From Los Angeles to New York, Underused Office Buildings Become … – CoStar Group

When new tenants started moving into a historic 18-story tower in Tacoma, Washington, they weren’t the office users who’d populated it for nearly 100 years. Developer Unico Properties converted the building, home to businesses since 1923, into the Astor — a 156-unit apartment building.

It’s just one conversion of underused offices across the country to meet rising demand for housing. In Dallas, a 49-story office tower downtown is in the early stages of an office-to-residential conversion. An 18-story building dating to the 1960s in downtown Atlanta may become more than 200 new apartments. And in West Hollywood, California, a 4,200-square-foot condo in a recently completed conversion of an 80,000-square-foot office building is on the market for more than $17 million.

Demand for housing at all levels across the United States — and in California in particular — has not kept pace with supply. As part of its ongoing, multipronged approach to addressing that problem, the state of California has added another layer of incentives to encourage developers to convert underutilized office space into residential.

The nation’s most populous state, which also has the biggest U.S. homeless population, is setting aside hundreds of millions of dollars to aid in the transformation of underutilized office space into housing. It’s a move that’s piqued the interest of landlords and developers as remote work renders some traditional offices obsolete. And it spotlights an issue that transcends California and offers a potential remedy that, if effective, could get adopted in other states across the country trying to address housing shortages.

California’s latest budget, signed into law by Gov. Gavin Newsom on June 30, calls for spending $400 million as an incentive to developers to convert commercial and office buildings into affordable housing in the budget years 2022-23 and 2023-24. It’s part of a larger $2 billion appropriation over the next two years aimed at building more affordable housing in a state where the median price for a home was $898,980 in June, up nearly 10% from the year earlier, according to the California Association of Realtors.

“These grants will help remove cost impediments to adaptive reuse (e.g., structural improvements, plumbing/electrical design, exiting) and help accelerate residential conversions, with a priority on projects located in downtown-oriented areas,” according to a budget summary.

Even so, critics argue that these projects are costly and probably won’t put a dent in the demand for affordable housing, which officials around the country say is needed. While acknowledging the limitations and shortcomings of the effort, advocates counter that efforts need to be made, even when the effect can only go so far.

California has plenty of company in looking to address a persistent housing shortage by providing incentives for the conversion of underutilized properties to residential uses. New York Gov. Kathy Hochul signed a bill into law in June to simplify the process to convert some hotels within or near residential zoning districts to operate as permanent residential spaces. These hotel conversions may be eligible for some funding through state grants.

Hines plans to convert the 217,000-square-foot, 24-story South Temple Tower in downtown Salt Lake City to a 255-unit luxury apartment building. (CoStar)

Office-to-residential conversions are occurring nationally as demand for office space fades. One Wall Street, the former home of Irving Trust bank, recently wrapped its five-year, $1.5 billion transformation into a condo building in lower Manhattan. It is now the biggest office-to-residential conversion in the city’s history. In Salt Lake City, Houston-based developer Hines plans to convert the 217,000-square-foot, 24-story South Temple Tower in downtown Salt Lake City into a 255-unit luxury apartment complex. Projects are also in the works in Dallas and Atlanta and in Tacoma, Washington, among other cities.

These types of conversions are nothing new for downtown Los Angeles, where an ordinance has encouraged adaptive reuse of buildings into new living spaces for roughly two decades, said Peter Belisle, market director at JLL, who oversees the Southwest region, which includes Las Vegas, Los Angeles, Orange County, Phoenix and San Diego.

Belisle said the $400 million in funding from the state has excited some real estate developers who are eager to learn more about how to obtain these incentives for their own projects.

“This new incentive program could be pretty compelling,” Belisle said. “Without incentives, a number of these buildings today don’t pencil.”

Numerous hurdles must be overcome for office-to-residential conversions to make financial sense for real estate owners. For example, the office building must be in a location where people want to live, meaning it must be proximate to amenities and services, Belisle said.

In addition, developers need to figure out how to make windows operable in office buildings that don’t have this feature. Plus, these buildings must be shallow enough to bring in natural light to the units.

