US office rebound raises questions for nationwide property transformation

The United States real estate industry, confronted with the post-pandemic rout of its tertiary markets, sped so rapidly toward converting obsolete office buildings that the transformations outpaced new construction. But a recent rebound in office properties could call this dynamic into question.

As leasing picked up at office buildings rated three and four stars in the third quarter, some developers are rethinking whether to pursue plans to convert offices. In New York City, Vornado Realty Trust has decided to scrap a planned conversion in a bet office demand will support its investment.

That's a shift from the push toward conversions that took center stage in the aftermath of the health crisis that prompted office landlords across the country, many faced with a staggering glut of empty space, to look for a quick remedy for aging and obsolete buildings unlikely to survive in their original use.

Demand atrophied as companies across the country responded to shifting workplace habits such as remote and flexible work policies. As a result, property owners and developers tried to pivot by overhauling assets into more valuable uses, often housing, a hotel, or even a warehouse or industrial facility.

For the first time in years, the rate of office demolitions and conversions has overtaken new development, spotlighting landlords' eagerness to quickly reposition their property as the national office market's vacancy rate continued to climb and set record highs. More than 81 million square feet of office space is moving through the conversion pipeline, according to a recent report from commercial real estate services firm CBRE, with more than 75% of those projects slated to become multifamily properties and spaces.

Over the past decade, office-to-multifamily conversions have generated at least 33,000 residential units across the United States. That has been a welcome boost for cities such as New York, San Francisco, Philadelphia and Boston, as many have faced worsening housing shortages. Local officials have scrambled to capitalize on the conversion trend's popularity by offering incentives, fast-tracked approvals, loosened zoning requirements or have created departments aimed at easing the costs associated with transforming otherwise obsolete properties into alternative, higher-demand uses.

The city of Denver plans to provide loans to fund about a dozen conversion projects throughout downtown to help transform Denver's core “from a central business district to a central neighborhood district," with buildings that can be converted to a more popular use.

"Having them activated — not just from nine to five, but 24 hours a day, 365 days a year — that is the real catalyst for us in helping stabilize long-term recovery," said Denver Mayor Mike Johnson.

One challenge is that conversions aren't always feasible. Issues such as complicated financing, environmental challenges and stagnating markets have proven to be among the biggest hurdles for those looking to transform some of the nation's older office buildings.

Then there are the physical attributes of properties themselves that can deliver their own set of headaches, such as irregular floor plans, unsuitable locations or aging systems that would be too expensive to fix and reuse.

The cost of converting an office building into a new multifamily one, for example, averages about 20% more than ground-up development in the United States.

It has been a financial bet some landlords have been willing to make, especially as many have had to contend with a bevy of pandemic-affiliated challenges that have complicated the financial outlook for a host of office properties, especially if they're older or facing maturing loans.

Yet since the start of the year, the office market landscape has significantly brightened.

Executives behind some of the largest landlords and brokerages in the United States are now saying the market has rounded an important corner, pushing some firms into record dealmaking territory after years of stagnant demand and plummeting property valuations.

While the nation's office vacancy rate remains stuck at a record high of more than 14%, that figure has most likely peaked as the volume of leases is nearing or has already surpassed 2019 levels in some pockets of the country.

Some of the world's largest companies including Amazon, Walmart, Starbucks, AT&T and JPMorgan Chase have ditched their pandemic-era flexible work policies, instead adopting strict attendance requirements that often call for employees to come in for a full, five-day week.

That return-to-office push, coupled with other ingredients such as increasing tenant certainty and corporate earnings growth, has once again changed the calculus for office owners.

And in some cases, the higher demand for office space has swayed owners to scrap the earlier conversion plans altogether.

Vornado, one of New York City's most well-known real estate developers, recently acquired the office space atop the iconic Saks Fifth Avenue department store in Manhattan. While that portion of the property had earlier been slated for a residential conversion, rather than pursue those plans, Vornado decided instead to bet it will serve rebounding office demand. It is going to preserve it as office space and invest even more in upgrading it as demand for top-tier office space outweighs what’s available.

"This building is like a trophy on top of a podium," Vornado CEO Steven Roth recently told investors. "The location is pretty amazing, and we will redevelop this building into the very best, elite boutique office building that will take less than half the time it would for a new build and importantly, at half the cost."

Other large developers and investment firms are following a similar route, especially in cities where demand among tenants has boomeranged beyond pre-pandemic levels of interest. Some are now scooping up older properties faced with dwindling occupancy rates and troublesome financial situations — many that had earlier been considered potential conversion candidates — with plans to renovate them and better compete for tenants' attention.

While the pendulum is shifting back toward the office market's favor, that hasn't meant the United States pipeline for conversion projects has slowed.

The new owners behind a prominent office building in Nashville, Tennessee, are quickly stitching together plans to transform the tower into a hotel. A historic office building in Philadelphia's Center City was recently purchased through a foreclosure auction and is now on its way toward becoming one with apartments and retail space.

Regardless of shifting market dynamics, however, the decision to convert or not convert comes down to pricing and feasibility.

When the property was built, how large the floorplans are and what kind of use is more popular in any given city will ultimately tip the scales, said Mark Lammas, the president of office property owner Hudson Pacific Properties.

"I wouldn't be surprised if landlords in Europe are looking at their portfolio and realizing they have a lot of interesting opportunities for underutilized properties for residential conversion, since a lot of the properties are much older and better suited for them," Lammas said. He added that isn't always the case for buildings in the United States, given the cost is often prohibitively expensive and many properties could still be better off operating as office.

"It's all a numbers game."