is vacant on October 27, 2022 in San Francisco, California. The city of San Francisco has a record-breaking 27.1 million square feet of office space as the city struggles to recover from the Covid-19 pandemic, according to a report by commercial real estate firm CBRE. The US Census Bureau reports that an estimated 35% of workers in San Francisco and San Jose continue to work from home. (Photo by Justin Sullivan/Getty Images)Getty Images
The world is filled with empty office space while workers fight for scarce and expensive housing. Why not solve both problems by converting the vacant offices into apartments?
Experts told me some office buildings could be converted into luxury condos.
Larger office buildings with a central elevator shaft, on the other hand, can hardly be economically converted into residential buildings. Grants may be required for conversions from office to affordable housing.
While this problem is resolved, investors should examine bullish bets on home builders and bearish bets on office building owners who are increasingly returning their keys to banks.
Too much office space
The pandemic has had a devastating impact on office building occupancy rates.
Employees do not commute to the office five days a week. According to Kastle Systems, which tracks security thefts in office buildings, the nationwide office return rate is actually 50% of pre-pandemic levels. Despite management’s best efforts, workers will likely continue to work from home and occasionally visit an office.
There is more office space than corporate landlords need, and they have billions to pay back — some even returning the keys to the lender. So much:
- Vacancy rate: 18.6%. According to Cushman & Wakefield, the average US office vacancy rate was 18.6% in the first quarter of 2023, up 5.9 percentage points from the last quarter of 2019. C&W estimates that by 2030, 330 million square feet of US office space could be obsolete.
- vacancies increase. Bloomberg estimates that more than 17% of US office supply is vacant and 4.3% is available for subletting. While these averages hide the wide disparities across the country — according to the Wall Street Journal, vacancy rates in San Francisco top at nearly 25% and in Silicon Valley at 17% (and counting) — C&W believes that the number of vacant office spaces will continue to increase until the second half of 2023.
- Billions in debt for landlords are due. The Mortgage Bankers Association estimates that office building debt of $92 billion will mature in 2023 and another $58 billion in 2024, according to Bloomberg.
- Some landlords return the keys to lenders. According to Bloomberg, a PIMCO-owned landlord has defaulted on its debts for seven office buildings in San Francisco, New York City, Boston and Jersey City. In February, Canadian asset manager Brookfield “pulled out of two prime Los Angeles office buildings after $784 million in loans defaulted.” according to fDi Intelligence. According to CNN, Mark Rose, CEO of global real estate consultancy Avison Young, has never seen such a high level of office returns.
In January, people working from home hurt New York’s economy. Stijn Van Nieuwerburgh, a professor at Columbia Business School, told the New York TimesNYT, “On an average weekday, nearly half of New York workers stay away from the office; on Mondays and Fridays the proportion is even higher. The number of subway and bus passengers has fallen by a third compared to pre-pandemic levels. Serious crime increased more than 20 percent last year, and more than 300,000 people fled the city in the first year of the pandemic, generating total income of more than $21 billion. If office value decreases in proportion to usage, the city’s property tax revenue will decrease by $5 billion per year.”
Too little living space
At the same time, there is not enough housing for all but the wealthiest people. The housing shortage keeps real estate prices high – unaffordable for most people. Despite the high mortgage interest rates, housing starts are increasing rapidly. It remains unclear whether this will create enough affordable housing to meet demand.
Here are indications of housing shortages and efforts to meet demand:
- Millions too few housing units. According to Axios, Freddie Mac estimates that the US is short of about 3.8 million housing units – both for rent and for sale. There are 142 million housing units in the US, the Wall Street Journal reported.
- Average house prices have increased by 40% since January 2020. The average home price is $419,103 — although down 3.1% over the past year, according to RedfinRDFN — 40% higher than in January 2020. Contributing to the high price is a 39% drop in homes for sale since 2018 at, so Redfin reported.
- Housing starts increased by 21.7% in May. New home construction in the US surged 21.7% in May as homebuilders began work on single-family homes to meet strong buyer demand. MarketWatch reported that housing starts rose to 1.63 million a year last month from 1.34 million in April.
