The rise in unused office space has triggered suggestions about
converting commercial real estate into residential
buildings. But our US Real Estate Research
analyst lists three major challenges.
----- Transcript -----
Welcome to Thoughts on the Market. I’m Adam Kramer, from the
Morgan Stanley U.S. Real Estate Research team. Along with my
colleagues bringing you a variety of perspectives, today I’ll
discuss a hot real estate topic. Whether the surplus
of vacant office space offers a logical solution to the
national housing shortage.
It’s Wednesday, August 14, at 10am in New York.
Sitting here in Morgan Stanley’s office at 1585 Broadway, Times
Square is bustling and New York seems to have recovered from
COVID and then some. But the reality inside buildings is a little
bit different.
On the one hand, 14 percent of U.S. office space is sitting
unused. Our analysis shows a permanent impairment in office
demand of roughly 25 percent compared to pre-COVID. And on the
other hand, we have a national housing shortage of up to 6
million units. So why not simply remove obsolete lower-quality
office stock and replace it with much-needed housing? On the
surface, the idea of office-to-residential conversion sounds
compelling. It could revitalize struggling downtown areas,
creating a virtuous cycle that can lead to increased local
tax revenues, foot traffic, retail demand and tourism.
But is it feasible?
We think conversions face at least three significant challenges.
First, are the economics of conversion. In order for conversions
to make sense, we would need to see office rents decline or
apartment rents rise materially – which is unlikely in the next
1-2 years given the supply dynamics — and office values and
conversion costs would need to decline materially.
Investors can acquire or develop a multifamily property at
roughly $600 per square foot. Alternatively, they can acquire and
convert an existing office building for a total cost of nearly
$700 per square foot, on average. The bottom line is that total
conversion costs are higher than acquisition or ground-up
development, with more complexity involved as well.
The second big challenge is the quality of the buildings
themselves. Numerous elements of the physical building impact
conversion feasibility. For example, location relative to transit
and amenities. Buildings in suboptimal locations are unlikely to
be considered. Whether the office asset is vacant or not is also
a factor. Office leases are typically longer duration, and a
building needs to be close to or fully vacant for a full
conversion. And lastly, physical attributes such as architecture,
floor-plate depth, windows placement, among others.
And finally, regulation presents a third major hurdle. Zoning and
building code requirements differ from city to city and can add
substantive time, cost, complexity, and limitations to any
conversion project. That said, governments are in a unique
position to encourage conversions — for example, via tax
incentives – and literally remake cities short on affordable
housing but with excess, underutilized office space.
We have looked at conversion opportunities in three key markets:
New York, San Francisco, and Washington, D.C. In Manhattan,
active office to residential conversions have been concentrated
in the Financial District, and we think this trend will continue.
We also see the East Side of Manhattan as a uniquely untapped
opportunity for future conversions, given higher vacancy today.
This would shift existing East Side office tenants to other
locations, boosting demand in higher-quality office neighborhoods
like Park Avenue and Grand Central.
In San Francisco, we are concerned about other types of real
estate properties beyond just office. Retail, multifamily, and
lodging in the downtown area are taking longer to recover
post-COVID, and we think this will limit conversions in the
market.
And finally, in Washington, D.C. we think conversion would work
best for older, Class B/C office buildings on the edges of
pre-existing residential areas.
In these three markets, and others, conversions could work in
specific instances, with specific buildings in specific
sub-markets. But on a national basis, the economic and logistic
challenges of wide-scale conversions make this an unlikely
solution.
Thanks for listening. If you enjoy the show, please leave us a
review wherever you listen and share Thoughts on the Market with
a friend or colleague today.
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