It’s happening everywhere. Former office buildings are being converted to apartments at an earthshattering pace.  Why now and when will it stop? There are a number of macro-economic reasons for the boom in multi-family development and conversions such as insecurity about long term job prospects, mountains of student loans preventing young people from making down payments on homes, and the desire to live in urban settings and younger demographics. However, another factor that has gone largely under the radar is the rapid change in office space design and its negative impact on economic returns for office buildings.

Millions of square feet of office buildings in the Philadelphia area have been converted to apartments over the past 10 years.  In addition, while we see more construction cranes around the city than at any time in recent memory, the overwhelming majority of them are for multi-family projects (excluding on campus university and health systems projects).  Even Brandywine Realty Trust which had traditionally been exclusively an office owner/developer has jumped into the multi-family arena.  FMC Tower, 1919 Market Street, EVO and their  suburban ventures with Toll Brothers all reflect the fact that money invested in multifamily may not only be a good way to diversify overall investment risk, it may also provide better long term risk adjusted returns than office buildings.

Why is that?  Let’s assume you have a Class B office building that has been struggling to achieve attractive returns. The only way to make it competitive is to undergo a major renovation to the core and shell including new windows, elevators, lobbies and HVAC system.  Once you do that, you then need to attract new tenants and provide them with a tenant improvement allowance of between $40-$60/sf.  If you’re successful in converting this to a Class A asset, let’s assume you can command a $33/sf (gross) office rent.  Let’s further assume that the operating expenses and taxes comprise $10/sf of that rent for a NNN rent of $23/sf.

Now let’s compare the economics of an apartment conversion.  Assuming that the landlord/developer performs the same core and shell renovations, he may then need to spend between $125/sf and $150/sf in fitting out the apartment units. That’s two to three times more than the tenant improvement allowance he would pay to a commercial office tenant.  Why does it make sense to spend so much more money to do apartments?  Market rents for new, higher end apartments in the city are close to $3.50/sf/month gross. That’s $42/sf/yr.  Since office operating expenses are generally higher than those for apartments (they could be between $1.50 and $2.00/sf less due to the fact that the landlord doesn’t have to clean the inside of unit), the NNN rents for apartments can be $34 /sf/yr or more—about $10/sf more than for office space. But that’s not the end of the story.

Apartments provide the landlord with credit diversification risk as compared to an office building.  A 300,000sf apartment project will involve hundreds of tenants as opposed to a similarly sized office building which could have as few as a handful of tenants.  If one of these large office tenants defaults on their lease or leaves when the lease expires, the project could be in serious jeopardy.  Conversely, no one tenant in an apartment building can bring down the investment.

However, getting back to our original point, there is another phenomenon taking place that is further fueling the conversion of office buildings into apartments.  With office buildings, the landlord needs to spend a lot of money to retain its tenants every five to 10 years when their leases expire.  These deals can be very costly in terms of new tenant improvement dollars, free rent and other transaction costs.  Conversely, renewing or replacing residential tenants is relatively inexpensive and, in a desirable project, the units don’t remain vacant for long periods of time.  This means that rent disruptions are minimized.

Up until the past 10 years or so, office environments didn’t change very much; they were fairly static.  Because nothing earthshattering was changing in the way businesses were utilizing their space, it was not uncommon for office tenants to renew their leases after five or 10 years while requiring little change or renovations.  As a result, tenants often accepted nominal tenant improvement dollars to “freshen up” their space with new paint and maybe carpeting.  Since it was relatively inexpensive to renew their office tenants (and in fact landlords make almost all of their profits on lease renewals), life was pretty good for landlords.  However, things have changed and they are likely to continue changing more rapidly in the future.

Tenants today are operating their business differently than they did 10 years ago. Many tenants  want more open space, collaborative areas, natural light and environmentally responsible offices.  They are also more efficient; consuming less space per employee than they were before. These changing requirements mean that tenants who have been in their space for 10 years or longer need more than paint and carpet if they stay in their space beyond their initial lease term. They need to completely remodel their offices and, in some cases, even move to a different building.  In fact, for this reason we are seeing more of our clients move than ever before.  Because the needed changes to their space are material, many tenants don’t want to “eat their dust” while living through “in place” renovations for a year or more. They prefer to move to new space and avoid the headache.  Because they are consuming space more efficiently, many of these tenants can more than offset the out of pocket move costs with the annual rental savings realized from leasing less square footage.

Technology is largely driving the transformation in office environments–enabling people to work more efficiently, with less space and from anywhere.  Because technology is changing at an ever accelerating pace, there is good reason to believe that office space will continue to change more rapidly than ever before.  Tenants will therefore constantly need to change their space as technology allows them to work more efficiently and differently.  A 10-year lease may seem like a lifetime and when the lease expires, tenants will need to adapt to the new reality.

Office landlords are very cognizant of this new paradigm for office space.  While an apartment conversion may initially cost more than an office renovation, some landlords are coming to the conclusion that over the long run, the tenant improvement dollars ultimately exceed the cost of a residential conversion while providing a lower rent and higher risk.

Conclusion

Demographics and macro-economic factors are clearly responsible for much of the rapid growth in apartment development and office conversions over the past 10 years. There is another, less talked about phenomenon, that is causing even leading office REITs to jump on the residential band wagon.  The rapid change in office environments brought on by technological advancements is having a major and permanent impact on the economics of office leasing.  Going forward, it will be more expensive to retain office tenants and that will directly impact landlord profits as well as their decisions about what to build next.

For more information contact Glenn Blumenfeld