Commercial real estate faces a real conundrum. Office vacancies hit historically high levels in 2023 as more employees continued to work from home or on a hybrid model while residential rental properties have hit an all-time low in many major cities.
The solution to the problem seems simple: convert those unused office spaces into residential units. Easy fix, right? Not so much, experts say.
Office-to-residential conversions can be highly complicated—and highly expensive. Indeed, a Goldman Sachs report released this week says office acquisition prices would need to fall nearly 50% for these projects to be “financially feasible.”
Although the appetite for office space is so low that there may be as much as 1 billion square feet of unused U.S. office space by the end of the decade, per Cushman & Wakefield, so few of those office spaces would actually work out as a residential property, whether owing to the age of the building, cost, or redevelopment challenges. Put simply, it would be too difficult to convert certain buildings because of zoning restrictions and layout.
“Not all buildings can be easily modified for residential use, and even for the ones that can, it can take years of planning and significant costs to complete,” John Walkup, cofounder of real estate data-analytics company UrbanDigs, tells Fortune. “In short, the incentive for conversion is only realized at the end of a long process filled with risks that new ground-up buildings don’t really experience.”
Goldman Sachs defines a “nonviable” office space as one in a suburban area or central business district built before 1990 that has not had renovations since 2000 and has a vacancy rate higher than 30%. “Nonviable” office spaces are actually the ones that are more likely to be successful as a conversion property because buildings need to be almost completely vacant. By Goldman Sachs’ calculations, converting a nonviable office that is priced at the current level will result in a $164 loss per square foot—meaning office prices would need to drop 50% “for the cost to be fully covered by the stream of discounted future revenues.”
In other words, developers won’t recoup their investments in conversion projects unless prices drop.
“In addition to zoning and other regulations, conversions can be very expensive and must overcome structural and financial challenges,” Ran Eliasaf, founder of real estate private equity firm Northwind Group, tells Fortune. “Often, it’s far less expensive to build housing from scratch, and only certain kinds of buildings can be converted successfully.”
Office-to-apartment conversions are a ‘fringe trend at best’
Despite the high costs and long runway for office-to-residential conversions to happen, some are still getting off the ground. A Deloitte study released in July 2023 found 217 conversion projects in the immediate pipeline for completion. While there were signs of a “conversion wave” in the immediate post-pandemic era (2021–22), Moody’s Analytics reported in its 2022 studyWhy Office-to-Apartment Conversions are Likely a Fringe Trend at Best that “it’s much easier to theorize about office-to-residential conversions than to execute and profit on them.”
Before the pandemic, only about 0.4% of office space was converted to multifamily space per year, which increased to just 0.5% in 2023, according to Goldman Sachs. At this pace, it will take another eight years to convert the 4% of offices they deem nonviable. In some cases, it can be easier, cheaper, and quicker to just build completely new apartment buildings.
Factors that play into office-to-residential conversions
The main factors at play when considering office-to-residential conversion projects include existing building infrastructure, cost, zoning, and government support, Richard Whitney, vice president of architecture, interior design, and sustainability firm FitzGerald, tells Fortune. Whitney’s firm has completed more than 100 conversions and renovations to historical buildings, and has several factors to consider before starting a project.
Architects at FitzGerald have to consider the floor-plate size of the building—or the amount of usable square footage. This is critical because it helps the firm determine whether they can design a floor plan that will provide adequate light and ventilation to each unit to meet building codes. This is only made more difficult when they don’t have access to original drawings or floor plans of the building. Plus, designers have to assume that existing HVAC, electrical, and plumbing systems will have to be replaced—especially if the building is older.
“The unknown factors of historic buildings can make some people hesitant to pursue these kinds of conversions,” Whitney says. “If we cannot locate the original drawings, it can be more difficult to determine how the building was built, and we might uncover hidden challenges down the line. It is something to factor into the conversation.”
Government incentives
In late October 2023, the White House introduced a multiagency effort to encourage states and cities to convert empty office buildings to apartments, with Transportation Secretary Pete Buttigieg saying there would be “over $35 billion in lending capacity” to provide below-market-rate loans to finance housing construction and conversions near transportation hubs.
This type of government involvement in office-to-residential conversions is “critical,” Whitney says.
“Construction costs are high, and real-estate developers are facing tremendous struggles with financing,” Whitney says. “These projects are much more likely to ‘pencil out’ if city governments are creating incentives and subsidies to help with the costs.”
Some cities, including Boston, have started offering their own incentives for office-to-residential conversion projects. Last summer, the city announced a program that waives up to 75% of property taxes for up to 29 years, with goals to create more downtown housing units in Boston and “more consistent foot traffic throughout the week to support downtown businesses.”
“Through this conversion program, we seek to incentivize lenders, property owners, downtown stakeholders, and the state to partner with the city to increase the production of much needed housing in our downtown core,” Arthur Jemison, the City of Boston’s chief of planning, said in a statement.
These types of incentives will “go a long way” in bringing more affordable housing to cities, Whitney says. Plus, established programs like this can help streamline approval processes, shortening completion times.
“The sooner that a project can move forward, the more likelihood it has to be successful,” Whitney says. “Protracted approval processes can be a huge drag on conversion projects.”
