Office Space: Bellwether for Distress or Opportunity for Revitalization?

5/18/2023

In the aftermath of the pandemic, and with the backdrop of slower economic growth, all eyes are turned to the office sector. Throughout American history, the office – and its underlying employment base – has significantly contributed to the lifeblood of a city. Companies long touted office locations as a central pillar in their recruiting strategy, and cities in turn benefited from tax revenue generated from corporate tenants and the employees that relocated to work there.   

Today, the office sector faces an economic, environmental, and existential crisis. Landlords find themselves at the convergence of disparate macro trends that negatively impact demand for office space, particularly among older buildings. Hybrid work, the rising importance of sustainability in decision-making and tenant flight to quality have put many Class B and C offices at the precipice of obsolescence. In total, American cities face a mounting crisis in the wake of hybrid work adoption and the associated loss of tax revenues.  

Hybrid work: In response to remote work trends adopted in the pandemic, employers are increasingly employing hybrid work strategies, both as a differentiating recruiting tactic and a source of cost savings. According to the latest Future Workplace Index survey, more than 70 percent of employees are working from home at least two to three days a week. While the survey indicates that a range of models, from fully remote to fully in-office, are currently in practice, employers are carefully evaluating their workplace strategy – and supporting real estate needs – on the backdrop of slower economic growth. In most cities, the impact of hybrid work has not been fully realized, given the longer term of most office leases. However, rising sublease space nationally serves as one indicator that the broader impacts of hybrid work are on the immediate horizon. 

Environmental, social and governance (ESG) policies: Additionally, the role of sustainability has become a key factor in both individual and company decision-making. For leading corporate tenants, ESG matters have had an increasingly important influence in leasing decisions, recruitment and overall corporate strategy. The heavier carbon footprint of older office buildings, relative to other commercial buildings, leaves Class B and C office landlords at risk from an economic and environment perspective. Additionally, across US cities, legislation akin to Local Law 97 in New York City, which fines landlords for failure to reduce greenhouse gas emissions by certain future dates, is rising. 

Flight to quality: The culmination of more employees working from home and a heightened focus on sustainability is evident in the flight to quality among corporate tenants in major urban centers. According to our analysis, Class A offices nationally leased up at a faster rate relative to Class B and C competitors over the past decade. Additionally, the capital required to upgrade subquality office properties is significant, and many times uneconomical.

Decreased Demand 

The impact of decreased demand for office space, particularly among older properties, produces a ripple effect in US cities: while vacancy erodes landlord returns and property values, the city must deal with an even greater aftermath. Across the nation, some formerly bustling central business districts (CBDs) now look like ghost towns, with a lack of daily commuters to fill downtown office skyscrapers and frequent the restaurants, public infrastructure and retail that were built to support them. Hybrid work continues to be adopted as a flexible working model across a range of industries, and this trend is expected to persist. 

Cities thus face an unprecedented challenge: as companies re-think their office footprint and population centers shift, governments must manage economic losses from a declining tax base and a growing stock of obsolete, older office properties that do not meet the practical or sustainability needs of today’s corporate tenants.  

The problem at hand represents one of the greatest challenges in the history of commercial real estate; solving it will require extraordinary collaboration between the private and public sectors. To revitalize downtown urban centers, cities must partner with private real estate investors to accelerate the redevelopment of qualifying office stock to other property uses through policy revisions, incentives and zoning regulations. If cities can create favorable conditions for property conversions, they hold the potential to revive blighted downtown centers, increase economic resiliency, and advance their own economic and social agendas.  

The art of property conversion 

In certain US cities, successful conversions from older office buildings have been undertaken by developers and repurposed to higher-demand property types, such as life sciences, multifamily and, in some cases, data centers. 

However, not every building within the existing Class B/C inventory represents a candidate for conversion. While there is no uniform playbook to follow, successful case studies to date suggest an initial set of property-specific characteristics must be present to make conversion physically possible. Then, when coupled with market-specific policies and incentives, conversions can offer a successful strategy for real estate redevelopment.  

Property-specific characteristics of office conversions include:  

• Favorable cost basis: As with any real estate deal, an investor’s basis is a determining factor for future returns. According to our analysis, Class B/C offices have suffered disproportionate declines in underlying value and transaction volume since the pandemic. A lower cost basis, coupled with the potential to re-use an older building’s shell, may provide significant cost savings over the life of the investment, relative to ground-up new development.  
• Accommodating zoning environment: Past successful conversions have occurred in municipalities that provide flexibility in changing a property’s zoning to allow for an alternative use. Jurisdictions possessing strict zoning regulations have historically discouraged developers from undertaking conversion projects. 
• Structural characteristics: Structural considerations around floor plate, floor-to-ceiling measurements and other critical infrastructure considerations such as plumbing and HVAC must be evaluated up front when designing future property use. When converting offices to residential, for example, the larger floor plates of older offices make conversion a more difficult proposition, given the inability of light to penetrate to the interior units of the property. Larger floorplates may also require the costly re-organization of essential building infrastructure, such as elevators, to create a better flow and common space for residential units. 
• Property location: The immediate vicinity of the property must be carefully evaluated to ensure the new property use is supported and successful upon conversion. For office-to-residential conversions, for example, consideration must be given to the surrounding amenities of the property, such as access to transportation, supporting retail and other critical infrastructure (e.g., schools). 
• Pathway to vacancy: Properties may be mostly vacant yet possess active leases in place. Investors must devise a strategy for physical vacancy for redevelopment work following acquisition of the property. Developers must plan for redevelopment around the remaining term on in-place leases and negotiate with existing tenants to incentivize physical vacancy of the property.  

