Can Conversions Help Fix the Multifamily Supply Gap?

No issue facing the multifamily sector poses more challenges than the long-term shortfall in the nation’s housing supply. A new report from the Urban Land Institute and the National Multifamily Housing Council makes the case that a significant part of the solution could come from the conversion of commercial buildings.

“The ability to convert obsolete structures could go far in adding to our housing stock and, at the same time, add value to our communities through such revitalization,” the report states.

Image by 652234 via Pixabay.com

According to a May 2022 study conducted by the National Multifamily Housing Council (NMHC) and the National Apartment Association, the U.S. multifamily market needs 600,000 units to bring the rental market back to equilibrium as part of meeting the need for 4.3 million new units by 2035.

The report, which draws on insights from the developers of 30 conversion projects from 2014 to 2021, maintains that a large volume of commercial space is potentially available for conversion.  Citing figures from the U.S. Energy Information Administration, the study notes that the median age of office space is 40 years old, and that more than 25 percent is at least 60 years old. Hundreds of millions of square feet of retail space—perhaps as much as 1 billion square feet—is likewise estimated to be obsolete.

Assessing feasibility

The majority of conversions showcased in the report involved Class B and Class C office buildings. Also in the mix were hotels, industrial facilities and two miscellaneous retail spaces. The study provides details about the multi-layered nature of the conversion process.

“Broadly, and perhaps self-evidently, it is clear from our interviewees that conversions can be financially feasible in a broad range of markets, original uses, building conditions and circumstances,” according to the study.

The Octave, a Nashville office building constructed in 1964 that was converted to market rate condominiums in 2016. Image courtesy of Promark Partners

On the financial end, responses from the interviewees took into account the relative feasibility of projects based on such conditions as their location, asset class, financial strength, occupancy, targeted resident demographics and expected returns.

These factors greatly impacted the interviewees’ reactions. One camp of developers purchased assets at an undiscounted rate, independent of their locations and performance, proceeding to terminate the leases of their tenants. The other group intentionally picked properties that had undergone substantial deterioration brought on by multiple years of vacancy for a discounted price.

The Wray, a 1940 office building in Washington, D.C., converted by Bozzuto into a multifamily community. Image courtesy of Bozzuto

Caitlin Sugrue Walter, NMHC’s vice president of research and the moderator of a webinar held in conjunction with the report’s publication, noted a common thread among the different financing strategies.

“Conversions require two phases of financing—first, to purchase the property as its current use, and second, to finance the construction,” she said. “If the current use still has occupancy, it can actually provide some income while the construction details are arranged.”

Among the developers interviewed for the report, there was no consensus about the overall value of a given conversion project, in large part due to the widely varying locations, asset classes and conditions of the buildings. Still, the projects themselves yielded positive results. The report cites the comments of one developer, who observed, “You go with the flow of what the building is telling you it wants to do or can do, and then merge that with your financials.”

Conversion costs varied widely. Two thirds had a median per-unit cost of $255,000, with an overall low of $176,000 and high end and $1.07 million per unit. Location and size were primary reasons for the variations, along with asset category. Projects encompassed the broad spectrum of multifamily projects, from affordable housing to luxury condominiums, and ranged in size from 24 to 435 units. Two other considerations were the ability to gain federal and state historic tax credit assistance for conversions of older spaces, as well as the expected construction costs in comparison with their projected returns.

Practicality and physicality

Despite similar causes for the varying project costs, construction and development of the commercial conversions were all unique and depended on many more variables. From the façade and floor plate renovations of a former 1960s office building to the structural preservation of a building floor structured without the use of rebar, the difficulty of the conversions varied widely.

READ ALSO: Making Adaptive Reuse Work for Affordable Housing

A kitchen at Gadsden Place, a Columbia, S.C. luxury apartment community that was converted from a historic industrial warehouse. The project preserved many of the building’s original architectural features. Image courtesy of Gavin Design Group

In a similar vein, the developers weighed the difficulty and risk of actually undertaking conversions to multifamily against leveling the sites entirely and building from the ground-up. These questions were often asked after a consideration of the risks associated with construction jobs such as foundational excavation, as well as possible savings in both time and money with construction and engineering costs.

Walter found the sheer number of details involved in the process to be “eye-opening,” and commended the developers for not only adapting to project-specific construction challenges such as unanticipated cost overruns, but taking advantage of them.

“There is a lot of concern about conversion projects because of fear of cost overruns, but every project manager from the report I’ve spoken with expected to have to handle the unexpected and didn’t shy away from it,” she said.