Archives for 2022

There was some moderate good news on the inflation front, with seasonally adjusted overall inflation up 0.1% month over month in November. Significantly better than October’s 0.4%. Without seasonal adjustment, the year-over-year view was 7.1%.

Slowing inflation is certainly better, although as Nancy Davis, founder of Quadratic Capital Management and portfolio manager of the Quadratic Interest Rate Volatility and Inflation Hedge Exchange-Traded Fund, said in an emailed note, “While Tuesday’s report showed a deceleration in inflation, which is great news, inflation is still very elevated and is over three times greater than the Fed’s 2% target, so this isn’t time for the Fed to take a victory lap.”

Also, “Tuesday’s number won’t likely change anything for the Federal Reserve ahead of its meeting this week, as its decision was likely made weeks ago. Powell wants to show the market that the days of the big, 75 basis point hikes are over and the pace is slowing, so it’s likely that the Fed announces a smaller 50 basis point rate hike on Wednesday.”

To be clear, Davis’s point isn’t that the CPI numbers didn’t suddenly turn the heads of Powell and others in the Fed and point them to a kinder and gentler economy. Instead, the plans were publicly firming in early November, as a Fed release stated, “In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”

There had been growing criticism from without, and signs of some from within, that there were too many large rate hikes that, as all Fed rate increases do, take months to fully have their effect felt by the economy. Powell and all likely did not want a repeat of 2018, with three now seemingly tiny 25 basis point increases with dour market responses, followed by multiple decreases in 2019.

For CRE, the prospects of slowing inflation would eventually be interest rates that might again drop. But a 50-basis point increase is still a significant hike and means even higher financing costs in the immediate future. To get real changes in monetary direction will require clear and ongoing improvements in inflation.

“While it is certainly possible that we have now passed peak inflation, if we keep up this pace of decline, price increases will continue at levels that are still very painful for consumers,” Davis wrote.

The Fed’s likely reaction would then mean higher interest rates for longer, which would be very painful for those in commercial real estate.

Source: “Inflation Moderates More, But How Will the Fed React?“

Conversions of obsolete office buildings to multifamily use have been going on for some time, but investor interest in these projects is accelerating due to anemic demand for office space in many major U.S. cities. However, the trend is not nearly as widespread as some in the industry have predicted it would be post-pandemic.

The latest newcomer to the strategy is New York City developer Silverstein Properties, which has launched a new fund aiming to raise $1.5 billion to acquire and convert older offices buildings in Manhattan that are experiencing growing vacancies and debt burdens. Marty Burger, the firm’s CEO, told Bloomberg that this is just the start of what could be a “$10-billion-plus” opportunity, as the effort could potentially expand to other markets, including Washington, D.C., Boston and the West Coast.

Silverstein has already acquired a 30-story office tower in Manhattan’s Financial District at 55 Broad St. and partnered with Metro Loft, a long-time specialist in apartment conversions, for this project.

Besides Silverstein, various institutional and private investors, including Invesco, recently allocated significant funds to increase their exposure to this strategy, according to Peter Nicoletti, managing director, head of capital markets—New York, with commercial real estate services firm Colliers.

Developers are also underwriting conversion opportunities, then raising money to fund them, notes Michael Muldowney, executive vice president, capital markets, with commercial real estate services firm CBRE. The most popular fundraising strategy employed by private developers for this type of project has been crowdfunding, according to him. Or at least, “it was before interest rates skyrocketed and regulators shut down the big banks for constriction lending,” Muldowney adds.

Currently, there are 125 office conversion projects underway nationally, according to Jessica Morin, CBRE’s Americas head of office research. Of that number, about 30 percent are multifamily conversions, while 50 percent are conversions to life sciences space, and the rest are conversions to hotel and other uses.

Getting a loan

There also appears to be some appetite for financing conversions. For example, Bisnow reported that Brookfield Real Estate Financial Partners in August provided the Vanbarton Group $273 million to convert a 24-story office tower at 160 Water St. in New York City into a 30-story multifamily project.

