. This is a decent indicator of high demand and the potential for adaptive reuse in an area with a high concentration of pre-war office buildings. Across the same time period in Midtown East, average effective rents increased by a larger $746. 

San Francisco’s SoMa experienced the largest year-over-year drops in effective rent across the five submarkets at the beginning of the pandemic coupled with weakest year-over-year post-pandemic recovery. Average effective rents decreased $639 between December 2019 and December 2022 – an unwelcome sign for potential developers of San Francisco conversions.

Central DC posted similarly weak year-over-year rent recovery post-Covid, but only after moderate year-over-year declines. Average effective rents now only slightly exceed their pre-pandemic levels, having increased $22 between December 2019 and December 2022. Effective residential rents in Chicago’s Loop increased $200 over the same time period.

Conversions are Still a Ways Off

It’s not just media chatter: there are certainly reasons to believe office-to-residential conversions are somewhere on the horizon. 

As RealPage’s data shows, with the notable exception of San Francisco’s SoMa, residential rents have recovered and surpassed pre-pandemic levels in submarkets in frequent discussion for conversion, reflecting higher demand. As CompStak’s data shows, office rents are declining across building age cohorts and expirations are looming for obsolete office products, indicating a continued collapse in value. 

Only one studied submarket that epitomizes both of these phenomena is dominated by older, smaller floorplate buildings, and will thus be one to watch for future conversions – Times Square South. 

Submarkets dominated by structures built between 1960 and 1990, with deep floor plates and thus limited internal lighting, will continue to struggle, as their offices are among the hardest to convert. And there’s a consensus among major developers that coupled with the continued rising costs of financing and construction, office values overall have simply not dipped low enough to make conversions economically feasible yet. 

For more market metrics, check out CompStak and our new residential data integration with RealPage.

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