“Unlike a Carnival cruise, no one is going to rent an apartment that doesn’t have windows,” said Jay Lybik, national director of multifamily analytics at CoStar Group.

These types of conversions are rare nationally and often make sense with older office buildings that have smaller floor plates, Lybik said. Those buildings are more common in office markets such as Chicago and New York City.

The newer office stock in California and Sun Belt markets is less well suited for these conversions, so government incentives may not be best spent chasing after these projects. Other states have struggled to woo developers with similar incentives. In New York, a $100 million fund set up in 2021 to incentivize hotel-to-residential conversions only drew one applicant, showing that even incentives aren’t enough to overcome the challenges these deals present, according to Politico.

“[It’s] not a good use of public money,” said Ken Rosen, chair of the Fisher Center for Real Estate and Urban Economics at the University of California, Berkeley. “If it makes economic sense, and if the building has the right bones, it will happen here.”

The state’s Housing and Community Development Department estimated in 2019 that California needs to add 1.5 million housing units by 2029 to meet anticipated demand. Construction has not kept pace. An average of just 80,000 units have been added annually over the past decade, well short of the minimum 150,000 needed to meet long-term targets.

On a national level, average apartment vacancy is a mere 5% despite roughly 850,000 units under construction. That building activity is the highest since the 1970s, Lybik said, but these units are taking longer to complete because many are in high-rise and mid-rise buildings, not the garden-style complexes common a half-century ago.

“The impact to availability is much lower than just looking at the construction number,” Lybik said.

Unico Properties is nearing completion on the residential conversion of the former Washington Building, an 18-story office tower dating to 1925 in downtown Tacoma. (CoStar)

The office-to-apartment conversion push comes after the office market has weakened nationally. Employees continue to take advantage of remote-work policies, leading many major employers to reduce their office space needs. Office use was at 44.1% in the week of July 13 in an average of 10 major U.S. metropolitan areas, according to data from security firm Kastle Systems, which tracks office attendance. That figure has remained flat since July 2021.

Chris Tourtellotte, managing director of Los Angeles-based apartment developer LaTerra Development, said he doesn’t think the office market is going to improve in California, which would open up more opportunities for such conversions. LaTerra is under construction on 3,000 apartment units and is exploring several office conversion deals involving apartments and other uses.

Tourtellotte said that while these conversions are expensive, public incentives can potentially help make the projects feasible even for affordable homes.

“We’re in a housing crisis,” he said. “What better thing to do than to convert vacant office into housing?”

In San Francisco, often billed as one of the nation’s hardest-hit markets during the pandemic, the office vacancy rate rose 15.5% over the past year, according to CoStar data.

Meanwhile, the Los Angeles market’s average office vacancy rate climbed 3.7%. San Diego bucked the trend, with its office vacancy rate decreasing by 9%.

But across the board, the largest California office markets are dealing with near-record amounts of sublease space more than two years into the pandemic. Los Angeles has 10 million square feet of space available for sublease, or about 2.3% of its total office footprint; San Francisco has roughly 9.4 million square feet, or about 5% of its total office inventory; and San Diego has 2.1 million square feet, or about 1.7% of its total.

One Dallas Center, designed as an office building by I. M. Pei & Partners, was redeveloped by Todd Interests, with the top 16 floors converted to 276 for-lease residences. (CoStar)

At the same time, Los Angeles needs to add 457,000 units by 2029, according to the city’s planning department; the San Francisco Bay Area needs to add 441,176 by 2031, according to the Association of Bay Area Governments; and San Diego needs to add 171,685 by 2029, according to the San Diego Association of Governments.

Ultimately, office-to-residential conversions are considered by advocates as just one piece of the puzzle to solving California’s housing shortage.

However, because of the high construction costs of converting office spaces, these projects probably will result in more market-rate housing, not affordable apartments that are desperately needed, Lybik said.

“We have to figure out how to build rental housing at the affordable price points,” Lybik said. “Unfortunately we continue to not be able to do that in the multifamily sector.”