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A Primer for Office to Multifamily Conversions

Several converging factors are making office-to-multifamily projects more appealing for investors and capital providers. Here's what you need to know.

The onset of the pandemic and the subsequent years brought several market realities to light. One is the need and demand for housing virtually every­where in the country. The other reality, particularly in light of the work-from-home phenomenon, is the U.S. simply has too much unwanted office space.

Housing prices have reached levels no longer attainable for many young adults, and the market for decent rentals is often competitive, particularly in areas close to employment centers. Multifamily occupancy, rent growth, and development surged across most U.S. markets, fueling investor appetite and asset values. The pace of the expansion has since cooled, but the sector remains healthy, with absorption back in positive territory, vacancy at 5.1%, and rents at a record high of $2,184, according to a Q3 2023 CBRE report.

Even more telling are long-term construc­tion trends, which have skewed in favor of single-family homes versus denser quarters. According to the Bipartisan Policy Center, 8.4% more single-family home permits were awarded between 2000 and 2021 than the historical aver- age of the prior 40 years. At the same time, permits for housing with five or more units declined by 16.4%.

Compare that to the office sector, depicted in Table 1, which is undergoing a massive reset as the definition of the workplace evolves. Companies have been shedding unused space for several quarters, resulting in sustained negative absorption and vacancy hitting a 30-year high of 18.4% by third quar­ ter, with a mere 40 bps difference between downtown and suburban offices. Conversely, the margin between asking and taking rents is getting wider, while tenants continue to exhibit a preference for smaller leases and Class A space. All of this is making it harder for office owners to generate enough net operating income (NOi) to service their debt. According to recent studies, U.S. office values could decline by as much as 30%, or more than $500 billion, by the end of this decade.

There's a reckoning coming for the office sector, and a bank of underutilized and obsolete Class Band C office assets will be left in its wake.

Given these conditions, it would make sense to tum that unwanted office space into housing-in theory. The truth is that despite the perfect cocktail of multifamily versus office fundamentals, the rate of office-to-multifamily (OTM) projects has changed little during the past 10 years. During the past two decades, OTM conversions have accounted for just 1% of overall multifamily deliveries. With much of that product at the upper end of the market, the OTM conversion strategy hasn't done much to help address the nation's housing crisis.


The  problem with OTM is office buildings aren't always good candidates for conversion. Turning offices into apartments isn't a simple matter of sectioning off space. These buildings often have centralized plumbing, electrical, and HVAC systems that must be overhauled to accommodate individual units with kitchens and bathrooms. Office buildings' deeper and wider floorplates also require creativity to allow for natural light and other necessities expected in multifamily units. In addition, myriad building codes and requirements can add to the cost and timeline of the conversion project.

For this reason, it's tough to justify a conversion without focusing on high-end properties in urban cores, employing a unique approach, or both. In San Diego's Gaslamp District, for instance, one sponso bought a semi-vacant mixed-use building for $8.2 million in 2019. It then converted three floors of former office space into 27 microunits averaging 336 feet and renovated the existing restaurant on the ground floor. The sponsor implemented a high-end marketing strategy, banking on the success of a new office and technology campus rising across the street. The project has been completed and is currently undergoing lease up.

The other issue is that, by now, many of the viable assets in major downtowns have already undergone the process-take Lower Manhattan's post-9/u resurgence or the fruits of Los Angeles' Adaptive Reuse Ordinance, for example. As conversion opportunities shrink and migration trends move away from primary markets, investors and developers are looking to infill and suburban locations for options. The type of available office product prevalent in these markets-older vintages with smaller floorplates, campus-style office parks with parking, and shorter buildings with smaller cores and operable windows-is also physically and financially conducive for conversion to multifamily.

That helps to explain why growing share of conversions are in areas traditionally considered secondary and tertiary markets. Primary, gateway markets accounted for five of the top IO cities with the most converted apartments in 2020 and2021, continuing a longtime trend. In 2022, however, Los Angeles was the only major city on the roster, with locales like St. Louis, Missouri; Kansas City, Missouri; Tucson, Arizona; Kissimmee, Florida; and Alexandria, Viriginia dominating the list. And, according to Rentcafe's analysis, Tier I markets account for just four of the top 20 cities for future conversions.


