Archives for March 2023

This past week, German car manufacturer Volkswagen AG announced that it planned to invest approximately $193 billion over the next five years on shoring up its business in China and the U.S., with $131 billion of that sum going toward the development of electric vehicles (EVs) and new digital technologies. Among the projects included in that five-year plan is the development of Volkswagen’s first battery plant in Canada, which would follow the decision to build a $2 billion factory producing all-electric trucks and SUVs in South Carolina announcer earlier in the month.

Likewise, another German car manufacturer, BMW, announced $1.7 billion in investments in production of EVs in the U.S. in recent months, including $700 million to develop a new high-voltage battery assembly plant in Woodruff, S.C.

Mercedes has also recently invested $1 billion in a battery factory in Alabama and is converting its nearby conventional SUV factory to EV SUV production.

These moves are part of a growing trend of foreign and domestic car manufacturers investing in EV production facilities and associated manufacturing plants in the U.S., opening up a potential opportunity for U.S. commercial real estate investors and developers.

The Biden Administration’s Jobs Act, CHIPS and Science Act, and Inflation Reduction Act (IRA) are supercharging a comeback in domestic manufacturing, especially around energy- and climate-tech products. Two of the areas benefiting most from IRA funding are electric vehicles (EVs) and EV batteries.

The IRA provides both tax credits for investments in clean-energy manufacturing facilities and loan guarantees for U.S.-based projects that utilize new or significantly improved technology or reduce greenhouse gas emissions.

In fact, with IRA allocating $370 billion for climate initiatives, demand for manufacturing space has escalated 100%, according to Silicon Valley-based Greg Matter, executive managing director and leader of the advanced manufacturing team with commercial real estate services firm JLL. “It’s been like pouring fuel on the fire,” he says. “I haven’t seen this much manufacturing activity in all of my 20 years in the industry.”

According to a Brookings report, automakers worldwide have committed to investing  an estimated $1.2 trillion to electrification globally through 2030. A tally by consulting and data firm Atlas Public Policy, announcements of investments in U.S.-based EV, EV battery and battery recycling facilities by members of the automaker alliance totaled $128 billion in 2022 alone.

Major automakers are investing in building battery startup facilities because they want to be in close proximity to or own their supply chains, Doron Myersdorf, CEO of Israel-based StoreDot, a startup concerned with optimizing battery charging, told Crunchbase.

Overall, the Dodge Construction Index reported that manufacturing construction starts in the U.S. reached a record $41.6 billion between May 2021 and May 2022—a 161% increase over the prior 12 months. Colliers Industrial Research reports that there are nearly 100 manufacturing facilities greater than 100,000 sq. ft. currently under construction in the country. Eight of these facilities contain more than 1 million sq. ft. and are located in Texas, Tennessee, South Carolina, Ohio and Arizona, says Miami-based Stephanie A. Rodriguez, national director, industrial services, at Colliers.

Emerging investment opportunities

The ramp-up in EV and EV-related manufacturing activity to regionalize production and supply chains is creating a variety of new opportunities for industrial real estate developers and investors, especially in the Midwest, South and Southwest. Automotive manufacturing facilities create local networks of suppliers and ancillary manufacturers, as well as third-party logistics (3PLs) facilities that tend to locate adjacent to EV and EV battery plants, all of which provide opportunities for industrial investors, notes New Jersey-based Nick Kim, senior managing director, tenant advisory, at commercial real estate services firm Transwestern.

In Tennessee, the state’s Department of Economic and Community Development estimates that an additional $5.2 billion in capital investment will be generated on top of Ford Motor Co. and South Korea-based SK Innovations developing a $11.4 billion EV and EV battery manufacturing campus called BlueOval City near Stanton.

