Office to Residential Conversions – Will the Supply Meet the Demand?

In almost every major U.S. city center you will see massive office towers being converted into multifamily buildings. A common question is how will these huge new apartment complexes be filled with new residents? Population and new construction data suggest that it depends on what city you are in.

If you look to a skyline of most major U.S. cities, you will see predominately office towers jutting above residential properties. Across the city centers of the 5 largest U.S. cities (New York, Los Angeles, Chicago, Houston, and Phoenix), there is nearly twice as much office space than residential space, as measured by square feet (source: CoStar). Although office towers have become iconic staples of most skylines, this overallocation to office space is becoming a major problem for America’s cities following the COVID-19 pandemic and the seemingly irreversible shift to remote work. According to Placer.ai, a foot-traffic data analytics firm, visits to office buildings are down 37% compared to pre-COVID levels as of July 2023

Source: July 2023 Office Index Recap – Placer.ai Blog

This poses an existential risk to office owners, as low usage eventually equates to high vacancy rates. Office vacancy rates for the city centers of the 5 largest U.S. cities highlighted above was 16.29% as of June 2023 compared to 9.94% in December 2019, a reflection of the pain felt by office owners post-COVID (Source: CoStar). Usually, vacancies this high result in widespread loan defaults and distraught landlords, but a solution has presented itself – Office to Residential Conversion. Take those empty office buildings and replace cubes with apartment units. This off-ramp from a potential doomsday scenario has already been implemented by many office owners, but a question remains: Are there enough renters seeking to live in high-rise towers?

Let’s look at the numbers. Assuming that, on average, it takes two years to construct or convert to a new residential building in the downtowns of the top 5 cities, there is currently enough residential space for 92,578 individuals available or being constructed across these downtown areas. Current vacancy rates in these city centers average 4.20%, therefore the cumulative population of these downtown areas would need to grow by ~86,000 residents over the next two years to maintain current vacancy rates and not create an oversupply issue.

Sources: CoStar; Placer.ai

Based on current population estimates for the zip codes in these downtown areas by Placer.ai, the populations in these cities would have to grow by a weighted average of 4.01%. This average, however, is heavily skewed downward by New York City’s downtown area, which only would need population growth of 2.24% to absorb upcoming supply. The other cities’ downtown areas would each need to grow over 7%, with downtown Chicago needing to experience population growth of over 11% and downtown Phoenix over 14%.

Over the past two years, the population of these downtown areas has grown on average by 4.16%. Although this outpaces the required growth rate of 4.01%, these numbers are heavily skewed by population growth rates in New York and Chicago, which grew 4.43% and 7.28%, respectively. Comparing these actual growth rates to the required growth rates reveals that all the top 5 city centers outside of New York’s will have to experience population growth significantly faster than achieved in the prior two years to absorb all the new multifamily space coming to market. If these downtown areas continue to achieve growth rates similar to what was achieved in the last two years, vacancies for Chicago, LA, Houston, and Phoenix are projected to increase by 39%, 65%, 72% and 140% respectively.

Sources: CoStar; Placer.ai

This data suggests that, in most cities, there will likely not be enough people moving to city centers to absorb new multifamily space created from converting downtown office towers to apartment buildings, unless you are in New York.

 

The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.  The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.