Long-lasting crisis in the Chinese real estate sector
1 September 2023
26 October 2023
New government incentives and shifting market dynamics could make it worth US real estate owners’ time—and money—to move forward with office-to-residential conversion projects.
With the shift to hybrid work models, there is much more unused office space available that, if converted to residential use, could help mitigate the dearth of affordable housing in the US market. To date, the economics of such a shift is not supported by the differing pricing dynamics in these two asset classes. But a variety of developing factors may make conversions more attractive and feasible for investment. The Deloitte Center for Financial Services predicts that office-to-residential conversions could become profitable within the next five years. We estimate that around 14,700 affordable units in central business district (CBD) areas across the country can be added by 2030, assuming approximately 20% of converted square footage can be earmarked for affordable housing.
Estimates suggest that there is just shy of one billion square feet of available office space in search of tenants in the United States, nearly 1.5 times the amount from the end of 2019. With a shortage of nearly three million homes, the US housing sector has emerged as a likely recipient of the unused downtown office space. So far, the US commercial real estate industry has been slow to respond: Between 2016 and 2021, there were, on average, 31 housing conversions from office products per year, totaling 188 projects. And while many Americans are still working from home, at least part of the time—a trend that will likely continue—only 217 conversion projects are in the immediate pipeline for completion.
Government and business leaders appear to be taking notice. Some political leaders at the local and state levels have put forward legislation or called for action specifically supporting office-to-housing initiatives. These actions could provide incentives for real estate developers to provide Americans with clean, affordable, and safe places to live. Here are some of the initiatives in the works so far:
City governments have provided these types of incentives for conversion projects before. In the early 1990s, New York City passed the 421-g tax abatement program, incentivizing 13 million square feet of downtown Manhattan conversions. And Philadelphia passed its own abatement program in 1997, resulting in 180 building conversions.
When considering these types of conversions, one of the biggest challenges owners and developers face is whether—and when—their investments will pay off. We anticipate that, by 2027, shifts in rents, valuations, acquisition costs, and conversion costs, in addition to added government-backed incentives, could allow developers to achieve a net profit on conversions of underutilized office space in favor of residential space.
Layout aside, two valuation assumptions could deter developers in the near term: comparable rent and vacancy levels. The median asking rent for an apartment unit in the United States is around US$22 per square foot (psf). With US office rents still averaging US$37.38 psf, a 41% pricing concession in addition to an amortized cost of conversion is a tough pill to swallow. Additionally, developers would be unlikely to convert a building with a below-average vacancy that is still operating best as an office building.
Over the years, high conversion costs may have deterred developers from converting underutilized office buildings into affordable residential buildings. However, since 2020, several new government-enabled incentives have been announced to provide supply-side solutions to help address both the shortage of affordable housing and the increasing number of vacant office spaces. Several regions are making progress in developing tax policies that will make these conversion projects feasible, with several developers already moving at the opportunity:
A combination of some of the benefits provided by local governments can make the math work for conversions at scale. In particular, government incentive programs can help make conversions more feasible by easing restrictions around zoning and density, providing direct financial subsidies and tax abatements, and waiving off or redistributing infrastructure upgrade costs to a longer time horizon.
Currently, real estate owners face financing issues due to elevated interest rates. But they don’t have to go it alone. Public/private collaborations with lenders focusing on community development, government agencies, and impact funds may help with this transformation. Affordable housing remains at the top of agenda for the federal government, with US$213 billion planned in government incentives to support affordable housing under the US$2.25 trillion infrastructure plan. Proposed legislation was modeled after the 2022 Revitalizing Downtowns Act, which aims to provide tax credits for such conversions.
More centralized land use planning, inclusionary zoning, and state-level initiatives can make way for more market-rate developments with designated affordable housing that can help address the affordable housing gap. Distress in the office sector could lower valuations in the next two to three years. This may provide an opportunity for collaborations among developers, government bodies, and lenders to prop up the affordable housing shortfall and revitalize downtowns. Stronger relationships between developers and local and state municipalities could be what’s needed right now, especially in addressing the dearth of affordable housing in the United States.