Why Most Office-to-Residential Conversions Don’t Add Up

The shift to remote work has contributed to diminished office valuations globally, especially in major U.S. cities where office leasing has dropped by 30% and vacancies have surged. Manhattan saw a jump from 1.4% to 21.6% between 2019 and 2022. In tech-heavy hubs, barely 35% of workers have returned to physical offices. New office leases are being signed for 30% less space, with valuations down nearly 50% from before the lockdowns.

Hope was raised that office-to-residential conversion could be a solution that would not only solve the problem of empty office buildings, but also increase stocks of affordable housing.

CLASS A OFFICE IS DOING FINE

Most of the office buildings developers would like to convert to apartments are fully let with waiting lists. Prime office properties have benefited from tenants relocating from larger spaces in lower-grade buildings to smaller footprints in Class A properties. This “flight to quality” has kept premium offices leased, while vacancy pain has concentrated in lower-tier, less desirable stock. What’s left are outdated, empty buildings in undesirable areas.

What makes you think a bad office building will make a good apartment complex?

DESIGN AND ENGINEERING HURDLES

Pre-war office buildings are often selected for conversion because they have smaller floor plates. These buildings were built before air conditioning and fluorescent lights, making it necessary for each office tenant to have windows for lighting, ventilation, and cooling. This is exactly what you want for apartments, otherwise, the interior units become cavernous and dark. In contrast, most post-1980s office buildings have deep floor plates, often 40–60 feet, limiting natural light and rendering many unusable for housing without costly design overhauls.

Old office buildings were built under different codes and when inspections were less rigorous. Many have structural integrity issues which won't be discovered until the building is cracked open and renovations have begun. Engineering surveys suggest retrofit budgets need a 20–25% contingency to cover surprises uncovered during demolition. Even if the building is structurally sound, building codes for residential are stricter than for office which impacts costs and timelines.

In most cases it's cheaper to demo the building and start from scratch. A 2023 Gensler report found that retrofitting typically costs 15–20% more per square foot than ground-up construction. To entice buyers and renters, architects must create layouts that include kitchens, bathrooms, landscaping, and gathering areas. Amenities such as gyms and swimming pools add further costs and complications. Facades generally need to be upgraded for the building to be marketable.

Office ceilings are usually 10%–20% higher than apartment ceilings. The wasted space can’t be lowered without substantial costs and risks and doesn’t generate additional rent.

THE BAD ECONOMICS

Conversions require the developer to “thread the needle” and find a well-located building, at the right price, without major structural defects, which can be retrofitted at a reasonable price, and made marketable.

Achieving a low entry point on a qualifying building is the only way to make the numbers work. A 2021 study by Moody’s Analytics found that only 3% of NYC offices were suitable for office-to-residential conversion. It further found that office buildings purchased for more than $262/ft² in the city would struggle to profitably convert. The median NYC office transaction price was $542/ft² in 2021. Most of the buildings identified for successful conversion were in dangerous parts of the city which wouldn't attract the type of buyers and renters required.

Another hit to the economics comes from the fact that offices usually generate some form of income on 100% of the building area, whereas residential has more unrented common areas. The office tenants pay for the common areas through service charges or higher rents. For a transaction to work, you need an office owner who is used to collecting rents on 100% of the building area to sell to a developer who only intends to collect rents on 80%. Gross leasable area often shrinks by 15–25% during conversion.

TOWN PLANNING CHALLENGES

When running for elected office, politicians support office-to-residential conversions in their cities. But approvals for entitlement applications in major U.S. cities are generally won through adversarial proceedings, at great cost of cash and time to the developer. In New York, for example, rezoning and permitting can take 18–24 months before a shovel even hits the ground.

When a node in the city is converted to higher residential uses, a few things change. Office nodes have lighter policing requirements with daytime focused patrols. Residential nodes often require heavier policing, with more patrols over more hours. There is a similar impact on other services delivered such as fire and electric services.

Tax Abatements and Credits are required and difficult to structure in a way so that just enough assistance is given, without going down the path of subsidizing private developers and picking winners. Real estate incentives tend to be longer-term (i.e., 10 years+) which equate to long-term obligations the city must agree and adhere to. Incentives for conversions will generally include a 10-year tax abatement, alongside historic- and energy-efficiency tax credits and rebates.

CONVERSIONS DO HELP, BUT WON'T SOLVE THE HOUSING CRISIS

Denver's experience is telling. A Brookings study in Denver found that the city at the time needed around 25,000 additional housing units to meet demand, but that only 1,500 apartments could be generated from converting all empty offices to residential.

In 2023, only 12,700 new apartments nationwide came from office conversions, according to RentCafe, just a fraction of the 3.8 million units Freddie Mac estimates are needed across the U.S.

The solution to the housing crisis will have to be solved with land outside of cities, not within.