By James Nelson
At first glance, the idea of converting office space into residential space would seem like an easy answer to dealing with the post-Covid office space glut while solving market rate and affordable housing. We can see clear evidence of this strategy at work in the financial district, especially after 9/11 when 10,000 new residential units were created, boosted by the 421g tax abatement program, in apartment buildings of existing offices. In the process, the office vacancy rate has tightened, and within 20 years, downtown Manhattan has become a vibrant neighborhood in which to live, work and play.
Today, New York’s challenges have more serious implications. With an availability rate in Manhattan approaching 20%, there is approximately 100 million square feet (sf) of office space currently available. Most of this space is in Class B and C buildings, many of which are outdated and in need of renovation. Unlike post-9/11, when there was a shared mission to rebuild, the dynamics of today’s office culture have changed, some would say permanently, as the return to the office (RTO) of Manhattan is 56% from pre-Covid.* We are dealing with the aftermath of fundamental changes in the way we all work.
Regardless of the debates over how much office space will be taken up, few can argue that there is a desperate need for housing. I’ve heard estimates that New York will have a shortfall of 530,000 units by 2030. With 421a expiring, I can personally attest that we’ve seen a massive drop in land sales. In 2018, the quarterly average for land sales is 24. Five years later, in the third quarter of 2022, there were 14 land sales, which represents a 43% decrease from the average.
The idea of converting offices into residences seems like a no-brainer. Yet since the start of the pandemic, only two office buildings out of 77, according to counts by Avison Young, have been converted into housing. Why is it? For there are three major considerations/hurdles to overcome for these conversions to become a reality:
1) Cost basis – only five office sales after Covid have been below $400/RSF, which is the level that most developers believe is a baseline for exploration. With the increase in construction costs due to the supply chain, these conversion costs could also reach $400/pc. Office properties are sold on a rental basis, so when the average 27% loss factor is removed and the net square footage is calculated for residential, the rental amount could decrease by 30% or more. Thus, if a developer’s all-inclusive base reaches $1,000/NSF, even with residential rents at $100/SF if taxes and operating expenses deduct one-third, the return on cost for a developer could reach only 6%. That doesn’t look too appealing in today’s rising interest rate environment, especially since the 421g tax abatement program was the previous incentive that enabled successful post-9/11 conversions.
2) Zoning – a dozen of the office buildings sold in Manhattan post-Covid were in M-zones, meaning they cannot be converted as of right.
3) Floor plates – most office buildings are built deep on the ground and do not provide adequate light and air for residential development. In most areas, residential requires a back yard of 30% on an intermediate block or 20% on a corner.
New York City and the State must provide programs to overcome these barriers. The New York panel has been created and it looks like the city and state are focused on this issue. The Real Estate Board of New York (REBNY) offers support. My hope would be that the 421g program, or something similar, could be advanced to make these conversions economically feasible. Assuming that rezoning would be necessary, the amount and
Affordability levels should be carefully reviewed to ensure projects are still feasible. Otherwise, all this will be for nothing.
Urgency is key. Chicago has already adopted a plan to allow this. Cities across Canada have already mapped office buildings that are good candidates for conversions. Typically, New York rezonings can take 18 months for environmental impact statements and community review. We don’t have that time because with rising interest rates it will become increasingly difficult for the private sector to address this situation.
In the meantime, we can start simple, which would be Buildings B and C which have the right zoning and the right light and air to facilitate a conversion. Personally, I propose the idea of living-working zoning that would allow buildings with deeper floor plates to have offices in the middle of the building and living quarters on the perimeter. I think the numbers would be on our side with this approach, especially if cut and sold for condos. Either way, we need good ideas, and we need them fast!
*Avison Young Vitality Index data from the week of October 17, 2022