Builders are optimistic about the housing market. Richard Moody, senior vice president and chief economist at Regions FinancialRF Corporation, wrote in a note, “To say we didn’t expect that wouldn’t even come close to reflecting the extent to which May’s housing data surprised us.”
Challenges in converting office space into living space
Will property developers close the gap between supply and demand? Or could all that excess office space be converted into housing?
The short answer is that office remodeling is most likely to meet the demand of those looking for luxury housing rather than affordable housing. In addition to changing zoning restrictions to allow for office to residential conversions, here are the most common reasons why it is difficult to convert existing office space to residential:
- Technical obstacles. “The large floor slabs of many commercial office buildings built in the late 20th century pose challenges for conversions, including limited access to daylight in most of the interior space on each floor (which is a violation of most housing codes),” says Justin Steil, an associate professor at MIT law and urban planning, wrote in a June 20 email.
- The sanitary facilities need to be modernized. Although some cities like Portland, Oregon, Washington, DC and Chicago are streamlining permitting processes and facilitating remodeling, office buildings require more water and sewer lines to accommodate one or more bathrooms per dwelling unit, rather than one or two bathrooms per floor in a typical office building, noted Steep.
- Due to the significant cost of office remodeling, apartment prices must be high. The cost of these retrofits is so high that they make the most financial sense in cities with high rents. “The retrofit will cost $200 to $300 per square foot. For this to make sense, either the building has to be cheap or the resulting apartments have to be expensive. High-rent cities like Manhattan, San Francisco and Boston are seeing luxury apartment conversions happening,” said Joseph Gyourko, a professor at the Wharton School, in a June 21 interview.
- The conversion of affordable housing can only succeed with state help. Without “additional municipal measures”, the conversion of office buildings will not solve the problem of affordable housing, said Steil. Such a measure could mean the waiver of tax documents during the conversion process. “Cities won’t pay real estate taxes for two years until people live in the apartments,” Kosta Ligris, an associate professor at MIT’s Sloan School of Management, told me in a June 21 interview.
- Many office buildings will not make it. “The really good buildings will be fine. The older ones are difficult to retrofit. Working from home will average one day a week, which will reduce demand by 20%. There will be quite a few buildings that don’t make it. I don’t see any conversions for the middle class. There will be a large number of landlords returning the keys. What happens to the regional banks that loaned them the $40-50 million?” Ligris closed.
Van Nieuwerburgh is optimistic that government-subsidized construction of new downtown housing and conversion of commercial buildings into apartments can help Manhattan. “Best case scenario, we’ll remove 30 or 40 percent of the office stock in New York City and turn it into beautiful living space. New York City has all these great amenities, it’s a wonderful place that young people want to live, regardless of where they work,” he told the Times.
What Investors Should Do
Investors should consider bullish bets on homebuilders who will benefit from meeting demand for housing, while at the same time betting against office landlords and banks who are lending to them.
Homebuilders worth evaluating include KBHome, PulteGroupPHM and LennarLEN – which are at or near all-time highs. Investors should consider whether these stocks could continue to climb.
Office landlords that could suffer include Brookfield Corp — which has lost nearly half its value since its November 2021 peak. Investors should assess the future creditworthiness of such companies.
Banks I wrote about in April that could be exposed include Valley National, East West Bank and Synovus Financial. Investors should consider whether they should expect higher loan defaults.
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In 1994 I gave up Corporate America and founded a management consulting and venture capital firm (http://petercohan.com). I started tracking stocks in 1981 while I was still in graduate school at MIT and first analyzed technology stocks in 1998 as a guest on CNBC. In April 2011, I became a Forbes contributor. My 15th book – published in November 2020 – is “Goliath”. Strike Back: How Traditional Retailers Are Winning Back Customers From Ecommerce Startups. I was featured in the 2016 documentary We The People: The Market Basket Effect eight times. (http://www.themarketbasketeffect.com/). I also teach business strategy and entrepreneurship at Babson College in Wellesley, Mass. (http://www.babson.edu/Academics/faculty/profiles/Pages/Cohan-Peter.aspx)
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