And in Austin, Texas, facilities that house parts suppliers and related manufacturers are locating near Tesla’s and Samsung’s advanced manufacturing plants. Tesla’s Gigafactory opened in the area last year to manufacture EVs. Samsung’s $17 billion semiconductor plant is under construction in Taylor, a hip small town on the northern edge of Austin. A joint-venture of Houston-based Hines and New York-based Galesi Group is developing 1.7 million sq. ft. of logistics and industrial space on a 150-acre site in Austin in proximity to Samsung’s semiconductor factory.

The partnership with Galesi Group, which owns hundreds of acres of land at Harris Branch in northeast  Austin, is allowing Hines to expand its footprint in Austin, Laura Denkler, managing director at Hines, told the Austin Business Journal. She says that the first phase of this 1.7-million-sq.-ft. master-planned business park will include three class-A industrial warehouses totaling 315,000 sq. ft. to accommodate tenants with a need for 30,000 to 150,000 sq. ft. of space.

Additionally, Chicago-based CenterPoint Properties, a national industrial real estate owner/investor, has acquired two class-A buildings located in Innovation Business Park in Hutto, a small community adjacent to North Austin’s tech manufacturing hub. CenterPoint spokesman Mike Noonan says the presence of advanced manufacturing facilities in the vicinity was a major factor that played in the decision to acquire these assets.

These facilities, which include a total of 361,467 sq. ft. of warehouse space on more than 20 acres, are within a short distance of Samsung’s Austin plant and eight miles away from its new chip plant, which is under construction in Taylor, while the Tesla Gigafactory is 25 miles away.

Warehouse space of that quality is in short supply in Hutto, a small city in a growing population area that provides immediate access to SH 130 and proximity to labor and amenities not available elsewhere on the SH 130 corridor, said Rives Nolen, CenterPoint’s senior vice president of investments.

The assets’ design provides the ability to divide the space into leasable units of 70,000 sq. ft., the most desirable size among users here, added CenterPoint Investment Officer Justin Gallagher, who adds that the market is expanding and demand for space here is expected to grow.

Meanwhile, Dallas-based developer Jackson-Shaw is planning to develop a 67-acre business park near the Tesla plant and Austin-Bergstrom International Airport called ATX 130.  The project will offer 602,400 sq. ft. of office, warehouse and distribution space, according to the Austin-American Statesman. Chicago-based Molto Properties has also announced plans for Blue Springs Business Park, which will include 600,000 sq. ft. of industrial space in Georgetown, which is just north of Austin.

Rent premiums

Despite record low vacancies, only 26 million sq. ft. of manufacturing space was completed in the U.S. over the last year, or just six percent of total industrial space delivered, said James Breeze, senior director and global head of industrial and logistics research at commercial real estate services firm CBRE. CBRE recently launched a new global EV services line to meet the growing demand for EVs.

“We have already seen demand for manufacturing space significantly affect rents,” Breeze added, noting that at the end of 2022, the availability rate for manufacturing space averaged only 3.4% and asking rental rates for manufacturing facilities increased by a record 22.7% to $8.39 per sq. ft./per year net.

Overall, rents for both manufacturing and warehouse/distribution space have risen approximately 40 percent since 2018, according to Rodriguez, who said that continued demand for space in the industrial sector, coupled with a slowdown in speculative construction nationally, should allow rents to continue to grow, albeit at a slower pace than over the past few years.

What’s driving investment

Energy instability in Europe sparked by the war in Ukraine and persistent inflation are driving a surge in foreign automakers investing EV facilities in the U.S., according to Matter. A report from Site Selection noted that a recent survey of about 350 member companies of Germany’s mechanical engineering business association, VDMA, found that three-fourths of respondents intend to expand their U.S. business activities, two-thirds will increase their U .S. workforce and 37 percent plan to expand their U.S. production facilities.

Part of Volkswagen’s reason for focusing more on the more stable and predictable U.S. market, for example, is resiliency strategy, according to Rich Thompson, JLL international director of supply chain consulting.

A change in the federal tax code should also boost domestic EV production, as consumers can now only qualify for the $7,500 EV tax credit if the EV is assembled in the U.S., added Rodriguez.

