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Developers Increasingly Find It Can Pay To Convert Office Buildings Into Apartments and Condos

More than Half of Office Space Removed from Inventory Returns To the Market as Residential
October 29, 2013
Analysis presented at CoStar’s recent Third-Quarter 2013 Office Outlook and Forecast found that developers added 39 million square feet of new office space over the last four quarters. However, the net impact was muted as another 22 million square feet of office space was removed from the market, either demolished or converted into other uses, with more than half of that former office space being converted to residential uses such as apartments and condominiums.

"Clearly, we see a shift in how real estate is being used and what developers are building," said Walter Page, director of office research for CoStar. "So far, over half of the office recovery has been driven by removals of space. We’re still at a very low level of [net] completions, due mostly to demolitions."

Outdated office buildings nearing the end of their usable lifecycles have long been subject to the wrecking ball in favor of other uses such as upscale condos and apartments.

In the current cycle, however, developers are not just looking to demolish or convert lower-quality office buildings. They're also repositioning higher quality office properties to meet growing demand for urban residential space, particularly in transit-oriented markets such as New York City, San Francisco, Chicago, Philadelphia, Baltimore and Washington, D.C.

The trend has been especially prevalent in Manhattan where planned conversions are a key component in some of the largest office transactions of recent years, including 650 Madison Avenue, which sold for $1.3 billion, or about $2,200 per square foot, and 550 Madison Ave., which Sony Corp. sold for $1.1 billion to an investment group headed by developer Joseph Chetrit that is exploring a conversion into luxury condos, a hotel and upscale retail space.

Abundant capital is available for office-to-residential conversions in submarkets where existing office buildings still suffer from vacancy overhang, noted James Murphy, executive managing director in Colliers International’s Investment Services Group. Residential condos in the same areas can command investment sale prices of up to $5,000 per square foot, far exceeding the going rate for even high-quality office buildings.

“In Midtown, you’re seeing some of these [4 and 5 Star] buildings in a ring around Central Park being converted [in condos] and going for sky-high pricing, targeted at the sometimes-New York foreign crowd," Murphy said.

The majority of the office buildings being taken off line are older 1 or and 2 Star quality buildings that are no longer competitive, said Aaron Jodka, manager of U.S. research for CoStar forecasting and analytics company Property and Portfolio Research (PPR).

"In many cases, the better use is not as an office building, and that’s really weighing on the demand side of the market," Jodka said, noting that opportunities to reposition and convert obsolescent office properties to housing and other products make this "a great time to be a value-add office investor."

The office-residential conversion trend has also been a major source of transaction activity in Baltimore, Chicago, San Francisco, and especially, Philadelphia and Northern New Jersey.

Northern New Jersey’s overall office vacancy rate has continued to inch down this year, fueled by an uptick in demand for vacant suburban office buildings for residential conversions and other redevelopment opportunities.

“Vacant buildings considered functionally obsolete by today’s office users are likely to remain on the radar screen for potential medical, mixed-use, multi-family or assisted living conversions,” said Daniel J. Loughlin, managing director and Jones Lang LaSalle’s office brokerage lead in New Jersey.

In many submarkets of Baltimore, landlords continue to struggle with chronic vacancy that has led to an increasing number of obsolete office buildings, which are now being considered for conversion to apartments, noted according Patrick Latimer, JLL senior research analyst.

In Baltimore City, the conversions will change the CBD landscape by helping offset the vacancy holes left by large tenants, such as Miles & Stockbridge, who over the past several years shifted from second- and third-generation space along Baltimore and Charles Street to newly-renovated Five Star product along Pratt Street. Over 800,000 square feet of office space has been removed from inventory in the Baltimore CBD for residential conversions in the last year.

Downtown Baltimore, however, may see the largest changes in 2013 as planned residential conversions could reduce vacancy by over 2% and spark the transformation of the traditional office oriented CBD to a mixed-use environment. The success of such projects as 10 Light Street, where Metropolitan is turning a 435,000-square-foot office building into 445 apartment units, may serve as a barometer for the viability of conversions for downtown office landlords, Latimer said.

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