In the real world, how to convert commercial into residential space
As remote and hybrid work has become the norm for many in the wake of the COVID-19 pandemic, the U.S. faces a drastic oversupply of office space alongside a housing affordability crisis in many cities. Converting underutilized office space into apartments is a compelling solution to address the challenge posed by stranded office real estate assets. It offers the potential to reduce the vacancy strain on office markets, provide additional housing units to relieve demand pressure in dense areas and revitalize cities more broadly through additional foot traffic which can help to reverse aspects of what we have dubbed the “urban doom loop.”
Conversion, however, is easier said than done. It is complicated by physical, financial and regulatory challenges and will require careful policymaking in order to facilitate these shifts effectively. We explore the challenges in greater length in a paper, “Converting brown offices to green apartments,” jointly written with Candy Martinez and published with the Hamilton Project at the Brookings Institute. We propose a series of criteria to identify office properties in the U.S. that are physically suitable for conversion, finding 11% of office buildings in high-density commercial districts meet our criteria. Using a model publicly accessible at the Hamilton Project’s website, we uncover the parameters under which these conversions are also financially viable for developers.
Fertile ground for transition
The good news for New York City is that, relative to many other metropolitan areas, the office stock is unusually suitable for conversion. That’s because New York City has a large concentration of pre-World War II office buildings, which often make for excellent conversion candidates, as buildings with smaller floors (say, below 15,000 square feet) are relatively easier to convert. These older office buildings, usually called Class B or Class C space (there are no official rules, it’s a you-know-it-when-you-see-it categorization system), are also cheaper given shifts in office preferences for newer class A+ buildings. What’s more, these buildings will also face steeply increasing carbon taxes on their emissions due to Local Law 97, a statute intended to combat climate change.
Converting these brown office buildings to green apartments therefore satisfies a number of policy objectives at once. New York City’s relatively high apartment rents also provide a natural economic rationale for conversion — the other piece of the equation.
The good news for New York City is that, relative to many other metropolitan areas, the office stock is unusually suitable for conversion.
There is historical precedent for conversion activity in New York, as demonstrated by the experience in the Financial District in Manhattan. Weaknesses there in the office market, beginning in the 1980s and 1990s and continuing after 9/11, led to large vacancies — and then pro-conversion incentives, in particular the 421-g property tax abatement program, which spurred the creation of 12,865 housing units in the area between 1996 and 2001. Ultimately, after 421-g kickstarted the process, over 30,000 apartment units were created in total office conversions, many outside the program.
This conversion activity turned the Financial District into a revitalized, mixed-use neighborhood, as the full-time residents attracted new retail and businesses. This experience serves as a model for other office-heavy neighborhoods such as Midtown.
The economic rationale for conversion in our current postpandemic era has so far led nine large buildings to file for conversion permits, with the potential to generate 4,095 housing units. Another 64 buildings are enrolled in the City’s Office Accelerator Program, set up to help developers navigate the red tape and speed up conversions.
The policy needed to nudge developers
But there’s much more potentially convertible space and a deep need for new housing. Recognizing the challenges, both New York City and New York State officials have recently proposed policies to spur office conversion activity. Following the 2022 “New New York” vision statement and the January 2023 office reuse task force study, City government is actively pursuing its own plan to fight the office vacancy crisis.
It has three pillars. The first is the City Economic Development Corporation’s Manhattan Commercial Revitalization plan, which has already begun to subsidize up to 10 million square feet of transformative upgrades of office buildings from class B to class A+.
The second pillar is the City of Yes for Economic Opportunity, a broad range of zoning reforms meant to make New York more business-friendly, including some that would facilitate adaptive reuse of offices into alternative commercial use. This includes uses such as life science, industrial, tech, maker spaces, home-based businesses, retail and more. It passed the City Council in June.
The third pillar is the City of Yes for Housing Opportunity, another sweeping Adams administration zoning reform that will come before the Council in the fall. This seeks to produce more housing in every neighborhood, notably by giving a density bonus for affordable housing, allowing for as-of-right office-to-residential conversions for offices built before 1990, reducing parking requirements, allowing for accessory dwelling units and more.
Additionally, the Midtown South Mixed-Use Plan would rezone a part of the city with many vacant or underutilized office assets to allow for residential use. In addition, the City Council approved the City of Yes for Carbon Neutrality last year, a set of zoning changes to facilitate the green transition of the built environment.
The recent New York State budget included legislation — complementary to Adams’ “City of Yes” reforms — that expands zoning eligibility for conversions to newer buildings, while removing statewide limits on residential density, currently capped at FAR 12.
Our analysis suggests that the economics of conversion are a knife’s-edge case, highly sensitive to conversion costs, interest rates, loss factor and the strength of the apartment rental market.
The state budget also includes a property tax abatement program: Office-to-apartment conversions qualify for a 90% property tax abatement for 35 years if 25% of the units in the project are affordable. Five percent must be permanently affordable to households with an income below 40% of the area median income, and overall 25% must be permanently affordable to households whose income does not exceed 80% of area median income.
All this will help encourage office conversions. We believe the loosening of regulatory constraints is particularly important, including the new allowance for co-living arrangements.
We are more doubtful that the property tax abatements are sufficiently generous to developers to lead them to choose conversions that contain affordable housing. We have modeled the effects of the new affordable housing provision, and find that, under realistic parameters and current market conditions, developers will prefer to do market-rate conversions rather than take the subsidy and provide 25% affordable units. Making the affordability requirement permanent turns out to be a particularly costly provision in the bill.
In our hypothetical Manhattan class-B office conversion, the conversion with 25% affordable units results in a net present value to the developer that is negative, and $7 million lower than the identical market-rate conversion. Of this $7 million gap, $5 million is due to the permanency of the affordability requirement.
While insufficient, the property tax exemptions introduced in the budget present a large cost to taxpayers in terms of forgone tax revenue. We estimate that each affordable housing unit will cost $1.175 million to taxpayers.
But does it pencil out?
And so, our analysis suggests that the economics of conversion remain a knife’s edge case, highly sensitive to conversion costs (which differ for each property), interest rates, the amount of interior building space lost in conversion and the strength of the apartment rental market, which varies over time and by neighborhood. Even conversion of office buildings to market-rate apartments is economically challenging in the current environment.
Our calculations also suggest that the financial incentives to create affordable units are insufficiently generous to developers to lead them to include affordable units, yet expensive to taxpayers. Many developers will find it uneconomical to take advantage of the subsidies, while those who do will cost taxpayers substantially in foregone tax revenue in order to produce a small number of affordable units.
New York City has seen radical changes and reutilization of real estate over its history. Once thriving manufacturing districts have been replaced with thriving retail, residential and office space. Though white-collar work helped New York City cope with the loss of manufacturing employment, the city now faces a new challenge as remote work has led to the exodus of professional workers away from the urban core.
Converting empty office buildings into apartments can stem the tide of urban decay and ensure that the city remains an attractive and vibrant destination. However, doing so at scale will require careful and thoughtful policymaking for years to come.