Opportunities for developers

Current EV development activity is just the tip of the iceberg. Rodriguez notes that while manufacturers have stepped up leasing activity, most of them still want to own their own factories, which may provide build-to-suit opportunities for developers. “There are tremendous costs associated with building these facilities, so it typically makes more sense for the facility to be manufacturer-owned,” she said.

Large companies have their own real estate divisions contract directly with construction companies to build factories. Ford Land, Ford Motor Co.’s real estate company, for example, chose Detroit-based general contractor Walbridge to build Ford’s battery and electric vehicle manufacturing campus, called BlueOval City, on nearly six square miles near Stanton, Tenn.

But smaller manufacturers and ancillary suppliers do present BTS opportunities. Matter suggested there are new opportunities for speculative industrial development as well. Real estate services and advisory firm Newmark, for example, reported that demand for manufacturing space in the fourth quarter of 2022 represented nearly 20 percent of all U.S. industrial leasing activity.

Prologis, CenterPoint, Link Logistics and Panattoni are among industrial developers/owners that are leasing facilities to manufacturers, according to Matter. He noted that any modern industrial building can potentially be utilized for advanced manufacturing that flexibility is built into the project.

The primary differences between a manufacturing facility and a warehouse are the size of the office space  and energy capacity, Matter said. Factories typically include 10% office space vs. 3% to 5% in logistics facilities and require a minimum of 4000 amps of electricity, while logistics facilities have a capacity of 2,000-3,000 amps.

Building industrial facilities for advanced manufacturing requires a higher initial capital investment than logistics use, according to Matter, but he notes that manufacturing tenants tend to invest millions of dollars in additional infrastructure in the spaces they occupy that adds value for owners. When they leave, things like solar panels, power upgrades, gas tanks, clean rooms and other specialized equipment are often left behind, which adds speed-to-market value for the next tenant that landlords can capitalize on with higher rent.

Site selection basics

The top Sunbelt markets for absorption of manufacturing space are located near ports of entry or distribution hubs with growing populations, including Austin, Jacksonville, Fla., Atlanta, Louisville, Ky. and Phoenix, according to Breeze. Rodriguez added that site selection for EV and EV-related manufacturing facilities has been centered on South Carolina, Texas, Georgia, Ohio, Kentucky and  Tennessee.

The main drivers for locating manufacturing in these areas include availability of labor, proximity to major transportation hubs and infrastructure, and financial incentives provided by state and local governments. A business-friendly environment that expedites entitlements and permitting has been one of the most appealing factors for manufacturers because speed-to-market is the top priority in selecting a manufacturing site, according to Matter.

With exponential growth in EV sales anticipated over the next decade, their first- and second-tier suppliers and third-party logistics (3PLs) firms will likely increase their footprints in Southeastern and Midwestern industrial markets in the next two to five years, said Kim. “Many of those companies are leasing, as they don’t have long-term contracts with the manufacturers,” he noted.

The Newmark report noted that auto manufacturers are locating their EV production facilities near existing auto plants and converting combustion engine plants to produce EVs to take advantage of existing supply chains and skilled labor. To maximize efficiencies, EV battery manufacturers are putting their facilities in proximity to the EV plants they supply with batteries. LG Energy Solutions, for example, located its $4.4 billion battery factory in Toledo, Ohio, near the Honda plant, Matter said. As a result, there are opportunities for investors to develop facilities to house companies that provide support services to these factories.

Nearshoring boosting development

Opportunities for building manufacturing facilities along the U.S.-Mexico border are also likely to increase with electrification of the auto industry. The Brookings report noted that this transformation provides an opportunity to build an integrated and resilient North American EV supply chain underpinned by the United States-Mexico-Canada Agreement (USMCA).

Morgan Stanley Real Estate Investing already has about 2 million sq. ft in manufacturing developments rising along the border, and TPG Inc., CBRE Investment Management and Clarion Partners have either invested in property along the border or plan to, according to a Bisnow report, which noted that newly constructed space gets snapped up quickly in the area.