From a development perspective, the benefits of conversion vs. ground-up construction can be compelling. In high-density markets such as New York City, ground-up development is not only costly but challenging in practice. Conversion can accelerate speed to market by leveraging a building’s existing infrastructure, ideally at a lower cost basis. Additionally, conversion can often result in a more sustainability-minded development. According to our analysis, redeveloping a property to net-zero emission standards can result in lower embodied carbon relative to new projects, given that the structure of the existing building is leveraged. Additionally, the conversion of older properties that include upgraded heating/cooling systems can result in reduced greenhouse gas emissions from operations, and higher market value upon exit. 

Enticing redevelopment – the vital role of the city 

If the physical characteristics of the property meet the requirements for conversion, private investors will subsequently look to local jurisdictions for policies and incentives to improve project economics. This is where the vital role of the city in accelerating older office conversions comes into play. Cities today hold the power to revitalize their downtown cores, and their policy agenda signals to the private sector their willingness to do so. For real estate investors, even small modifications to existing policies around zoning, the entitlement process and financial incentives offered can have a significant impact on increasing the rate of conversions. 

So how can a city help induce demand for redevelopment while simultaneously advancing critical social and economic objectives? It’s important to note that there are multiple strategies at the disposal of jurisdictions to accelerate progress: 

• Incentives and credits: Typically set at the state and/or local level, incentives usually involve a form of tax relief to the investor undertaking a conversion project. In markets with high barriers to entry, small changes to tax relief programs can go a long way in inducing demand. Programs such as real estate tax abatements, tax increment financing, payments in lieu of taxes (PILOT) and other tax credits offer multiple benefits in offsetting development costs. Incentives help developers to improve the financial returns of conversion projects, reduce initial capital outlay and improve the future operating income generated by the project. These benefits can lead to development that otherwise might not have taken place and essentially make the local government a partner alongside the private investor in the redevelopment. 
• Fast-track programs: This form of commercial incentive is often nonfinancial but can accelerate speed to market and the redevelopment timeline. For qualifying projects, fast-track programs can streamline the development process by reducing “red tape”, thus decreasing approval times for entitlements and expediting receipt of construction permits. For example, within certain cities, an office-to-residential conversion may involve the commitment of a certain percentage of units for affordable housing and, in turn, qualify for fast-tracking. 
• Zoning requirements: Policies in urban markets often carry significant zoning restrictions that inhibit conversions, such as limitations on use and minimum parking requirements. Cities can reduce the burden and risk to private investors by allowing for greater flexibility in zoning changes. As an example, local zoning codes may mandate a certain amount of parking spaces that accompany property development, depending on property use. In dense urban markets, parking requirements often make the economics of redevelopment challenging. By reducing or eliminating parking requirements within the zoning code, investors can develop more rentable area and thus increase the revenue-generating potential of the project.  

We analyzed over a dozen recent conversion case studies across US markets to understand the role of incentives and city development policies in redevelopment deals. Ideally, a property for conversion already meets certain return thresholds prior to incentives. However, in the majority of cases studied, some form of financial incentive was present to make the deal feasible or improve the economics. Even more, developers will frequently seek a combination of the strategies outlined above to improve project economies. Thus, cities can play a direct role in the future of their economic vitality by  promoting policies that entice private capital. The more incentives available to the developer, the greater the appetite to undertake projects and the greater the likelihood of restoring or maintaining a city’s economic vibrancy. 

A big problem, but an even bigger opportunity  

The current uncertainty surrounding the office sector poses a growing problem; however, there is an even bigger opportunity at play for both the private and public sector to partner in accelerating a solution.  

It is important to note that the decline of Class B/C offices does not suggest the demise of the office sector altogether. According to the recent Future Workplace Index survey, 58 percent of organizations surveyed are investing in their existing real estate portfolios, even as “work” becomes less of a fixed place and more of a network of connected spaces for productivity. But as corporate tenants continue to seek sustainability-minded Class A properties for in-person gatherings, conversions offer an increasingly attractive solution to reduce the growing glut of older office stock. And there are benefits for all parties involved. 

Private-sector benefits: commercial real estate developers 

Cities must act now or risk further challenges. 

On the backdrop of a softening economy and the heightened interest rate environment, real estate investors today are seeking ways to strategically deploy capital. For qualifying properties, conversions of older offices to new property uses can represent a compelling investment opportunity. But absent financial incentives and broader cooperation with public jurisdictions, developers will be less inclined to take a risk.  

Cities hold the future of their economic resiliency in their hands, and the time to act is now. Private investors want to play a role in the recovery of downtown CBDs, but cities must pave the way for them to meaningfully participate. By offering incentives, fast-track programs and greater flexibility in zoning changes, cities can create a win-win scenario for the public and private sectors by (1) inducing demand for the redevelopment necessary for restoring the vitality lost in the wake of the pandemic and (2) offering the right level of incentives and programs that advance the city’s social and economic agenda. Policymakers have an opportunity to build on the lessons learned from prior economic downcycles, such as in New York City, where the expiration of the city’s 421-g incentive has slowed the pace of conversion.  

The stakes are too great for cities not to act today. Failure to act will prolong local economic recovery, weaken competitive advantage and potentially contribute to the further loss of population and tax revenue as employers look elsewhere to build their businesses and house their employee base.  

Even as the role of the office changes, physical offices, and the talent employers attract to them, will continue to play a significant role in shaping the economic vitality of a city. It is imperative that the public and private sectors work together to keep America’s downtown centers vibrant – the economic success of both parties depends on it. 

Mark Grinis is Commercial Real Estate Leader for EY.