Vacant commercial buildings are also a bane for local governments that rely on property taxes for revenue. A reduction in the tax base means there's less capital available to fund public services, further reducing a market's prosperity. Turning an underutilized office asset into housing can both boost the property's value and create an influx of residents to help support local businesses and offset lost tarevenue. Yet years of conversion trends have shown that the math on the types of OTM projects that would help transform cities won't work on a massive scape without public involvement-and investment.

Recognizing that the same zoning rules and regulations that helped cities manage sprawl in the past are now hindering their ability to adapt and evolve, municipal and state officials are aggressively trying to address the crisis. Public leaders everywhere are introducing legislation and initiatives to make conversions more attractive to developers. Several cities and states are offering new tax abatements, tax credits, grants, loans, and other incentives to promote OTM conversions. Others have allocated funds for future programs or are conducting studies on how to stimulate OTM activity in their towns.

Officials are also leveraging tools that are already in place, such as historic tax credits, tax-increment financing, and low-income housing tax credits. Existing programs are being adjusted and expanded, with officials streamlining approval processes and easing certain regulations to remove monetary and bureaucratic hurdles, rezoning areas to allow for more and denser residential product, reducing the age cutoff of applicable buildings for certain programs, and expanding the programs' reach beyond core business districts to infill and outlying neighborhoods.

Federal-level activity is also promising. Efforts to address the nation's housing crisis are intensifying, and OTM conversions are a large component. In January, sponsors introduced a new version of the RevitaHzing Downtown Act, which would provide a 20% tax credit on qualified office conversions of properties more than 25 years old. Such bills support trends indicating that nearly all currently scheduled OTM projects are on properties built before 2000 shown in Table 2. HUD has also released a notice of funding opportunity for a study of post-pandemic OTM conversions.


Although conversion activity this cycle has slowed slightly from the initial surge earlier in the pandemic, a convergence of factors will make OTM projects more appealing for investors and capital providers:

  • Nearly one billion square feet of U.S. office space is currently vacant. With more than 100 million square feet under construction, vacancies will likely increase with deliveries. The sustained reduction in office demand and tenants' continued flight to quality will render millions of square feet of older product obsolete.

  • Office is accounting for a growing share of overall delinquencies. Many loans are coming due in the next couple years and rising debt servicing costs continue to pressure borrowers. Owners will need to decide whether to refinance, get the assets off their balance sheets, or put capital into improvements. Given the tighter lending climate, the latter two options are more likely.

  • Although property types like hotels and industrial are more conducive to residential conversions, the window to buy them cheaply has passed and investor appetite remains high. As office values will fail to keep up with their counterparts, they will remain the primary target for reuse.

As of July 2023, 122,000 units worth of new conversions were under way, with 45,000 of them in former office buildings, per Rentcafe's analysis. Future conversions are expected to grow by 63%, and OTMs will comprise a greater share of these projects as more sellers adjust their valuations.

A more recent report from CBRE supports this theory (see Table 3 below and Table 4). About 100 office conversions are slated for delivery this year alone, up from a longtime annual average of 41. Another 201 conversions have been started or announced. These projects account for some 60 million square feet of space, or 1.4% of U.S. office inventory-a 20-basis-point uptick from last year. As expected, the markets with the most conversion activity not only have higher-than-average vacancies but also higher numbers of older buildings.

OTM projects make up 118, or 48%, of all upcoming conversions, with plans calling for 21,000 units to be created in the coming years. Office-to-mixed-use conversions account for an additional 18% of total projects. Most of the office conversions are thus far scheduled for 2025 or later, just in time for the expected rebound of both the multifamily market and broader economy. If the market demand and financial specifics are favorable, a strong sponsor with an OTM conversion project can be a great candidate for a bridge loan.

By Gary Bechtel

Private Lender, The Official Magazine of AAPL

Winter 2024, p. 20-28


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