Source: “Growth in Electric Vehicle Production Expands Opportunities for Industrial Developers“

Belen will get a big economic boost with the expansion of a wind-tower manufacturer into the area, one that will add roughly 250 jobs. Texas-based Arcosa Inc. announced Tuesday its subsidiary, Arcosa Wind Towers, will open a wind-tower production facility in Belen with production to begin as soon as next year.

The company’s expansion into New Mexico is aided by $4 million in Local Economic Development Act money from the state, which will be disbursed as the company meets economic development benchmarks.

“We look forward to expanding our manufacturing capacity to New Mexico, where market demand for new wind projects is robust,” Antonio Carrillo, president and CEO of Arcosa Inc., said in a statement. “Our new facility will strengthen our position in the wind-tower market and enable Arcosa to benefit from growing wind investment in the Southwest. We are pleased to create new jobs in the State of New Mexico, which has been a supportive partner and a strong proponent of wind-energy development.”

The announcement of the new facility comes as the company has received $750 million in tower orders, many of which are for projects in the southwest.  Deliveries of those orders are expected to begin in 2024 and go through 2028, the company said.

Arcosa, a publicly traded company, plans to invest $55 million to $60 million in the expansion, which includes the purchase and modification of an existing facility in the Rio Grande Industrial Park and the procurement of needed equipment.

Gov. Michelle Lujan Grisham has long identified sustainable energy as an industry ripe for further growth – an area which she believes can attract higher-paying jobs for New Mexicans.

In 2021, New Jersey-based WTEC Energy Corp., with state assistance, announced it would bring more than 300 jobs to New Mexico with its expansion into Chamberino. The company manufactures wire cable designed to power solar projects and wind turbines. WTEC also announced plans to use its Chamberino facility to eventually produce wind towers.

“The transition to clean energy brings with it more diversified, higher-paying and skilled jobs,” the governor said. “Arcosa is repurposing an old factory for new investments in our state and our communities – this is a win-win.”

Additionally, the New Mexico Economic Development Department said Arcosa can qualify for Job Training Incentive Program funds. The city of Belen is also planning on assisting the expansion through industrial revenue bonds, or IRBs.

Once Arcosa expands into Belen, payroll is expected to hit $12.5 million annually. The company’s expansion, according to the state, will have an overall economic impact of $314 million over the next decade.

Belen Mayor Robert Noblin expressed his excitement for the Arcosa expansion, saying the “anticipated creation of 250 jobs is vital to our local workforce and economy.”

Source: “Arcosa chooses New Mexico for new wind-tower production facility“

Executive Summary

• The Consumer Price Index (CPI) rose by 6.0% year-over-year and 0.4% month-over-month in February, in line with consensus expectations. Lower energy prices helped reduce the annual rate from 6.4% in January.
• Core inflation, which excludes food and energy prices, rose by 5.5% annually. On a month-over-month basis, core inflation increased more than expected by 0.5%.
• Although the Fed has made progress in its inflation fight, the February CPI reading makes clear its job is not yet finished.
• CBRE expects the Fed will increase rates by 25 basis points (bps) next week, provided that recent stress to the banking system eases. The Fed also may slow its quantitative tightening campaign.
• Over the near term, recent banking sector turmoil will be a headwind for commercial real estate, lessening occupier demand and dampening capital markets activity as credit underwriting standards tighten further.

The Bottom Line

The Fed has made progress in its fight against inflation, as the annual rate has fallen to 6% in February from a peak of 9% in June 2022. However, the rate of decline in annual inflation each month is beginning to slow and core inflation rose more in February than in January. This indicates that the Fed’s job is not yet finished.

Recent stress in the banking system—specifically, the second and third largest bank failures in U.S. history during the past few days—will complicate the Fed’s balancing of risks as it sets policy. Nevertheless, we expect that the Fed will increase the federal funds rate by another 25 bps next week to a range of 4.75% to 5%. Although more gradual rate hikes may be necessary, the Fed could pause if banking system stability further erodes. We also anticipate the Fed may slow its balance sheet reduction (quantitative tightening).