But large banks are mostly out of this market right now or have fully allocated for 2022, according to Justin Glasgow, senior vice president, debt & structured finance, with CBRE. The most active and cost-effective construction lenders today are the regional and local banks, he says.

The catch is that these smaller banks are typically constrained on loan size and favor deals with existing borrowers, low overall leverage and often have some partial recourse requirement, Glasgow notes. Debt funds are active at higher leverage, but the all-in cost of the debt is often cost-prohibitive.

“In addition to basis and overall location, lenders want to see the ‘right’ physical attributes to the building, such as column spacing, appropriate finished ceiling heights and market amenities in common areas,” he notes. “And they are very focused on the sponsor’s track record in converting to residential. Lenders view conversions as riskier than ground-up development and loan term will reflect that.”

Government help

The number of conversions to multifamily is expected to accelerate next year and beyond, as state and local jurisdictions with dire housing shortages try to create incentives to stimulate residential conversions, which provide a quicker, more sustainable solution than ground-up development. For example, California Gov. Gavin Newsom signed two bills into law in September that open districts zoned for commercial use to residential conversions for both affordable and market-rate projects and streamline the entitlements process for affordable projects.

Additionally, California’s 2023 budget allocates $400 million in grants for office-to-multifamily conversions; Denver’s budget provides funds to study the matter; and Washington, D.C. Mayor Muriel Bowser is calling for a 20-year tax abatement tied to these kinds of conversions.

The city of Baltimore recently reauthorized a High-Performance Market-Rate Tax Credit that incentivizes both new multifamily construction and conversion of commercial buildings to apartments, notes Muldowney. The city of Chicago has also proposed an initiative to repurpose high-vacancy buildings in its downtown financial district into homes, offering tax credits and incentives, along with financing tools.

But while city would like to see such projects create more workforce housing, Morin notes that most of the office buildings are being converted into luxury units with the rents high enough to make the projects pencil out. Nicoletti concurs, pointing out that with the cost to convert on top of acquisition price ranging from $300 to $400 per sq. ft,, market rate rents are the only way to get the returns investors expect.

This is not because the cost to convert is high, but rather because rents for workforce housing aren’t high enough to get a return on cost investors will accept, says Muldowney. The expected returns for such projects range from the high-teens to low-20s.

The cost of converting an office building into apartments is estimated to range between $100 and $200 per sq. ft., plus the cost of recent inflation, according to Jeffrey Havsy, commercial real estate industry practice lead for Moody’s Analytics. In New York City, for instance, a developer would need to acquire an office property at $262 per sq.ft. or less, which only applied to 20 percent of New York City’s office buildings in 2021, to realize a profit on a conversion, he notes.

“A lot of low-hanging fruit has already been completed or is in the pipeline,” notes Muldowney. It will take time for office owners and lenders to accept pricing that is low enough to have conversions make economic sense for the buyers, he says. “If the building cannot deliver an 80-percent net rentable area, it will be difficult to get to pricing that an office seller will expect.”

A similar situation can be found in Los Angeles. The city’s adaptive reuse ordinance, which has been in play for more than 20 years, streamlined the overall approval process for residential conversions downtown, cutting the timeline from years to months, according to Tim Mustard, principle and director of business development with Southern California-based TCA Architects.

This ordinance is responsible for one-third, or about 12,000 of the 37,000 new residential units created in downtown Los Angeles over the last 20 years. The city is expected to update the ordinance this year to provide developers with financial incentives and expand it to areas outside of downtown.

But Mark Tarczynski, Los Angeles-based executive vice president at Colliers, notes that a lot of the most “viable” buildings were converted to apartments back when this ordinance was adopted in 2001.

In the details

The most efficient floor plates for housing have single-loaded or double-loaded corridors; otherwise, the project would require cutting in an atrium, notes Muldowney. New York state’s multiple dwelling law, for example, requires bedrooms to feature windows of a certain size that open out onto the street.

