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
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“