Among the sectors hardest hit by the pandemic, the office sector continues to struggle as post-pandemic business norms evolve and companies maintain a cautious approach to space commitments. Facing a tough market for 2023 and beyond, office property owners and managers are challenged to preserve value through leasing efforts and must embrace resourceful, creative asset management and repositioning strategies.
The “return-to-work” path looks different for every employer, as companies balance employee expectations with the requirements of doing business. Will employees work remotely, in office, or will they adopt a hybrid working model? Employee schedules remain in flux, so space requirements are hard to define. Companies are waiting to make space decisions until they are forced to do so by looming lease expirations or renewal options that they must exercise or decline.
The softening job market may help to boost office demand. With less competition for employees, employers have more leverage to get workers back into the office. Time will tell if this makes a material difference in office occupancy.
Certain markets are more competitive in terms of office demand, such as Dallas, Miami, Raleigh, and Nashville. There are numerous reasons for this, but one main factor is that these cities are viewed as “company friendly” markets, offering aggressive incentive packages for companies to operate there and are more favorable tax climates.
Overall, we have not yet seen a material change in tenant demand for office space. It is a tenants’ market, and landlords are being very accommodating to get deals done. They are holding face rental rates as much as possible, but tenant improvement allowances and rent abatements are not subsiding.
Some property owners used the window of low occupancy during the COVID shutdown as an opportunity to upgrade their properties with refreshed lobbies, destination-direct elevators, and new amenities. While we did not see the recovery we expected in 2022, these properties will be in a more competitive position when the market begins to recover.
While occupancy remains low and transaction volumes are down, office owners may continue to focus on asset management. Now is the time to catch up on deferred maintenance and address outstanding regulatory or compliance issues to protect asset value. Investing in building efficiency can reduce operating expenses and increase asset value. Exploring alternative revenue sources, such as rooftop solar or technology tenants, may reveal options to increase operating income and asset value.
Repositioning via Conversion
Seeking creative strategies to bolster value, some owners and managers of office portfolios are looking to convert struggling properties to more profitable uses, such as multifamily, hotel, student housing or self-storage.
Cost is the primary barrier to successful conversions. The proposed new use must offer sufficient income/value potential to offset the construction costs required to convert the property. Given current capitalization rates for multifamily–even considering increases due to rising interest rates—multifamily is the top conversion candidate.
Municipalities are beginning to see the value in repurposing vacant office buildings. Empty office buildings result in lower real estate tax revenue. They also hurt optics; that is, current and prospective companies doing business within the municipality may see low occupancy office buildings as an eyesore. Converting these buildings to other uses is an opportunity to breathe new life into an area. As a result, a municipality may subsidize conversion projects with tax credits, tax increment financing, or tax abatement (either full or partial abatement). These development tools are not necessary in every case, but they can often help bridge the gap in real estate returns to make a conversion financially feasible.
Far from a simple solution, converting an office building is a costly endeavor with challenges ranging from market factors, engineering obstacles, zoning and permitting hurdles, and construction risk. We have valued a number of converted office properties. Some of these conversions have been more successful than others. The reasons for less-than-successful outcomes have included poor design for the new use, cost overruns, and construction delays causing the project to miss its prime leasing season, i.e. a student housing project missing housing application deadlines, or multifamily coming online in the winter months in a midwestern or northern city.
A qualified consultant can help mitigate some of the challenges to successful office conversions through well-scoped due diligence.
- A market study can help identify the highest and best use for an asset according to the characteristics of the surrounding market area and provide market information such as rental rates and occupancy data to support decision making.
- A feasibility study will assess zoning ordinances, utility services, traffic generation, storm water and slope constraints, investor return requirements, performance forecasting, construction budgeting, and other land use planning factors that can affect the viability of a change-of-use project.
- A property condition assessment (PCA) can be customized to support repositioning by addressing building system capacity and condition for both the existing use and the proposed use. This approach can be beneficial in validating rough order of magnitude (ROM) construction budgeting; highlighting building systems that will require extensive modification or replacement; preparing pro forma documentation; and supporting discussions with investors and bridge/construction lenders.
- Construction risk management services, such as contractor evaluations, document and cost reviews, and construction monitoring can ensure the conversion is successfully executed as planned.
Despite bracing headwinds over the short- to mid-term future, owners and managers of office properties have options to maintain and even increase the value of their portfolios. By staying abreast of market conditions and leveraging the support of valuation, engineering and construction consultants, savvy office investors can stay competitive in this challenging market.