Can office vacancies give way to more housing? 'It's a step in the right direction'

NEW YORK – On a recent afternoon, Joey Chilelli, managing director of a commercial real estate investment and advisory firm, joined a small crew of construction workers as he stepped into a large cage-like mesh hoist elevator installed on the outside of a steel and glass office tower in the financial district of Manhattan.

Amid the cacophony of jackhammers and cement mixers, the elevator made a few stops on its way up as workers stepped off with trolleys carrying bags of cement before reaching the 28^th floor of 160 Water Street. There, set back from the perimeter of the roof, two more floors were rising.

By spring, the 1972-built, 24-story tower, which housed more than 1,200 offices until October 2021, will metamorphose into a taller residential building with 30 floors and 588 apartments, including a landscaped communal rooftop, a co-working space, gym, spa and other amenities.

Chilelli, who was visiting the site to check on progress, says the pandemic spurred the office to residential conversion.

“When 2020 hit, the office market took a pretty big turn,” he says. “There were no office tenants. Nobody knew what was going on, what the future would hold. But we felt conviction in the multifamily space.”

Plus, Vanbarton Group LLC, where Chilelli works, had done this before. In 2017, the tower next door, at 180 Water Street, went through a similar conversion resulting in 573 apartments led by Vanbarton and a development partner.

The pandemic has transformed how Americans live and work, which has had a domino effect on many sectors of the economy, but none as pronounced as the commercial real estate market in big cities. As remote and hybrid work has taken root, many companies have chosen to consolidate their footprint and move into smaller offices or even eschew office space altogether, leaving many office buildings in big cities languishing without tenants.

The overall U.S. office vacancy rate hit a 30-year-high of 18.2% earlier this year, according to CBRE. This has also meant that businesses that tended to office workers such as delis, coffee shops, or salons in big cities have been hit hard, with many of them shuttering.

Office-to-residential conversions have the potential to stop the erosion of a crucial tax base while restoring the vibrancy of cities, address a national housing shortage and affordability crisis and reduce greenhouse gas emissions, say proponents including the White House, which recently released a guidebook with over 20 federal programs across six federal agencies aimed at supporting conversions.

“It’s a step in the right direction,” says Stijn Van Nieuwerburgh, professor of finance and real estate at Columbia Business School, who along with Arpit Gupta and Candi Martinez co-authored a working paper on office-to-residential conversions for the National Bureau of Economic Research. “At the end of the day, we have too much office space, we have too little housing, and we also have too much CO2 emissions in our cities coming from buildings.”

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The real estate sector is a major target for emissions reduction policies as buildings account for 29% of the U.S. as a whole. The rehabilitation of existing buildings produces 50% to 75% fewer carbon emissions than new construction, according to the paper.

According to the White House guidebook, the 2022 Inflation Reduction Act offers climate-focused funding that can be used for commercial to residential conversions and help buildings achieve zero emissions as the conversions typically require the installation of all-new plumbing, new heating and cooling systems, new windows, doors and walls.

Chilelli says the converted 160 Water Street will have 75% fewer carbon emissions than the old office building and its carbon emissions will be well under the energy efficiency and greenhouse gas emissions limits set by New Yorks City's ambitious climate legislation, known as Local Law 97, for 2024 and 2030 that limits pollution from the city's largest buildings.

What are the challenges of office-to-residential conversions?

Around 15% of office buildings in the commercial districts of the 105 largest cities in the U.S. are physically suitable for conversion, according to the National Bureau of Economic Research working paper analysis. Discounting properties that still have a large share of long-term tenants in place reduces the inventory to 13%, and removing relatively clean buildings brings it closer to 11% of properties.

“A lot of office buildings are very large,” says Van Nieuwerburgh. “Think about a full block, large skyscraper in a major city. The floor plates are very, very deep.”

That means that they are not easy to divide into apartments because a lot of space in the interior of the building doesn’t get enough light or air.

“So you have to do something quite extensive, such as drilling a light well in the middle of a building where you literally take out a piece of the building in the middle so that you can have some light and air,” he says. “So that obviously creates a lot of extra costs and architectural complications.”

For instance, at 160 Water Street, three blind shafts had to be carved out through the center of the building, says Robert Fuller, the lead designer and architect. The lost floor area was then relocated to the top of the building.

Another issue developers face is regulatory challenges such as zoning laws that don’t allow residential buildings in certain commercial zones or building code regulations that make transformations difficult.

In New York City, for example, only buildings built before 1977 or 1961 are eligible for conversions, depending on where they are located.

In August, New York City Mayor Eric Adams unveiled plans to rezone manufacturing areas in Midtown Manhattan (home to a high density of office buildings) and make zoning changes allowing buildings built before 1990 eligible for conversion to housing. Both changes will require City Council approval.

“These outdated regulations are holding us back,” says New York City Planning Director Dan Garodnick. “We also think that there should be a tax incentive available that would both incentivize the opportunity to create housing and also include affordable housing as part of the mix.”

A proposal that would have extended a controversial tax exemption, commonly known as 421a, that served to incentivize developers to build affordable housing in exchange for tax breaks failed in the state Legislature earlier this year.

Streamlining the permitting process can also expedite the conversion timeline, say experts.

Then, of course, there’s the economics of conversion. For instance, how strong is the apartment rental market when a developer is done with their conversion?

The typical conversion is financially feasible in New York, San Francisco, San Jose, Boston, Washington, D.C., and Denver, according to the National Bureau of Economic Research report. These are markets where apartment rents are high enough to overcome the purchase cost of the office building and the cost of conversion, the authors say.

Fuller, the architect who led the design at 160 Water Street, says his firm, Gensler, has been studying quite a few underperforming buildings over the two years to see if they are suitable.

“For as much talk and interest in the subject, I'll say relatively few projects move forward because these are complicated and the ability to make them work financially is sometimes challenging,” he says.

The appeal of conversions for developers

The timeline for completion of the transformation generally takes about 30 months, inclusive of the permitting phase. This process is expedited in comparison to a ground-up development, which could take well over four to five years. In New York City, a conversion might cost $300 to $400 per square foot vs. $600 to $700 per square foot in a brand-new building, according to Chilelli.

"When we were on the design of this in 2021, we started to see the multifamily market really roar back, it really took off in New York," says Chilelli.

At 160 Water Street, which will have studios, one- and two-bedroom apartments, rents will be market rate and range from $3,500 to $7,500.

Vanbarton Group has another conversion in the works – an old WeWork building in Midtown Manhattan will be converted into a residential tower.

Earlier this year, California approved $400 million to incentivize commercial-to-housing conversions. Last year, Washington, D.C., launched a $2.5 million, 20-year tax abatement program for owners who add at least 10 housing units and change a building’s use in the downtown area, with 15% of those units being set aside for affordable housing.

“I think now is the time to act. The longer we wait, the more the problem will fester, the larger the vacancies will be and so the more intractable the problem will become,” says Van Nieuwerburgh.”Cities can play an important role to make that as simple and easy as possible.”

Swapna Venugopal Ramaswamy is the housing and economy reporter for USA TODAY. Follow her on Twitter @SwapnaVenugopal