To Convert or to Rebuild?

With less than one in six office buildings being good candidates for residential conversions, according to Yardi’s CommercialEdge Conversion Feasibility Index, it may be time to consider calling in the wrecking ball.

That very situation is already playing out in places like California, New York and New England as redevelopment has become far more common than adaptive reuse conversions, according to a commercial-residential conversions report from Fannie Mae.

In the Golden State the report finds that most commercial-to-residential projects have taken place through the redevelopment of obsolete buildings or vacant commercially zoned land. In the Big Apple the nine-story building that was the home of Pfizer will be redeveloped into a 29-story multifamily property with up to 660 units. And in New England conversions usually occur because of a lack of raw land rather than from any difference in the suitability of the existing commercial structures.

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“Adaptive reuse of many commercial buildings is more expensive than their demolition and redevelopment,” the report reads. “Even among the best candidates for adaptive reuse, total development costs often approach, and sometimes exceed, equivalent costs for demolition and redevelopment.”

The next three to five years will determine the future of conversions, Fannie Mae researchers point out. But for now, several obstacles stand in the way of most potential reuse properties: politics, financing and the question of whether conversions will produce enough housing units to be meaningful.

Policy and conversions

While conversions avoid some of the political issues involved in producing more housing, the regulatory changes “that could best unlock the potential of conversions” don’t align with other policy initiatives, the report points out. Residents often see the conversion of commercial properties into multifamily housing as beneficial, especially if those properties are vacant. However, people don’t normally take kindly to policy changes that facilitate conversions, particularly when they take the form of liberalized land use regulations.

“Politically, this means providing benefits to developers, which is often unpopular unless it is coupled with specific requirements meant to address housing affordability,” the paper says. Yet these affordability requirements can negatively impact the feasibility of conversion projects by lowering rent revenue. It’s for this reason that many conversion projects, specifically reuse conversions, have resulted in luxury units.

And while mixed-use has some potential, the report concludes, “we believe that the impact that conversions will have on affordability through filtering is limited.”

Money, money money

So far, at least, many conversion developers have reported few problems obtaining the funding necessary to do their work. However, aspects of most projects—bedrooms without natural light or relatively small unit sizes—are not standard for lenders, who often need additional explanation.

Fannie Mae researchers did not find any instances in which deals faced financing gaps or involved any financial innovations. However, revealing such gaps, or showing their absence, would clarify what can be done to facilitate conversion financing, they suggested.

The potential conversions might (or might not) unlock

Without a property-to-property analysis, estimating the potential of office-to-housing reuse is largely imprecise. On the other hand, total redevelopment possibilities are an easier metric to calculate, the report suggests. Overall, the number of units created through redevelopment is likely to be larger than those from adaptive reuse.

For the time being, though, existing studies suggest that conversions from redevelopment have outpaced those from reuse. For one thing, researchers note, reuse is generally more expensive. For another, a lot more commercially zoned land is amenable to redevelopment than to reuse.

The report also cites major design challenges of adaptive reuse, all of which suggest that “it would be better to entirely redevelop inefficient buildings.”

One such challenge includes the numerous building code differences between commercial and residential uses, which raise questions that threaten the feasibility of otherwise promising conversion deals. Another is that conversions are rarely attractive if the site isn’t near its original zoning envelope.

And then there is the problem of the unforeseen risks that conversions hold. These might include the building’s systems, foundations and structural improvements, among others.

While older buildings are often better candidates for reuse, they are more likely to have unanticipated costs, the report notes. Even among the dozens of successful conversions, developers found that the contingency budget ended up being larger than expected.