New York City has established an Adaptive Reuse Task Force that’s expected to recommend regulatory changes by the end of the year that would spur conversions of obsolete office buildings. Real estate trade association REBNY estimates that a “conservative” conversion rate of 10 percent of New York City’s lower-tier office buildings could generate approximately 14,000 new apartment units.

New York City office buildings built prior to 1961 are allowed to convert and are exempt from the city’s Uniform Land Use Review Procedure, which takes about a year to complete, according to Nicoletti. He notes that buildings with light and air exposure or a center core, which are mostly found in Lower Manhattan and in Manhattan’s Third Avenue corridor, are the most adaptable for apartment use and attractive to investors.

“The best candidates are not mid-block buildings, [but] preferably free-standing, with light on four sides, and really cheap,” adds David Webb, Washington, D.C.-based vice chairman of capital markets and leader of the Mid-Atlantic debt and structured finance group with CBRE. Most projects will require the building to be gutted down to the concrete, he notes.

Right now, office-to-apartment conversions are mostly happening in markets with a scarcity of developable land and/or with a good concentration of “meds and eds” who “need a place to crash,” says Muldowney. In addition to New York and major California cities, these include Philadelphia, Pittsburgh and Washington, D.C.

Source: “How Attractive Are Office-to-Apartment Conversions Right Now?“

Recent research from NAIOP reveals that office sector absorption is likely to slow dramatically in 2023, with predictions for the entire year coming in just slightly higher than fourth-quarter 2022 estimates alone.

Net office space absorption in the fourth quarter is predicted to be 7.1 million square feet, and absorption for the entirety of 2023 is estimated to clock in at 8.1 million square feet, according to Hany Guirguis, Ph.D., of Manhattan College and Michael J. Seiler, DBA, of College of William & Mary. The pair forecast absorption in the first three quarters of 2024 to total 13.3 million square feet.

“The mere threat of a recession has caused tenants to take a defensive posture and become more cautious when renewing leases, with many instead choosing to move to a smaller, newer and more flexible footprint,” Guirguis and Seiler note. “Moreover, the large supply of space available for sublease weakens rental rates and contributes to lower net absorption.”

The NAIOP forecast draws from historical data on the economy and office real estate absorption to project future demand and assumes there is a 60% chance of a recession in 2023. If a recession does occur, actual net absorption is expected to turn negative in 2023, according to the researchers. If a recession does not occur, absorption will be higher than the current forecast.

The researchers also point to the ongoing flight to quality assets, noting that “a deeper look into the numbers reveals an appetite specifically for high-quality office buildings, which may support leasing activity in newly completed buildings despite continued weakness across the office sector.” The ongoing adoption of hybrid work models is also expected to further temper demand: earlier this fall, analysts from Newmark predicted that “high-quality assets in dynamic suburban markets may hold an advantage over traditionally stable Downtown assets,” with “relatively high availability, downward pressure on rents and greater demand for a vibrant worker experience” benefiting the upper tier of the office market.

Source: “Office Absorption Likely to Significantly Slow In 2023“

With the mid-term elections behind us, it’s a good time to recap the status of rent control across the country. The National Multifamily Housing Council (NMHC) is tracking 23 states that have such proposals or laws in play.

NMHC points out that this year, the issue even gained traction at the federal level, with tenant advocates urging President Biden to issue an executive order mandating rent caps on mortgages backed by Fannie Mae and Freddie Mac.

The “flawed policy” failed in 2022 with the exception of California, Maine and New York cities, NMHC said. In 2023, it poses that Massachusetts is the top threat to enacting it.

“We anticipate significant activity in state legislatures in the coming year and a continued effort at the federal level to push the Biden administration to issue an Executive Order (which would not require Congressional approval),” NMHC writes.

“Whether or not these measures are enacted, they will get media attention and, as such, pose a reputational threat to the apartment industry at a minimum.”

