Marketing Director, Valbridge Property Advisors
Business Development, Valbridge Property Advisors | Northern California
In recent years, the real estate investors have gotten creative with the utilization of existing properties, particularly the conversion of office spaces into multi-family properties. This trend has gained traction due to evolving market dynamics, changes in work preferences, and a growing demand for residential housing. However, while the idea is promising, there are considerable barriers to overcome, financial concerns to address, and potential impacts on real estate property values to consider.
Promise and Potential
Converting office spaces into multi-family properties presents an opportunity to repurpose underutilized or vacant offices, especially in primary market downtown cores that are still struggling to recover following the pandemic. With the rise of remote work and flexible schedules, the demand for traditional office spaces has declined, making these properties suitable candidates for conversion. Multi-family housing, on the other hand, has had a hard time keeping pace with demand as the housing crisis worsens across the nation.
The United States continues its decline in demand for office space, largely attributed to the shift towards remote work and flexible work schedules. According to a recent report by brokerage firm Marcus & Millichap, the national vacancy rate for office space rose to 16.8% in Q2 2023, the fifth consecutive quarterly increase. Available square footage is expected to continue to rise. Some markets mitigated occupancy losses better than others, with the largest increases of up to 20% in vacancy recorded in primary markets, and the lower end around 10% in secondary and tertiary markets. This increase in vacant office space is putting downward pressure on rents as landlords grapple with a surplus of available square footage. Additionally, the rise of remote work has led to a decrease in demand and leasing of large office spaces, prompting many businesses to reevaluate their office space needs and opt for smaller, more cost-effective solutions.
The situation is exacerbated by the looming commercial mortgage maturities. A significant portion of commercial mortgages are due for refinancing in the coming years, adding financial strain to property owners. In the next two years, $1.5 trillion in commercial mortgages will come due, a sign of trouble as higher interest rates and office vacancy rates point to decreasing property values. This impending wave of maturities, combined with the declining demand and rental incomes, underscores the challenges faced by the office real estate sector, necessitating proactive strategies to adapt to the evolving market conditions.
Barriers to Redevelopment
In appraisal, we address the question of highest and best use with the following questions: Is it legally permissible? Is it physically possible? And is it financially feasible? These questions hold especially true when considering a conversion from one property type to another.
One of the significant barriers to converting offices into multi-family properties is navigating zoning and regulatory challenges. Most commercial properties are zoned for specific uses, making it difficult to obtain the necessary permits for residential conversion. Municipalities often have stringent zoning laws that dictate the type of development allowed in a given area, and changing these designations can be a lengthy and complex process. Some cities may be more amenable to conversions than others, so local governments’ receptiveness to the concept varies widely by local market.
The existing infrastructure and design of office spaces may not align with the requirements of multi-family housing. Adapting the layout, amenities, and services to meet residential standards can be a costly and time-consuming endeavor. Additionally, offices are designed with work-related needs in mind, such as large common areas and fewer bathrooms, which must be reconfigured to cater to residential living.
The cost of converting office spaces into multi-family properties can be substantial. The reported cost of retrofitting office buildings into multi-family units in most markets ranges from $100 to $200+ per square foot, depending on the extent of renovations required. In some markets, this figure rises to around $500 per square foot or more. These costs encompass navigating a complex web of construction costs, regulatory matters, and the property design and engineering.
Securing adequate financing for the conversion is a critical financial concern. Traditional lenders may be hesitant to provide loans for conversions due to the inherent risks and uncertainties associated with repurposing properties. Developers often need to explore alternative financing options, such as private equity or government grants, to fund these projects effectively.
Impact on Real Estate Property Values
Despite the challenges, successful conversion projects can significantly impact real estate property values positively. A well-executed conversion can revitalize an underused property, attract new residents to the area, and contribute to the overall improvement of the neighborhood. This can lead to a recapture of lost rental income from the previous office use, and an increase in subject property and surrounding property values.