Remaking obsolete office space: An opportunity for a select few properties

The US office market faces a prolonged downturn in demand, the legacy of the pandemic. Workers came back to the office in 2022, but not as many days of the week or hours in the day as they did before 2020, and the shift looks to be permanent.

Less demand will put downward pressure on valuations for many office buildings, especially older ones of lower quality, leading owners and investors to consider alternate strategies for their assets.

One increasingly popular strategy is to take poorly performing office space and redevelop it into mixed-use, multi-family or some other property type. That kind of redevelopment can work for some buildings in some markets, but the process is always complex, and not always the answer to buoy property valuations.

A weak office market

Towards the end of 2022, 16.83% of US office space was vacant, according to our data. This was up from 12.77% at the end of 2019. During the pandemic, the office properties suffered millions of square feet of negative absorption – tenants leaving space, in other words, with not nearly as much taken by new tenants.

That drop in occupancy is probably only the beginning, as companies with long-term leases come to the end of those leases later in this decade, and opt for less space, and shorter-term leases, when renegotiating with landlords or looking for new space.

The average in-office workweek has shrunk dramatically from pre-pandemic levels. Kastle Systems, which tracks office utilization through office security keycard use in major US metro markets, puts the average at just over 50% as of March 2023, compared to the pre-pandemic levels. That is higher than it was two years ago, when the average hovered between 20% and 30%, but it isn't anything close to pre-pandemic utilization.

As the pandemic ebbed in 2021 and '22, office managers tried to bring workers back to the office, with many companies eventually settling on a hybrid schedule, and two or three days a week in-office being especially common. The trend toward hybrid schedules looks to be permanent, and so the space needed per worker will eventually find a new equilibrium.

There are many estimates and studies aimed at quantifying the effect of hybrid work on office demand, most studies agree that there is a supply-demand mismatch and that a significant portion of office space may become obsolete in the coming years. While estimates vary widely, one recent analysis by Cushman & Wakefield estimates a surplus of 330 million square feet by the end of the decade.

In addition to the magnitude of the change, the speed and timing of this transition is a major unknown and debated topic amongst industry participants. At year-end 2022, our data showed that nearly 25% of all in-place office leases were set to expire over the next 36 months. Some of this space will either be renewed or re-leased quickly, but much may not.

Also, major companies are putting their own office developments on hold, pointing to further weakening of the office market. Recently Amazon put construction of its second headquarters on hold in Virginia, and Microsoft paused its development of a large campus in Georgia indefinitely.

But also an evolving office market

The office market may be weak, and not as many workers come to the office as before, but that doesn't mean office properties will have no place in the future of work. Rather, office space and office buildings are going to evolve to meet the needs of workers and their employers.

It is widely acknowledged that corporate culture, and a company's health, depends in large part on person-to-person interaction. As a result, there will always be an important place for office space in making businesses survive and thrive.

Instead of the end of office space, the sluggish return to the office by workers had created a two-tiered US office market: newer properties stocked with the amenities that tenants want, and older properties less suited to post-pandemic workforce realities.

Much of the older space that will struggle in the coming years to find tenants is in the older parts of the country, such as the Northeast. By contrast, Sunbelt states tend to have newer properties. Even so, both more and less obsolete office properties can be found in every market, in every part of the country.

Much undesirable office space will simply be removed by demolition and replaced with an entirely new property. This, in fact, will be the main way of dealing with obsolete office space, as it is with any obsolete properties. Yet a much smaller number of office properties will be ripe for conversion into another use, including multi-family, but also mixed-use and other kinds of assets.

Conversion of office space

Some of today's obsolete office buildings will find a higher and better use without being torn down. Developers are already at work on such projects in markets around the country.

In New York, some of the floors of the historic McGraw-Hill Building are being converted from office to apartments, resulting in mixed-use property. In Los Angeles, work is underway to convert a low-rise office building on Wilshire Blvd. into a mixed-used building with a large residential component. In Atlanta, an office tower that was once home to state offices has been sold to a company with plans for a residential redevelopment.

Conversions can be financially feasible in a range of markets, building types and uses, and other circumstances, according to a report by the National Multi-family Housing Council and the Center for Real Estate Economics. But the process is highly individualized, with dozens of factors in play.

In 2022, architectural firm Gensler did a study of 300 North American office properties to determine how many of them, and which of them, would be suitable for conversion from office into another income-producing property. The findings were not encouraging for owners dreaming of conversions, since only about 30% of the buildings were suitable.

The reasons are complex. Cost is often a major obstacle, especially when compared with razing a structure and starting anew. Location is also important, as it would be for any real estate project, but so are building form, floor-plate size and other aspects of the physical structure. Also important: local zoning, which can pose an important barrier to redevelopment, and pushback against conversion from a municipalities and community groups.

Still, a relatively small number of properties are well suited for conversion, and some office features that are out of style as office features might help make the conversion to multi-family space easier, Gensler pointed out. One example: what would be considered claustrophobic low ceilings in office space (such as 12 feet) would be a luxurious ceiling height for apartments.

For most office properties long past their better days, conversion to some other use is probably an impossible dream. For a select few, however, in the hands of expert and experienced real estate professionals, a new use is possible.