Office to multifamily conversions: Implications for CMBS investors

Demand for office space has dropped dramatically amid the rise of hybrid/flexible work policies in the post-pandemic world, posing challenges for states and cities and creating opportunities and risks for commercial mortgage-backed securities (CMBS) bond investors. By implementing programs that encourage converting office space into multifamily housing, some states and cities are taking steps to address an issue that is vital to their economic and civic health. While markets have been dismissive of the impact of these efforts, we take a different view, and believe it could provide a tailwind for investors over time as it removes some excess office supply and accrues other economic benefits.

Multiple motivating factors

Cities and states are implementing policies to promote conversions for a variety of reasons:

• Utilize vacant office spaces. Converting offices into housing is one way to make better use of available space and drive economic development.
  
• Address housing shortages. This phenomenon is particularly relevant to high-cost cities. Often, these policies are designed to promote affordable housing development. Additionally, conversions can help stimulate the local economy by creating construction jobs and increasing residential density, which can lead to more local spending.
• Provide sustainability benefits. Converting office buildings is more sustainable than constructing new housing. It reduces the need for new materials and helps preserve the architectural heritage. Generally, this trend is more economically viable for older buildings because their floor plans are more conducive to conversion to living spaces.

Incentivizing developers

Common policies from states and cities to promote office conversions include tax incentives, tax increment financing, and easing zoning policies. Municipal governments are offering tax incentives to developers to help subsidize the often-prohibitive costs of office-to-housing conversions. Additionally, municipalities are expanding by-right zoning policies to ease the burden of entitlement processes and make conversion simpler. Some are also offering building code exemptions, and are advantageously reducing parking restrictions, setbacks (minimum distances from roads and other properties), and open space requirements.

Other municipalities are directly funding a portion of conversion projects with tax increment financing. The federal government has launched a multiagency effort to encourage states and cities to convert more empty office buildings into housing units. This includes billions of dollars in low-interest loans, loan guarantees, grants, and tax incentives for developers. We have seen multiple success stories of these incentives encouraging conversions in New York, Boston, Philadelphia, Chicago, and Los Angeles (Figure 1). Ultimately, we believe the amount of office supply converted to multifamily spaces will largely be dictated by how significant the incentives from individual municipalities are.

Figure 1: Office-to-housing conversion initiatives in major US cities

Lessons from malls and underappreciated benefits

Conversions alone won’t solve the large supply/demand imbalance in the office sector, but they are an important part of the longer-term need to take supply out of the system which could ultimately be a tailwind over time. Just as we saw with retail properties several years ago, many malls had to be closed to bring the market into equilibrium. We saw on average of 15 – 20 mall closures per year. While this didn’t have an immediate impact on the sector, it did matter over time. A similar dynamic may be needed for the office sector’s health, and multifamily conversions are one outlet for excess supply.

We believe the market may be underappreciating some near-term benefits. For example, once a property owner decides to convert an office building, they stop renewing leases and start relocating tenants. That supply of office space immediately comes out of the system even though the property itself could take years to hit the market.

Excessive costs are the main factor that holds back many would-be developers. The market seems to be hung up on this reality. But as we discussed earlier, some cities have announced programs to reduce/remove some of the barriers to converting properties. We expect this trend to increase, and believe it is something worth watching because it could be material for the sector down the road.

Implications for multifamily housing supply

We don’t anticipate conversions to create so much new supply that it would negatively impact multifamily properties in aggregate. While there has been overdevelopment in multifamily housing space in recent years, it has been concentrated in higher-end units, and the overall housing picture (when including single-family residences as well) remains fundamentally and structurally sound longer term. Additionally, we expect a 20% pullback in new multifamily completions during 2024 and have already seen a 40% decline in multifamily starts. While it will take time for new units to be absorbed, the demand drivers in place should be sustainable for the near future as homeownership remains unaffordable for many.

Outlook and CMBS market impact

We remain cautious on the office sector. We are often asked “what inning are we in of the office cycle”? The answer is “it depends.” When looking at underlying loan performance in the CMBS market, delinquency numbers indicate that we are in the early innings, whereas bond prices would suggest somewhere in the middle innings. We believe there is more stress to come as loans mature and borrowers are faced with higher borrowing costs to refinance their loans. Additionally, we think rating agencies are still early in the downgrade cycle. Additional ratings stress could force selling from ratings-constrained investors, further pressuring prices. However, with stress also comes opportunity for those who can sift through the rubble and pick up attractive CMBS at distressed prices. The bottom line: For investors in CMBS bonds, we are in an environment where security selection and fundamental credit analysis will be key to uncovering opportunities and mitigating risks.