What You Need to Know for an Office to Apartment Conversion

Pandemic-related precautions may be waning, but office building vacancy rates in major urban markets have increased to historical highs and do not show signs of  dramatic improvement for quite some time.  This is true despite employer requirements for employees to return to in-person work. By some reports, there is a looming apocalypse of failing office buildings with a number in key markets likely to be the subject of loan workout discussions with lenders .  This impending crisis is further fueled by a general trend (even pre-pandemic) toward office downsizings, increasing interest rates and other financial market uncertainties , office tenants’ flight to quality and away from the large inventory of aging buildings, unrelenting high office rents and the seemingly permanent reality of virtual work.  Should any number of these factors (or all of them) profoundly affect a building owner, how can office owners address this challenge, outside of selling their buildings at a meaningful loss or undertaking a demolition/redevelopment project, assuming that would even be feasible?

One Solution: A Conversion

The conversion of an office building to an apartment/multi-family use is one solution that can be pursued for an office that is experiencing significant vacancies and a resulting decline in value. 

• Conversions can be advantageous for a number of reasons, including their potential for higher returns, lower materials’ costs and reduced environmental impact when compared to ground up office redevelopment projects.

• Conversions also appeal to jurisdictions intent on preserving the urban fabric, increasing the rental housing supply, establishing more live/work environments and supporting more environmentally sustainable renovation projects. 
• However, conversions have traditionally been pursued much less frequently than ground-up development (or redevelopment) projects.  Since developers have less experience with these projects, they face more uncertainty around the financial, legal, physical/design and market risks that conversions present and how to best mitigate them.

Managing Conversion Risks:

A comprehensive due diligence process tailored to the specific issues presented by a conversion will go a long way to reduce the project’s risks and facilitate the development of a more accurate conversion budget.  This should include an assessment of the existing physical condition, structural issues, and design potential of the target building, the legal implications of changing its use from office to housing, the impact of existing market conditions and other relevant financial and transactional factors.

The ultimate objective of these due diligence efforts is to select the “right” building for the conversion that can be completed based on a reliable conversion budget (and, most importantly, to rule out others that are unsuitable due to, among other risks, the design challenges they present and the unanticipated costs they could yield). 

Critical Due Diligence Factors:

Here are several critical factors to evaluate before pursuing a Conversion:

• Physical Condition and Design Potential of Building

• From a conventional feasibility perspective, is the building structurally sound and are all needed operating systems and other building components functional?  Consider all renovation requirements (separate from those required for the conversion) to be included as part of the project (such as a need for a new roof or the replacement of elevators or other key building operating systems). Since it is likely that conventional office building mechanical and distribution systems will not work for a residential conversion, it would be prudent to budget for their replacement. 

• Are accurate “as-built” building plans available and can one or more schematic plans be developed that clarifies the conversion’s design challenges.  One potential setback in the conversion process is finding out (after the start of the project) that the building plans do not correctly depict key building elements.

• Does the building have physical, functional and technical components that support its conversion? Examples include major building components that can be reused and floor plans (including the building width) that can be easily adapted for residential use.  Pay particular attention to the depth and configuration of the floor plate and whether it is workable for apartments. Also, determine whether the building has a centralized interior core.  Is the distance from the perimeter of the interior core to the exterior walls of the building suitable for the desired unit count and bedroom types?

• Can the building be redesigned to accommodate the need for private kitchens and bathrooms and associated mechanical, engineering and plumbing systems? Check how much natural light comes into the building and whether the building have windows on all sides. If not can innovative design features (i.e., removing sections of the building to build courtyards) solve this challenge?

• Will the building accommodate residential amenities, including fitness facilities, club rooms, outdoor cooking areas and co-working spaces, since residents may be working virtually from home?  If parking will be required by the jurisdiction or desirable, is there existing adequate parking?

• How much “dead” space will there be after the conversion (i.e., space that cannot be designed into rentable units or amenities without significant retrofitting)?  Too much dead space that will be a drag on revenue might be sufficient to eliminate a building from consideration for a conversion.

• Requirements for Change-of-Use

• Does the proposed apartment use fall within the building’s existing zoning classifications or is a rezoning required? If not, understanding the process, timeline and obstacles are involved in obtaining needed rezoning and other entitlement approvals (including to pull required building permits) will be critical.  

• What building code requirements are applicable to the conversion and is it feasible to satisfy them with the anticipated changes to be made to the building?  Also determine the other regulatory requirements that must be satisfied (i.e., if the building is designated historic or in an historic district or overlay or if neighborhood review boards will be involved). 

• Will the jurisdiction favor a conversion?  This may likely be the case if the increase in rental housing or revitalization of neighborhoods is a priority.  This assessment should also cover the following questions: 
  • Are there available incentives or subsidies for a conversion?
  • Is a change in the building’s submarket from single-use office to mixed-use including residential an objective? 
  • Will the residential conversion have a positive impact on the surrounding area?

• Market Conditions and Building Submarket:

• Consider whether current market conditions are favorable for a conversion.  What are the vacancy rates in the building’s submarket and generally in the jurisdiction?  Are increasing numbers of office buildings being listed or auctioned for sale? Is there sufficient housing demand for the class and size of the proposed apartment community?
  • How might current supply chain issues impact the project?
  • What is the cost of needed equity and debt capital and can rising interest rates and costs in an inflationary environment be managed?

• Is the building’s location suitable for a residential conversion?  To increase the probability of a successful conversion, there must be adjacent access to public transportation and essential amenities (i.e., grocery, pharmacy and restaurants).  Also, the surrounding neighborhood should be a draw for prospective residents. 

• Do the demographics of the likely residents of the submarket, including income levels and employment status, support the demand needed for the project?

• Are there many competitive apartment communities located in the same submarket, suggesting that the project would face significant competition for prospective residents?

• Transaction Structure:

• Who owns the building, what is the building’s debt structure and what pressures is the owner under that might impact the sale price, such as an impending loan default?  Consider whether there are their looming regulatory requirements for the building, such as those relating to its environmental impacts) that would further depress its value.

• The key is to determine whether the pricing for a building sale be low enough to meet the parameters of the conversion budget.  If not, might an alternative transaction structure facilitate the conversion from a budget perspective (i.e., will the owner entertain a joint venture or ground lease transaction in lieu of a sale that could reduce the project’s costs)?

Customized Due Diligence is Key:

In pursuing an office to apartment adaptive reuse transaction, start with a comprehensive due diligence process that is customized to uncover the issues typically associated with a conversion.  This approach will enable developers to identify and develop work-arounds for the attendant risks in advance of committing to the project, leading to an overall positive outcome for the developer, its investors, and the relevant municipalities.

Pam Rothenberg (pam.rothenberg@wbd-us.com) is a Partner in the Real Estate Practice Group at Womble Bond Dickinson (US) LLP, Scott Hoffman (Scott.Hoffman2@cbre.com) is an Executive Vice President at CBRE and Steve Polo (polo@opxglobal.com) is the Managing Partner at OPX.