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Since the early 1900’s office buildings have been a staple of corporate America. What began as modest structures, a few stories tall and accommodating only a limited number of employees, has evolved into towering skyscrapers dominating the skylines of major U.S. cities, housing thousands of workers. Over the decades cities have grown around office buildings and have benefited from the taxes they brought in. However, this decades old image of the office building is changing as vacancies remain high, and hybrid working is becoming the new norm. In turn, landlords have been seeking out creative ways to pivot their investments into new profit.
According to Moody’s Analytics, the office vacancy rate hit an all-time high of 19.6%, compared to an average pre-pandemic rate of 16.8%. As vacancies continue to rise because fewer people are working in the office full-time, the value of these buildings decreases. By the end of 2025 nearly, $1.5 trillion worth of commercial office building debt will be up for refinancing. Landlords are now exploring innovative ways to adapt their investments to changing trends, ushering in a wave of optimism amidst uncertainty.
"As more commercial real estate loans come due for refinancing some banks will try to implement what many call "Pretend and Extend". Where lenders will rework loans to extend them for another year or two in hopes that rates come down and the borrower can improve occupancy, thus increasing the property value. Banks (especially smaller regional banks with large CRE loan balances) would prefer to try and extend these loans so they don't have to write off the loan losses. The question is whether the borrowers even have an appetite to continuing incurring losses on their properties and rather just hand the keys back and be rid of it."
Which office buildings can be converted?
As vacancies persist and the value of office buildings fluctuates, landlords are looking for viable alternatives to traditional office space. One promising avenue is the conversion of these empty spaces into residential units, addressing the pressing housing shortage in our country. While it’s true that not all office buildings are immediately suited for residential conversion, approximately 15% of commercial office buildings in major U.S. cities hold promise for successful residential adaptation, particularly those with smaller footprints and better layouts conducive to apartments. This potential could yield nearly 172,000 new apartments, a significant boost to housing inventory and a welcome relief for the housing market.
KGO’s Director of Innovation & Change Mathew Xavier attended New York Build Expo in February, where many of the panel discussions touched on this important topic.
"Repositioning office buildings from commercial to residential or "resi-mercial" will help to activate and occupy commercial office buildings that are hit with the most vacancy. The reposition maintains the asset without losing the existing air rights in place."
The key obstacle for repurposing office space to residential use is making sure the return on investment is attractive enough for developers to pursue the renovations. To that end, the Department of Transportation has recently announced $35 billion in loans available to developers at below market interest rates to help incentivize commercial to residential conversions. Commercial to residential conversions happened all the time before Covid, now it looks to accelerate as developers and landlords embrace the opportunity to reimagine empty office spaces.
Understanding Commercial Building Classes
Not all segments of the commercial real estate market are experiencing downturns. Class A buildings, with their modern layouts and extensive amenities, are seeing increased demand, demonstrating resilience in a shifting landscape. As a little background, commercial buildings are generally broken down into three categories of Class A, B, and C. Class A buildings are roughly three years old or less and have an abundance of amenities and any repairs are done immediately. These buildings have the highest ROI out of the three classes. Class B buildings tend to be up to 10-15 years old and only have a handful of amenities compared to Class A. They also tend to take a little longer to address any needed repairs, thus their ROI is lower than Class A. Lastly, Class C tends to be the oldest, needing the most updates. These have the lowest ROI and are not profitable investments if upgrades are not made.
Class A buildings have always been in demand, but it appears that in a new world of hybrid work they are able to draw more people into the office due to the modern layouts and expansive list of amenities. In a CNBC article, they even mention how there may be a shortage of Class A buildings in the coming years. Just as certain malls adapted to survive the rise of e-commerce by offering unique experiences, Class A buildings are thriving by providing top-notch amenities and fostering a desirable work environment. A great example is the One Vanderbilt project in New York City. It has direct access to Grand Central Terminal, features world class restaurants, has a hotel style social club for tenants, an outdoor terrace, and is LEED and WELLNESS certified. These amenities help draw in tenants and entice workers to leave their homes and come into the office.
Addressing the high vacancy rates of commercial office buildings requires a multifaceted approach. For older buildings suitable for residential conversion, incentives and support from the government are crucial in facilitating the transition. Meanwhile, for Class B and C properties, renovation and redevelopment into mixed-use spaces offer a path to revitalization, drawing tenants back with new amenities and experiences.
The future of office space is bright, characterized by flexibility, innovation, and a renewed focus on human experience. No longer mere structures for work, office buildings are evolving into dynamic environments that cater to the diverse needs of tenants and employees alike. As we embrace this era of transformation, we usher in a new chapter of optimism and possibility in the world of commercial real estate.