Not as Simple as It Seems – March 4, 2024

There’s a school of thought that sees a solution to the current housing shortage as a no-brainer. Why not just convert empty (or emptying) office buildings into apartments? Well, as with many seemingly cut-and-dried remedies, the solution isn’t so simple to implement.

“Only about 0.4% of office space was converted into multifamily units per year before the pandemic, and so far this has risen only to 0.5% in 2023, suggesting that there are still large financial and physical hurdles to conversion,” Goldman Sachs reported in a note last week.

“We estimate that the annual conversion rate from office to multifamily will remain low and only increase slowly to 0.7% in the next four years, delivering about 20,000 additional multifamily units per year,” write Goldman Sachs’ Elsie Peng and Vinay Viswanathan. At that rate, it will take at least eight years to convert the 4% of office buildings that Goldman Sachs believes are no longer viable.

“Because the conversion process is slow and costly, available office space is likely to remain excessive and many buildings are likely to remain underutilized. As a result, we expect new office investment to remain sluggish in the next few years, resulting in a 0.2-percentage-point drag on fixed private investment growth, which will only be offset modestly by a 0.05-percentage-point boost from increasing multifamily construction.”

The cost is a sticking point and is likely to remain one in the near term. Using a stylized discounted cash flow model, Peng and Viswanathan show that current acquisition costs are still too high for conversion to be financially feasible given the high costs of conversion and financing and the current level of multifamily rent.

“We start by considering an office with an acquisition price of $307/square foot, the average transaction price of nonviable offices,” they write. “Industry reports and a recent economic study… suggest a wide range of conversion costs from $100/square foot to $500/ square foot, depending on the location and the materials used. Our baseline assumes a slightly above-median conversion cost of $280/square foot because we think that conversion is more likely to occur in metro areas that are hard-hit by remote work, which are high-price markets. We also assume that the conversion will target a high-end multifamily rental market, with an average monthly rent of $4.5/square foot.

“Under these parameter assumptions, our model suggests that converting a nonviable office that is priced at the average current level will result in a $164 loss per square foot,” write Peng and Viswanathan. “This means that current office prices would need to fall by that much, to around $154 per square foot or by 50%, for the cost to be fully covered by the stream of discounted future revenues.”

Even so, conversion is something to consider. “The total cost of building a new multifamily building on an empty lot of land may be lower than the total cost of buying an underutilized office and converting it to multifamily units, because prices of empty land lots in some locations are likely still well below current market prices of underutilized offices,” Peng and Viswanathan write. “However, empty land lots that are available for new development are scarce in central business districts where demand for residential housing is high. As the office vacancy rate continues to rise, especially in dense and accessible urban areas, office conversion will likely still be a viable option for creating new housing supplies.”