CBRE maintains its view that the U.S. economy will enter a recession later this year. Stress in the banking system will further impact credit availability for real estate and other parts of the economy. These factors will result in lower occupier demand and subdued investment activity. As the rate-hiking cycle peaks in coming months, we expect that capital markets activity and leasing demand will pick up late in the year.

Source: “Economic Watch: Annual Inflation Falls to 6% in February; 25-bp Rate Hike Likely Next Week“

Initially, the COVID-19 pandemic dealt a heavy blow to office and multifamily demand. As cities across the U.S. closed indoor spaces, office workers resorted to working from home, and many of those workers moved to homes further away from urban centers. Multifamily renters in expensive, shuttered downtowns fled major metros for more affordable markets where a home office fit within their budgets. From Q4 2019 to Q1 2021, EA’s Sum of Markets¹ national vacancy rate for office rose 380 basis points (bps), and the multifamily vacancy rate rose 80 bps (170 bps within urban cores).

In Q1 2021, multifamily demand sprang back. As soon as cities eased pandemic restrictions, pent-up demand for urban amenities was uncorked, and multifamily vacancy rates plummeted. The national multifamily vacancy rate dropped to its lowest reading on record at 2.4%, with some large metros, like New York City, recording vacancy rates below 2%. Housing shortages and increasing unaffordability became a growing national concern.

Meanwhile, office demand did not have the same bounce-back. The virtual work era lingers, and office vacancy rates continue to rise, with the national rate reaching 17.3% as of Q4 2022 from a pre-pandemic low of 12.2% in Q4 2019. Additionally, office space preferences have shifted. As CBRE Econometric Advisors (CBRE EA) noted in a recent Viewpoint, higher quality office spaces, with modern amenities and modern structures (higher ceilings, usable rooftops), are increasingly in demand, leaving some older buildings that lack these features stranded, with few interested tenants.

This tale of two recoveries has led to the popular suggestion: why don’t owners convert stranded, low-demand office space to high-demand multifamily units? The notion gained significant media attention as a cure for the nation’s persistent housing shortage. It’s been nearly two years since the gap between office and multifamily demand widened. Are we seeing markets reallocate space in accordance with changing demand? If not, why not?

Have OTM Conversions Increased Since COVID-19?

Slightly, but not significantly. It has been two years since multifamily demand sprang back from its COVID-19 slump. Office demand is lagging due to the persistent impact of virtual work. We would expect to see a corresponding increase in the rate of OTM conversions over the past two years if the relative demand of the office and multifamily sectors drives conversions, but despite the perfect cocktail of multifamily/office vacancy rates, the rate of OTM is little changed over the past 10 years.

Figure 2 shows the number of OTM building conversions, and subsequent new multifamily units underway, started each year since 2000 for the largest 65 metros by population in the U.S. In 2021 and 2022, 33 and 38 OTM conversions were started. Though this is up from 23 and 26 conversion starts in 2019 and 2020, neither is significantly different than the 10-year average of 30 conversion starts a year2. It does not appear that the widening gap between office and multifamily vacancy had any impact on conversions.

Let’s put this in perspective: Figure 3 shows OTM conversions account for a very small number of multifamily completions. Since 2000, 47,656 units in 486 buildings have been converted from office to multifamily. This represents approximately 1% of the over 4 million multifamily completions delivered over the same time period, and only about 0.3% of CBRE EA’s Sum of Markets multifamily stock as of 2022. Though conversions have been increasing, they have roughly kept pace with overall new multifamily construction since 2014. OTM conversions contributed the most to new multifamily housing in 2011, when conversion deliveries were relatively steady, while new multifamily development lagged.

