By James Nelson
On the surface, the idea of converting office space to residential use would seem like an easy answer to address the post-Covid office space glut while solving for market rate and affordable housing. We can see clear evidence of this strategy at work in the Financial District, especially post 9/11 when 10,000 new residential units were created, spurred by the 421-g tax abatement program, within existing office buildings. In the process, the office vacancy rate tightened, and over the course of 20 years, Downtown Manhattan has become a vibrant live, work, and play neighborhood.
Today, New York’s challenges have more severe implications. With the availability rate in Manhattan approaching 20%, there is roughly 100 million-square-feet (sf) of office space currently available. Most of this space is in class B and C buildings, of which many are outdated and in need of renovation. Unlike post 9/11 when there was a common mission of building back, the dynamics of today’s office culture have shifted, some would say permanently as Manhattan’s return to office (RTO) is at 56% compared to pre-Covid.* We are dealing with the aftermath of fundamental changes in how we all work.
Regardless of the debates on how much office space will be absorbed, few can argue that there is a desperate need for housing. I have heard estimates that New York will be at a 530,000-unit deficit by 2030. With 421a expiring, I can personally attest that we have 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% decline off the average.
The idea of converting office to residential seems like a no-brainer. Yet, since the onset of the pandemic, only two out of 77 office buildings, by Avison Young’s counts, have been converted to residential. Why is this? Because there are three major considerations/obstacles that must be tackled for these conversions to become a reality:
1) Cost basis – only five office sales post-Covid have been below $400/rsf, which is the level that most developers would say constitutes a basis worth of exploration. With increased construction costs due to supply chain, that conversion costs could also reach $400/sf. Office buildings are sold on a rentable basis, so when the average 27% loss factor is removed and the net square footage is calculated for residential, the rentable amount could decrease by 30% or more. Thus, if a developer’s all-in basis reaches $1,000/NSF, even with residential rents at $100/SF if taxes and operating expenses deduct a third, the return on cost for a developer might only reach 6%. This doesn’t seem too attractive in today’s rising interest rate environment, especially given that the 421-g tax abatement program was the previous incentive that enabled the 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) Floorplates – most office buildings are built deep on the lot and do not provide the proper light and air for residential development. In most zones, residential requires a 30% rear yard on a mid-block or 20% on a corner.
New York City and State must come up with programs to tackle these obstacles. The New York panel has been created and it would seem both the City and State are focused on this issue. The Real Estate Board of New York (REBNY) is offering its support. My hope would be that that the 421g program, or something similar, could be brought forward to make these conversions economically feasible. Assuming rezoning would be required, the amount and
levels of affordability would have to be looked at carefully to ensure that the projects are still feasible. Otherwise, it will all be for naught.
Urgency is the key. Chicago has already adopted a plan to allow for this. Cities in Canada have already mapped out office buildings which are good candidates for conversions. Typically, New York rezonings can take 18 months for environmental impact statements and community review. We don’t have this time as with rising interest rates, it will only become more challenging for the private sector to attack this situation.
In the interim, we can start simply, which would be B and C buildings that have the right zoning and proper light and air to facilitate a conversion. Personally, I propose the idea of live-work zoning that would allow buildings with deeper floorplates to have office space in the middle of the building and residential on the perimeter. I think the numbers would be on our side with this approach, especially if chopped up and sold for condos. Either way, we need good ideas, and we need them fast!
*Avison Young’s Vitality Index data sourced representing week of October 17, 2022