New converts: Hype vs. reality when it comes to converting office to multifamily

THE LOFTS AT MERCHANT ROW IN DOWNTOWN DETROIT IS AN EXAMPLE OF A SUCCESSFUL CONVERSION OF OFFICE TO MULTIFAMILY SPACE.

As the office landscape continues to evolve and a post-pandemic world features more hybrid or full-time work-at-home models, developers are presented with more opportunities to convert underutilized offices into multifamily. At a time when quality residential options are sorely needed in many markets, these opportunities can deliver both civic and financial rewards.

For development professionals, understanding why these conversions are so timely and potentially valuable is critically important. So is a strong grasp of the priorities, tips and best practices for executing a successful office-to-residential redevelopment, what kinds of locations are best suited for these conversion projects and what the future holds for this intriguing development segment.

What’s old is new again

Conversions have been around for decades and take many forms, whether it’s an old fire station repurposed to a Class-A boutique hotel and restaurant, a pre-war wool mill converted to a unique office space or a vintage office building converted to multifamily residential.

Conversions generally work best for both developers and communities when converting an antiquated space that is either not optimized or is no longer functional to accommodate a higher-demand use. Taking unused or underutilized space off the market bolsters demand for remaining properties in that segment.

On the flip side, because the updated use in the newly converted space feeds higher demand, it can relieve pressure and fill a market need. Municipalities and local taxpayers benefit from improved functional spaces that increase the tax base.

Geography and geometry

Converting office to residential sounds simple in concept, but the execution is often more complicated. A foundational real estate adage is that you can fix a property, but you can’t fix a location. The rare exceptions to that rule are projects so large and so consequential that they create their own gravity and have a broader transformational impact. Think Hudson Yards in New York City or Dan Gilbert’s contributions to Detroit’s CBD.

For most developers, however, project success is highly dependent upon location, which highlights one reason why the hype may sometimes get ahead of reality.

You need two key ingredients to make a conversion recipe work: the right building and the right location. Conversions generally work best in areas with existing community appeal. Pre-war office buildings are prime conversion targets. Older buildings often benefit from strong locations and oftentimes have the desired smaller floorplates—as well as traditional window openings.

These older buildings are also popular conversion targets because deferred maintenance sometimes yields a lower basis and warrants full renovation to update electrical, HVAC and plumbing. In Detroit, Farbman Group was an early leader in converting older generation office into residential units with projects like Woodward Lofts and Riverplace Lofts. It’s noteworthy that Bedrock, the current Detroit conversion leader, acquires and converts almost exclusively vintage properties (e.g. The David Stott Building, Book Tower, The Free Press Building, The Assembly and 35 W).

Hype vs. reality

While conversions can be an effective solution to remove excess office space from the market, it’s not a one-size-fits-all fix, and media coverage can sometimes overlook the complexity of conversions—and fail to communicate that not all conversions succeed.

One example of how a conversion project can run into problems is illustrated by a development in Cleveland: a pre-war office building converted to apartments. Very large floorplates created very deep units with limited light, an issue exacerbated by a high core factor, with oversized hallways and a center skylight the only source of natural light. Consequently, the units felt dark and not very functional given their relatively long and narrow floorplans. Most critically, the location was in an up-and-coming Cleveland neighborhood that wasn’t quite vibrant enough to attract the top market rents needed to support conversion costs.

In today’s market, there may be an understandable trend to view many office properties as conversion opportunities. But each property needs to be evaluated on its own merits to determine the probability of success—and if the costs of conversion and the existing building layout make sense.

Costs and context

As advisors, we need to promote opportunities where conversion projects do make sense—and help give buyers and sellers the resources they need to evaluate them.

We’ve worked with architects to provide basic floorplan evaluations and designs to see how many units could be modeled in a conversion. That data can inform ballpark conversion costs and market rent analyses to provide pro-forma unwriting. Architects are also a great resource to evaluate the possibility of government support programs that may help support conversion costs. Given that many of these buildings were simply not set up to be residential, architectural oversight and financial analysis is essential.

Upcoming lender-owned properties could provide fertile ground for conversions, as buying at the right basis makes it possible to convert more buildings. A favorable basis obviously helps inform those conversion investment decisions, understanding that potential conversions generally demand a more rigorous level of due diligence than comparable redevelopment projects. Longer design and development timelines may be needed to secure tax credits and other incentives. Sellers should approach these transactions recognizing that their office building is unlikely to stay office—otherwise agreements on price will be elusive.

Getting Political

Cities can take a more active role in promoting and incentivizing conversions to support more residents living in their cities and potentially boost property values. For decades, cities have addressed the affordable housing crisis with a combination of carrots (tax incentives) and sticks (regulated requirements).

New York City’s 421-a and 421-g tax incentives for residential conversion are just one example. Chicago, for example, is incentivizing investments in a targeted area of LaSalle Street as part of a strategy to stimulate office-to-apartment conversions and infuse social and commercial energy into targeted districts.

Other cities are surely watching closely and considering whether similar incentives might be used to stimulate growth or help preserve neighborhoods in their own cities. Legislation like the Revitalizing Downtowns Act currently being considered by Congress—and other potential tax law changes, such as allowing 1980s office buildings to qualify for tax credits, would also be beneficial.

While there are many units already scheduled for 2023 completion in the Midwest and national pipeline, there will likely be a slowdown in new development in response to higher interest rates and construction costs. Despite these economic headwinds and the challenges and complexities of these conversion projects, we believe the market is there for finished apartment conversions in quality locations. In many markets, there are simply not enough high-quality residential rental options, and conversion volume will likely be readily absorbed.

Bill Bubniak, adjunct professor at the Taubman College at the University of Michigan, and Todd Szymczak lead the investment sales division of the brokerage department at Farbman Group, a Southfield, Michigan-based full-service real estate firm with Midwest expertise. To connect with Bill and Todd, email bubniak@farbman.com or szymczak@farbman.com.