Figure 3: Contribution of OTM Conversions to Yearly Multifamily Completions

While we do not find a statistically significant relationship between a spike in multifamily demand and OTM conversions, we do see the number of starts increase. And there are caveats to this method of analysis. First, because the number of yearly conversions is small, it’s difficult to separate the signal from the noise when any variation could arguably be random. Second, we’re not making an apples-to-apples comparison when examining the construction environment before COVID-19 and the 2021-2022 period, which was beset by supply pipeline disruptions and construction delays.

Without the construction challenges in 2021-2022, those insignificant additional conversions could have grown into a significant number. On the other hand, there is no clear and consistent link to historic variations in conversion starts and the multifamily construction.

Why are OTM conversions so rare?

Conversions remain rare because NOI and property value differentials between office and multifamily are unlikely to cover the cost of conversion.

According to CBRE’s North American Cost Consultancy, the cost of converting an existing office building into a multifamily development varies considerably from project to project: “internal partitioning, reworking of plumbing and electric, and distribution of HVAC throughout the building must be addressed, as must the redesign of spaces that include multifamily amenity areas, such as a gym or lobby. The cost of conversion may range from $100 to $500+ per square foot, depending on the original layout, existing conditions, and exact scope of work.”

Meanwhile, there’s not much difference in returns between the average office and multifamily space, despite the gap in vacancy rates. In 2022, CBRE EA estimates that the average multifamily building, with 96.5% occupancy, recorded a NOI of approximately $16 per sq. ft. per year and sold for approximately $300 per sq. ft. Whereas the average office building, with an occupancy of 83.7%, had an approximate NOI of $15.50 per sq. ft. per year and sold for approximately $320 per sq. ft.

The current vacancy differential between multifamily and office space clearly isn’t covering the cost of conversion for an average building. The events of 2021 that widened the gap between multifamily and office vacancy don’t appear to have created enough of a gap to spur any more OTM conversions than we see in any year.

So, what is special about the handful of office buildings that are successfully converted year after year?

Characteristics of Converted Buildings

Summarizing the characteristics of OTM converted buildings in our dataset in the table below, we find converted office buildings tend to be smaller, older, and more vacant than the average office building. All of which speak directly to justifying the cost of conversion.

Smaller and older buildings are prime targets for conversion because they are less costly to convert. Housing regulations require natural light for multifamily units. The typical office building, built in the 1980s and ‘90s, has a deeper, more square-shaped floor plate, which limits the number of interior multifamily units possible through conversion. Square office buildings larger than 14,000 sq. ft. increasingly lose convertible square feet due to unlivable interior space³.

Converting a 57% vacant office building to the average 4.6% vacant multifamily building will bring obvious gains to NOI and property value. High-demand metros have lower vacancy rates and should attract even more conversions. But Figure 4 shows that while high-multifamily-demand metros do show up in the list of top conversion markets (NYC, D.C., LA), so do lower-demand markets in the Midwest (Kansas City, Cleveland, St. Louis), suggesting there’s more to this equation than simply chasing demand.

Figure 4: Conversions vs. Multifamily Vacancy from 2000-2022

The common factor shared across both higher and lower demand metros in Figure 4 is local government incentives aimed at downtown rejuvenation and/or historic building preservation⁴. For example, tax credits for historic building preservation in Missouri and Ohio have helped developers in Kansas City, St. Louis, Cincinnati and Cleveland make financing work for multiple downtown conversions.

Demand differentials alone do not appear to drive most OTM conversions. Conversions are limited to a relatively rare subset of older, smaller and mostly vacant office properties in a handful of markets with downtown rejuvenation incentives, likely because these are the only properties for which the cost of conversion can be justified.

Given these findings, where might we see OTM conversions in the future?

Which markets have smaller, older, downtown space available?

We searched our database for metros with the highest OTM conversion potential—metros with the most downtown office buildings that are more than 50% vacant, with a floor plate less than 15,000 sq. ft., built before 1980.

