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.

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.

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.

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.

The demand for multi-family properties is robust and continues to grow, making converted office spaces attractive to both investors and tenants. Repurposing office spaces to accommodate this demand can enhance rentability and provide a steady income stream for property owners. Despite recent softening in the national multi-family market as the economy stagnates, year-over-year growth is up 6.4%, according to Marcus & Millichap. As of Q2 2023, more than 950,000 multi-family units were under construction; delivery of these units will continue to flatten rents until the market stabilizes.

Even with these fundamentals, net absorption is expected to remain positive for the foreseeable future. Further, the U.S. Department of Housing and Urban Development (HUD) awards grants and other programs to encourage developers to deliver low-income housing. While the potential for oversupply is an immediate concern, population and housing fundamentals nationwide point to the need for these projects to be delivered in the long term.

Converting office spaces into multi-family properties holds promise in meeting the evolving needs of the real estate market. While it presents a viable solution to repurpose underutilized commercial properties, overcoming regulatory challenges, addressing financial concerns, and understanding the potential impacts on property values are crucial for successful conversions. Put bluntly, for an office property to work as a multi-family conversion, it must pass the test of highest and best use. As the commercial real estate landscape continues to evolve in the face of economic trouble, embracing innovative solutions like these will be essential for sustainable growth and development.

Feasibility studies play a crucial role in helping developers make informed financial decisions regarding the conversion of an office property into a multi-family property. These studies assess various aspects such as market demand, construction costs, potential rental income, zoning regulations, and renovation expenses. By evaluating the local real estate market, the demand for multi-family units, and the projected rental rates, developers can gauge the potential net profit of the conversion. Additionally, feasibility studies provide insights into potential challenges and risks associated with the conversion, enabling developers to make well-informed decisions that align with their financial objectives and risk tolerance.

Valbridge Property Advisors provides feasibility studies as part of its valuation advisory offering to our clients. If you are considering making a big change with your investment, make informed decisions with support from our team. Contact your local Valbridge Property Advisors office to discuss your conversion project today.

Disclaimer: The information presented in this article is for informational purposes only and does not constitute financial or investment advice.