Office Conversions

The most talked about asset class within commercial real estate since Covid has been Office.  Its demise has been extensively written about.  I believe that there will be a return to office for the majority of employees, but it will look different from before.  More flexible hours and days, a hybrid model of some days virtual from home, and more shared space with fewer large private offices.  Therefore, even with a return to the office, it will result in a much reduced square foot requirement for the days in-office.     

See my prior post on return to the Office here: 

https://www.mulcahycapital.com/blog/2023/5/2/theoffice   

I don’t believe that office is dead, but the inevitable reduction in demand will result in winners and losers.  There is no doubt going to be a lot of office landlord failures and lender debt write-offs in the coming years.  There remains demand for well-located and newer vintage office buildings in the Class A category.  The remaining office space will compete on lower rent rates in a fight to the bottom.    

There has been speculation as to what will become of the obsolete office inventory.  A common assertion is that it can be converted into much-needed multifamily units.  Many cities are beginning to offer tax breaks to encourage such conversions, which will help alleviate housing shortages.  This sounds great in theory, but is not very practical to implement nor seldom is it economically feasible.  

Most office buildings do not convert easily to multifamily property.  Quite often the floor plates and mechanicals are not suitable.  Floor plans and natural window lighting are more critical for housing.  The cost to convert an existing office property can be much higher than building new from the ground-up.  The end product with a conversion will also be inferior to a new build, although some old office buildings may have better exterior aesthetics.  There are a lot of risks involved in taking on a conversion that is not present with a fresh ground-up project.  

The most suitable buildings to convert will be properties with smaller footprints.  However, even if you have a property that lends itself well to conversion, you could have tenants occupying some of the existing space with leases of up to 5 years remaining.  To convert the building you would need to have the property vacant and you may need to buy the tenants out of their leases, only if they were willing to move.    

The fact of the matter is, that most obsolete office buildings are not economically feasible to convert, and they are more valuable razed to the ground.  The tax incentives to convert don’t even come close to making the numbers work.  Some office buildings would need to be handed over at zero cost and include tax incentives before becoming feasible.  If office conversions were a practical solution there would be a lot more of these projects underway, whereas there are very few in progress.

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