Following is a recap of NMHC’s tracking of the cities and states considering rent control measures that have been placed in Tier 1, 2 and 3 categories.

Tier 1

Colorado: Rent control legislation is regularly introduced in Colorado. To date, such efforts have stalled.

Florida: The Sunshine State maintains statewide preemption on rent control. The preemption law, however, includes an exemption via a successful local ballot initiative allowing for a one-year rent regulation. NMHC expects measures to be introduced in the legislature to revoke preemption, but given the way the current law is written, the real action may take place at the local level.

Lawmakers in St. Petersburg and Tampa, and Orange County and other cities and counties may again pursue workarounds to rent control preemption.

Illinois: In Illinois, rent control is seemingly an annual issue in the state legislature. Efforts have failed to date, but should resurface.

Maryland: The real action here is at the county level where efforts to impose rent control in Montgomery County are expected to continue.

Massachusetts: In Boston, Mayor Michelle Wu made rent control a central theme of her candidacy in 2021 and has since been working to push state lawmakers to revoke its statewide rent control preemption. She now has a more sympathetic ally in Governor-elect Maura Healey, who has signaled that she would support revoking preemption.

Nevada: Rent control supporters were dealt a blow when sitting governor, Steve Sisolak, lost his election to Republican Joe Lombardo. Still, NMHC expects a strong push in the state legislature, which only convenes in odd-numbered years.

Washington State: Legislation to lift rent control preemption is regularly introduced by state lawmakers at the behest of local lawmakers in Seattle.

Tier 2

Connecticut: A bill to create a study to explore rent control did not gain any traction, but supporters may make another push next year.

Hawaii: Multiple state lawmakers in Hawaii introduced rent control measures. These bills failed to get a vote.

Michigan: After flipping both the State Senate and State House, Michigan Democrats now control the legislature and the governor’s chair. Democrats have introduced bills to repeal rent control preemption during past sessions.

New Mexico: In 2022, the Albuquerque City Council rejected a measure asking state lawmakers to lift rent control preemption.

Rhode Island: A bill that would have limited rent increases to no more than four percent annually failed in 2022 but may be reintroduced in 2023.

Tier 3

Arizona: While the focus of Governor-elect Katie Hobbs’ (D) plan largely prioritizes initiatives to spur development and incentives for low-income residents, it is a state worth watching for rent control activism.

Kentucky: In 2022, bills were introduced but not passed. They could be reintroduced in 2023, though passage is unlikely given the Republican composition of the legislature.

North Carolina: The state currently maintains statewide preemption on rent control and Republicans control both houses of the legislature.

Pennsylvania: A Republican-led Senate makes it difficult for rent control measures to pass, including from 2022 that would impose statewide rent control limiting rent increases to the lower of five percent plus the change in cost of living or 10 percent.

South Carolina: Passage of failed legislation from 2022 in 2023 is unlikely given the conservative composition of the state government.

California: Voters in three California cities – Pasadena, Richmond and Santa Monica – approved rent control measures on the 2022 ballot. Further expansion is possible.

Maine: Portland voters approved a rent control measure on the 2022 ballot. The South Portland City Council is also expected to take up rent control in 2023.

Minnesota: After a 2021 ballot initiative, St. Paul implemented rent control this past year and quickly witnessed a dramatic decline in development, forcing city leaders to amend the policy. Minneapolis voters also gave their city council the ability to implement rent control in 2021, though local officials have yet to adopt it.

New Jersey: The City of Perth Amboy adopted rent control this year. Additional cities could take up the issue in 2023.

New York: Kingston became the first upstate city in New York to adopt rent control. However, a State Supreme Court judge blocked the city from putting it into effect.

Oregon: While lawmakers in Oregon enacted statewide rent control in 2019, they continue to explore ways to address the state’s housing affordability challenges.

Source: “Rent Control Largely Failed This Year But Expect It to Re-Emerge in 2023“