The Road Ahead for Office Conversions

The upswing in remote work induced by the COVID-19 pandemic has had the global demand and occupancy rates for offices plummet to their lowest. And though the home administration in various countries relaxed their social distancing norms, “Hybrid” was touted as the “New Normal” implying lesser days in office for the people and shared workspaces for the organizations. While some parts of the US embraced the “New Normal” and acquired greater occupancies over a period, the national office vacancy rate hit a 30-year-high of 17.1% in Q3 2022 and was last reported at 19.6% for Q4 2023.

Even as the tenants took to the offices in 2022 after a long, convenient haul, their understanding and consequently, their expectation of office space underwent a paradigm change. They sought more value in terms of location, design, quality, and sustainability. They wanted the most modern facilities laden with amenities even if it meant paying more for a smaller space. Employees, meanwhile, were guided by considerations such as the proximity to public transport, quality finishes, amenities, and flexible working schedules.

With these expectations almost carved in stone, it became a tight rope walk for the older buildings with obsolete configurations and designs to attract more tenants.

In the wake of lower occupancies and record-low effective rents, the office owners had only two options to sustain themselves…either to offload the property at a lower price to other property operators or repurpose the property through demolition or conversion.

Since then, the term ‘Conversion’ has become a buzzword for office revamp. And as the office occupancies dived further, 2023 saw five times more conversions planned for office properties in comparison to 2022. But before we draw our conclusions and see “Conversion” as the panacea for all Office sector woes, it’s essential to consider several aspects critical to achieve purposeful transformations.

The first crucial step in office conversions is determining the alternative use for the property. This decision depends upon the location, age, floorplate sizes, configuration, depth, and clear height of the property. The most common conversion of offices has been to multifamily properties. This choice is largely driven by the housing demand-supply gap as the multifamily market can effectively absorb the additional supply of apartments while maintaining low vacancies and yet achieve sustained rent growth. While conversions are most successful in infill locations where land for new development is scarce, office conversions to multifamily have little relevance to the CBD location such that a greater inventory of older properties in the suburbs can also be repurposed. This is a huge facilitator as 30% of office inventory in the US comprises of older properties constructed prior to 1980.

However, when converting to hotels, the CBD location becomes an imperative factor. Considerations extend beyond CBD location, and encompass factors such as whether the property has proximity to major employers in the region, convention centers, sports stadia, entertainment venues and other relevant amenities etc.

Additionally, whether the office is converted to multifamily or hotel, the zoning regulations, and requirements for the converted use (which differ from market to market) need to be complied with. These zoning regulations dictate how the properties can be used. In particular, changing the zoning from commercial to residential is fraught with difficulty and is a tedious and time-consuming process. So is adhering to building codes specific to residential use that adds to the costs of conversion. These codes ensure safety, accessibility, and habitability for the occupants. While some buildings are excellent candidates for conversion, zoning regulations and site-specific requirements must be carefully analyzed.

The age of the office building also plays a crucial role in conversion. Older buildings may have outdated configurations, designs, and materials. If the buildings are constructed prior to 1978/79, they may contain asbestos and lead based paint or have other environmental concerns which involve additional costs and expertise to operate and manage. Remediation efforts, if needed, can further add to the operational and management costs.

That being the case, feasibility studies are not only imperative but inevitable to ascertain if the benefits from conversion will justify the capital costs of conversion. This is especially so because each building is unique and presents different challenges. The conversion process involves massive expenditures with respect to plumbing, HVAC, bathrooms, kitchens, light & electrical fixtures, and interior finishes. And to top it all, the apartments/rooms so created essentially demand the provision of windows for natural ventilation, thus adding to the costs, timelines as well as carbon footprint.

Yet another viable alternate use of offices can be Life Sciences facilities. These are properties that house research and development pertaining to biotechnology, pharmaceutical industry, digital health and medical technology, molecular biology, and environmental sciences. They are a subset of the Research & Development category.

The discipline of life sciences is the industry for improving life. Research in life sciences and its underlying sub-disciplines has assumed greater significance in the post COVID-19 era as we strive for increased life expectancy, seek greater health awareness, and look to prevent and combat diseases in a more effective and timely manner. This propels the need for life science real estate. What makes it lucrative for the investors are the top-end rental rates that these facilities command along with stable demand, both of which are result of the processes involved in the research activities, most of which are very niche in character and can only be conducted in the laboratory.

Additionally, office-to-lab conversion requires shorter timelines (18 months vs 2-3 years for other alternatives) with permits and zoning approvals much easier to obtain. Location considerations for Life sciences facilities include proximity to educated workforce, housing, and amenities as well as transportation.

The flip side however is creating the laboratory infrastructure with specialized features and cutting-edge technology which is extremely expensive. These features mostly include higher ceilings to accommodate upgraded HVAC requirements, bigger rooms for research, increased loading docks with separate freight elevators, enhanced security and safety precautions, increased mechanical, electrical and plumbing engineering (MEP), all of which cost relatively more to provide. 

And while the investors contemplate alternate uses for the property, they also need to strategize the execution of the improvements since none of the office properties are ever 100% vacant. Consequently, the landlords are drawn to buy back the existing leases to enable tenant relocation for capital improvements. This further dents the operating potential of the properties.

However, instead of converting the entire building if the landlords focus on only those portions of the office buildings which are either vacant or undesirable such as spaces with no or poor views, they can then consider a partial conversion that modifies the office to a mixed-use property. Such conversions have been gaining ground because they have the unique advantage that the tenants need not vacate the property while the capital improvements for conversion are being carried out.

In conclusion, there is no “one size fits all” theory as all offices may not be suitable for conversions and the choice of converted use depends upon the overall size, age, configuration, location, and the floor size of the property. When done in cognizance of these factors the conversions not only optimize the potential of the property but also help to recover capital costs within a reasonable time frame. And while the federal government is supporting office-to-residential conversion projects through a program of grants, low-interest loans and tax incentives, the crux of the matter lies in creating such spaces which are coveted (both by businesses and people) so as to ensure sustained occupancy and growth in rental rates for the converted use.