The amount of office space meeting these criteria is a very small segment of the overall office market. Only 1.1% of total office space on the market is smaller, older, mostly vacant and downtown. This number grows quite a bit, to 13%, if we relax the criteria to only older and smaller buildings, suggesting there is a larger pool of convertible office space should market conditions shift to make OTM conversion construction less cost prohibitive.

There are a few reasons we limited our forecasts to downtown. First, downtowns are facing higher office vacancy rates as virtual work lingers. Second, downtowns are more likely to receive local government conversion incentives, with policy makers in Chicago⁵ , Boston⁶ , Washington, D.C.⁷  and New York⁸  showing recent interest in supporting conversions to boost downtown revitalization efforts.

Manhattan not only sees the most conversions at present, but it also has the most office space meeting our criteria for future conversion potential, and so we expect it to remain the leading market for OTM conversions. West Coast and Mountain cities, currently not leaders in OTM conversions, may be the next frontier due to the relatively large and untapped number of smaller, older, and mostly vacant office buildings in those high-demand multifamily markets.

We expect OTM conversions to gradually drop off in the near term, as the cost of capital rises, and the stock of easily converted buildings dwindles. But the future of OTM is difficult to predict. It’s a niche market with idiosyncratic drivers. Re-purposing unique, historic office buildings, and contributing to downtown revitalization may not have an immediate macro impact on housing, but it is a meaningful contribution to urban sustainability, with likely spillover effects further down the line in rejuvenating neighborhoods. Further, increased media attention, interest from companies like Silverstein Properties⁹ , and steady local government support could extend the conversions market beyond smaller, older, and mostly vacant office space, creating new opportunities for conversion investment in the medium term.

Has the flight to quality created more vacant, smaller, older space?

Not by much. There aren’t many buildings that fit the criteria of being older, smaller, and mostly vacant. As Figure 6 shows, while demand has softened among office space across class types, vacancy has risen the most among Class A buildings, rising and remaining above Class B/C vacancy from Q4 2020 to the present day.

Figure 6: Office Vacancy by Class

This seems to contradict the CBRE EA research we cited in the first section that claimed office preferences are shifting due to a flight to quality—how are tenants upgrading the quality of their space if the highest vacancy rate is in Class A? Because demand isn’t shifting that far. This is a connecting flight to quality—which as an upcoming CBRE EA Viewpoint titled “The Hardest Hit U.S. Office Buildings” will explore in detail—shows that many of the hardest hit buildings are in the Class A- space, built between 1980 and 2010, whose tenants moved up to Class A+. Class B/C remains attractive to frugal tenants priced out of Class A space. So, while office demand is softening overall, the buildings more likely to be orphaned by the flight to quality are too new, large and expensive to make convenient conversions. There simply isn’t much easily convertible, low-cost, office space available.

Figure 7: Share (by count) of Hardest Hit Office Buildings and Overall Markets by Year Built

Conclusion

The idea of converting vacant office space to multifamily units is enjoying a moment in the spotlight as a quick solution to the persistent housing shortage impacting many urban downtowns in the U.S. It seems like an obvious resource reallocation. The uptick in virtual work precipitated by the COVID-19 pandemic saw workers trade commercial office space for home office space. Why shouldn’t landlords do the same in the face of higher multifamily and lower office demand?

Unfortunately, it’s not as simple as that. Elevated multifamily demand on its own is not enough to justify the cost of conversion in most cases. Successful conversion candidate buildings exist in a rare intersection of supply, demand, and cost characteristics, in which the primary factors tend to be related first to cost of conversion (building size and shape, government funding) and second to office/multifamily demand (older buildings in rejuvenating downtowns). Different markets have different dynamics and successful conversions will make a powerful impact to some submarkets, providing an opportunity to rejuvenate historic buildings and neighborhoods. But we find few office buildings meet the required criteria, and that OTM conversions will likely remain a drop in the bucket compared with total supply of either office or multifamily space.

Source: “The Rise and Fall of Office to Multifamily Conversions: A Real Estate Investigation“