“A tale of two cities” was the analogy cited by more than one panelist on the “View from the Top” panel during the recent Connect Midwest Multifamily + Adaptive Reuse Trends event in downtown Chicago. Another way of putting it might be “a tale of two asset classes,” namely multifamily and office. However, neither property type is inured to the headwinds blowing through the commercial real estate landscape at present. 

From the apartment standpoint, “In ‘20 and ‘21, Chicago tied with Seattle for our worst market,” said Gregory Mutz, founder, chairman and CEO of Amli Residential. “And today it’s our best,” with urban properties running slightly ahead of Amli’s suburban holdings. 

He added, though, “it’s a long way from being at a rent level that justifies new construction.” 

Lee Golub, managing principal at Golub & Company, offered a similar take. “Our occupancies are as high as they’ve been,” he said. “Our rents are as high as they’ve been pre-COVID. But the growth has probably slowed down to 2% to 3% on renewals and some new deals.” 

Rising costs present another challenge in the face of slowing growth. “I can’t remember a time in my career where you’ve seen expenses increasing at a faster rate than rent growth,” said Gary Bechtel, CEO of Red Oak Capital Holdings. “So you actually have the potential for negative net operating income growth over the term of a loan, which in a rising cap rate environment is a double whammy.” 

Along with cap rates rising, so is the cost of debt. “The whole capital stack doesn’t make sense—you’re replacing relatively moderate-price capital with more expensive capital,” said moderator Collete English Dixon, executive director of the Marshall Bennett Institute of Real Estate at Roosevelt University. 

So where does it lead, she asked. “I think it’s just more accepting an erosion of return than anything else,” said John Murphy, CEO of Murphy Real Estate Services. “You’re trying to stay in it, stay alive, but you’re not going to get your high teens IRR, or you’re going to end up in the single digits in a lot of cases. You just have to accept that. And that’s not such a bad outcome.” 

That being the case, Murphy said the erosion of values on the residential side was “nowhere near” what’s happening in the office sector. In common with Waterton CEO David Schwartz in the opening keynote presentation, Murphy was skeptical that residential conversions of largely vacant and outmoded office properties were the panacea that some have made them out to be. 

“The first thing you’ve got to look at, even before the basis, is physically does the building work,” he said. “Do you have enough natural light? What’s the floor plate like?” 

Assuming that the office property passes muster on those counts—and panelists agreed that many office buildings don’t—there are questions of underwriting the rents, which can’t compare to those commanded by new construction, said Murphy. Then there are construction costs. 

“Lots of people think that adaptive reuse of an existing asset or an office building is going to cost you so much less because you already have a whole bunch of stuff there,” he said. “That’s absolutely not the case.” In fact, he said, the conversion will end up costing about the same as a new build, and possibly a little more. 

Panelists agreed that public-private partnerships would be necessary to make large-scale conversion of older office stock into residential a viable proposition. Mixed-use is another scenario, where a property that wouldn’t succeed solely as one asset type could be effective combining multiple purposes. “That’s the kind of vision we’re going to have to bring to the city,” said Dixon.