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Real Estate

As the Commercial Market Falls Apart, These Three Assets Could Be Your Next Big Opportunity

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Offices across the country are still sitting empty. The nationwide office vacancy rate reached a high of about 20% in the first quarter of 2023, according to JLL, and while big tech companies are pressuring workers to return to the office, the hybrid work model has led to an increase in commercial office delinquencies. According to Trepp, a real estate analytics firm, the office delinquency rate surged 125 basis points in May to over 4%

This spells trouble for the commercial real estate market and the broader economy, according to some experts. Analysts at Morgan Stanley are predicting a decline in commercial property values of up to 40%, a crash akin to the 2008 financial crisis. Fred Cordova, CEO of Corion Enterprises, believes the crash is already underway. But while most firms agree the office sector is under stress, some are more optimistic than others about the outcome for commercial real estate. For example, UBS Global Wealth Management asserts the problem is manageable, and a crash resembling 2008 isn’t likely. 

Peter Margolin, National Broker Network Manager at Alliant Credit Union, agrees. “While we do not think the CRE market will fully crash, we do believe there are certain markets that are going to struggle more than others going forward,” says Margolin. “This cycle is different from 2008, in that the capital markets are still open, if not as liquid as they were last year. Today, there are still commercial real estate lenders like Alliant that are actively lending on specific asset classes demonstrating strong demand to borrowers with sound credit quality.” 

Commercial real estate has been historically viewed as a high-risk investment, according to the FDIC. Investors who risked purchasing commercial office space are finding themselves in a tight spot now that demand for the space has fallen, but there is a way out. “There should be opportunities for property owners to adaptively reuse their unoccupied office space,” says Margolin. 

Repurposing Vacant Office Space

While remote work is here to stay in some capacity, retail space demand is rebounding from the pandemic slowdown, and the outlook for self-storage remains promising. The demand for multifamily housing is expected to wane, but housing shortages and rising rents in many markets still make the option attractive to investors in the right locations. 

“For older, less-amenitized buildings, multifamily and residential products are popular

conversions. This can include market-rate rentals, workforce housing, student housing,

senior housing, and even affordable housing, depending on location and market

demographics,” says Micah Solit, Senior Project Manager at national real estate advisory firm Project Management Advisors, Inc. Matt Silvers, Vice President at the firm, says “Other conversion options are hotels and, depending on building size and configuration, self-storage, document storage, and technology uses, like life sciences.” 

But what kind of an undertaking is required for these conversions, and can the cost be recouped? When does it make sense for commercial real estate investors to repurpose office space, and when is it not worth the endeavor? We asked several experts in the commercial real estate space so you can evaluate your options. 

Mixed-Use Retail 

Shopping malls began dying out long before the pandemic, and the retail space sector has been shifting towards services since reopening. Mixed-use retail is gaining momentum as people seek more amenities where they live and work. The homebuying slowdown may contribute to the popularity of mixed-use space as well. “Mixed-use is the past, present and future,” says Sean Slater, Senior Principal at RDC. That’s especially true in areas of the country where multifamily housing is in high demand, like New York, where investors are rapidly developing Class B and C properties into mixed-use space. 

Repurposing office space to mixed-use retail works better than an office-to-retail conversion, according to Slater. “Multi-level retail is rarely successful, and offices are rarely at street level, so taking a mixed-use approach seems to be most appropriate,” he says. “Street-level retail and Food and Beverage with residential and smaller office lease spaces might diversify many vacant buildings without swinging too far into the residential-only conversion.” 

It’s better for the future of the economy as well. Slater notes that office space is still in-demand and may even become undersupplied at some point if too many urban Class A office properties are converted to residential housing. “I believe a patient approach and a move to diversifying within individual buildings will create a more stable market,” he says. 

Office tenants are paying an average of nearly 25% more for mixed-use space when compared to traditional office space, and investors can expect renters on the multifamily side to pay a premium for an amenity-filled building as well. But there are definite challenges, including finding the right management for a property with multiple use cases. 

Self-Storage 

While rents are moderating in the self-storage sector, the outlook looks promising when compared to other types of commercial properties. A conversion from office space to self-storage could be advantageous for investors holding onto a property with low occupancy rates. 

“While it can be a challenging undertaking, conversion of office floors can be rewarding,” says Margolin. “In some cases, for truly outdated spaces, self-storage might even command higher rents than offering the space for office use. For example, lower floors with less ideal views would be ideal locations for storage,” he says. 

But investors who choose to repurpose office space into self-storage face obstacles. “The good news is that there is likely plumbing and a lot of lighting already in place to tap into for storage conversion,” says Margolin. “The bigger issue would be how much work has to be done with those floors to remove all of the walls, flooring, furniture, and other equipment to clear out the space before converting to storage use. The next biggest cost would be designing storage units to fit the floor plates and being able to transport the materials up to those floors.”

Margolin says securing financing has also gotten more difficult but not impossible. “There is a natural trend that when the economic outlook becomes more choppy, traditional lenders pull back,” but that creates an opportunity for non-bank lenders and private equity firms to enter the space and even work with more traditional lenders to offer note-on-note financing packages and A-note financings. “Financing is generally still attainable for strong credit borrowers on properties with strong fundamentals,” says Margolin. 

Multifamily Housing 

Despite housing shortages and rising office vacancies, the conversion from office space to multifamily housing remains an uncommon solution, and that’s not expected to change because of the significant costs associated with making the switch. “What investors must realize is that a conversion may ultimately cost more than a new development on a cost-per-unit basis,” says Solit. But it remains a financially viable option in certain circumstances. “Owners will have to get granular about the economics of their project and determine the market for additional residential units, along with a clear path toward re-entitling their building for this new use.”

States looking to promote conversions have removed fees, implemented more lenient zoning change processes, and even provided tax incentives to redevelopers, but a 2022 Moody’s report notes that office property values would have to plunge significantly to make the conversions worthwhile. In certain areas, however, it may already be the case that an office-to-multifamily conversion is a good solution. 

“Location is a major factor,” says Solit. “Investors will want to limit jurisdictional and regulatory hurdles that could complicate a conversion, but there also has to be housing demand in the area, which drives values and rents. If the location works, the building itself should have a relatively high vacancy rate” so owners can avoid lease buyouts.

“Finally, the building itself is important. Operable windows, high perimeter density, and

shallow floor plate depth are all conversion-friendly features, presenting owners with more square footage for eventual living space. Adequate street frontage and open space around the structure also contribute to conversion readiness,” says Solit. Silvers adds, “Older, smaller buildings tend to be more well-suited to conversion, rather than large, hyper-modern structures.”

The Bottom Line

Repurposing office space can be challenging, expensive, and altogether risky. But with increasing vacancies and delinquencies, even among Class A office properties, some investors may find that it’s necessary to adapt to minimize losses. Of all the options available, mixed-use retail conversions seem to be the trend, especially in areas where there’s demand for live-work-play spaces, but self-storage and pure multifamily conversions are also viable options in certain markets. The outlook for commercial real estate is still unpredictable. However—prices could further plummet, but the demand for office space may also rebound. It’s essential to evaluate your individual situation before making any sudden moves. 

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.

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