Old Office Towers Turning Into Apartments

Investor's Business Daily

Dan Mayock and his colleagues at SSH Real Estate spent three years seemingly trapped in ownership of a partly vacant office building as their local market soured with the commercial real estate crisis and the recession.

Then they made a big move: To get more mileage out of the property, which Mayock says had some "dicey" tenants anyway, they converted it into apartments.

And so far, so good.

With multifamily housing in demand, a growing number of office property owners are revamping old 9-to-5 office buildings into round-the-clock residences with the appeal of city life. It's happening around the U.S. even as signs point to an office market recovery in many metro areas.

It was back in 2007 that SSH bought its 100,000-square foot-office tower at Philadelphia's 12th and Chestnut streets. That was right before the city's office and condo markets tanked, in 2008.

The company "sat on it" as a 60%-leased office building, says Mayock, director of investment services at the firm.

Suited For Restyling

While it proved hard to fill the space with new office tenants, the 104-year-old building had the type of smaller, irregularly shaped floor plates (rentable area) and other features ideal for apartment conversions, says Mayock.

So when it looked like the city's apartment market was making a comeback in 2010 — and financing became available — the SSH team decided converting the office tower to apartments would be a lucrative route to take.

Several factors helped drive SSH's decision to convert.

"The building was made with great floor plates for an apartment conversion and it was next to a Lowe's convention-center hotel and Jefferson University Hospital, where there was a good medical student population," said Mayock.

SSH finished the conversion in July 2011, had apartments about 95% leased by the second quarter of 2012 and sold the building to Invesco Real Estate of Dallas that July. The sale came just as the market for high-quality apartment projects in Philadelphia was "heating up," letting SSH give a better return to investors, Mayock says.

A growing number of cities are set to see office properties converted to apartments and other uses, or demolished, and several factors drive these trends.

Many people want to live in cities now, for work or urban amenities. Meanwhile, demographics show the typical apartment-age population is swelling, while some people shy away from single-family homeownership or can't afford it.

These and other factors add up to a vibrant market for multifamily-housing investors, at a time when many older office buildings, such as the one SSH converted, are being deemed obsolete.

"We're definitely seeing this trend from office to multifamily continue to kick up," said John Sikaitis, managing director of local markets and office research at commercial real estate firm Jones Lang LaSalle (JLL). "We're seeing the amount of geographies participating starting to widen.

Downtown Manhattan and Los Angeles have been at the forefront of the trend, he adds, posting a combined 18.1 million square feet of conversions in the past decade. Sikaitis says conversions have been happening "more aggressively" the past two years in several cities, including Philadelphia and Baltimore.

"Since the office market recovery started in the second half of 2009, over half of the gain in occupancy is attributed to the removal of office space through demolition," said Walter Page, director of office research at CoStar Group (CSGP). "And half of those (removals) have been for residential uses.

Condo and apartment conversions constitute 34% of the lost office space in CoStar's database, and another 13% of office space has been demolished to make way for new residential construction, according to a CoStar report.

Market Dynamics

The pull of apartment demand is a clear spur for conversions.

"We have a red-hot apartment market with record rents and record-low vacancy rates," said Page. He adds that the national vacancy rate for apartments reached a record low of 4.0% in the third quarter. And net absorption for apartments, or the amount of rental space filled, rose 28% from a year ago with rent growth at 5.4%.

On the flip side, Page says, office market rents are 7% below the level that would support construction of new office buildings in many markets.

"We have rents at the high end to support construction for apartments and condos, and not for offices," he said.

Adds Jones Lang LaSalle senior research analyst Sean Coghlan:"Given the cost of ground-up construction and potential rental income from multifamily properties compared to office assets, returns on office conversions — even if some form of office de-tenanting is required — are notably higher in select markets such as Baltimore, Pittsburgh and Philadelphia.

The multifamily sector is "very strong" for investing in real estate for a few reasons, says Douglas Bibby, president of the National Multi Housing Council.

"We've got very strong demographics and household formation trends working in our favor," Bibby said.

The growth in single-family heads of households is strong, he says, which bodes well for apartment living. And there's a trend toward unrelated people living together in the wake of the housing downturn and high unemployment.

Also, baby boomers are downsizing to apartments. And, he adds, there are people who were "burned" during the housing downturn who are leery about getting into an ownership situation and are opting to rent.

The key factor driving the conversion trend is the demographic shift in where the millennial generation, ages 18 to 32, opts to live vs. the baby boomers, adds Sikaitis. Over the past five years there's been a "flight" on the part of the millennials to urbanized environments, which has helped drive increased demand for more multifamily housing, he says.

On the supply side, Sikaitis notes, many cities in the Northeast and Midwest have prewar office buildings that have become "functionally obsolete," with features such as smaller floor plates that "don't align" with today's office tenants.

"The types of office buildings being converted don't tend to affect the market because they're not the type of properties that a broker would define as competitive office space," said Jon Southard, managing director of the Econometric Advisors group for commercial real estate firm CBRE Group (CBG).

In terms of the "competitive" space, how much gets torn down or converted is a very small percentage of the stock in any area, he adds.

Page expects the office-to-multifamily conversion trend to continue. "The flight to quality is very prevalent in the office sector, and outdated space is becoming more difficult to lease," he said.

There's evidence that tenants desire new office space. For the most part, buildings constructed since 2008 have leased up, and the vacancy rate for 2000 to 2007 for vintage buildings is the lowest of any office subset, at just under 10%.

"In contrast, due to vacancy in the older 40- to 50-year-old vintage buildings, investors are often converting these to residential uses," Page said.

Overall, the office market recovery has been "slow and steady," says Southard, noting that U.S. office vacancies fell to 15.1% in the third quarter from a peak 16.8% in the second quarter of 2010.

For a more "normal vacancy rate," the figure needs to decline to the vicinity of 13%, Southard adds.

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