Will New Incentives Spark Office-to-Residential Conversions?

Office-to-residential conversions, where an existing office building is renovated and turned into housing, could be an important tool to help address housing affordability and urban decay. Although there are obstacles, several government programs could help make these projects profitable.

The economy has shifted dramatically after the pandemic, and several interlinked factors can potentially create a “doom loop” environment in many urban areas. The rise of remote working (among other economic factors) has led to a sharp decline in demand for commercial office space, and many office buildings have been unable to replace tenants leaving the market.

Vacancy rates are higher than they’ve been in 30 years. This has led to a concomitant loss of foot traffic in city centers, meaning fewer people using public transit and frequenting businesses downtown. As businesses reliant on foot traffic (retail, food service, etc.) shutter at an alarmingly high rate, this leads to lost tax revenue and raises concerns about how cities will continue to provide essential services efficiently and effectively.

Meanwhile, the demand for affordable housing remains incredibly high, as the number of Americans paying more than 30 percent of their income on housing continues to grow yearly. Nationwide, there’s an estimated shortage of at least 7 million affordable housing units. For these reasons, office-to-residential conversions appear an attractive way to restore urban areas while increasing the housing supply. There are, however, several obstacles to the feasibility of these conversion projects:

• Expensive to renovate. Many downtown office buildings, especially those built after World War II, are not architecturally suited for conversion without dramatic changes to the floorplan. These buildings tend to have deeper floor plates, making it difficult to comply with requirements that each bedroom have at least one opening window. Many conversion projects have seen developers create a courtyard or blind shaft to avoid leaving an unusable middle portion that lacks access to natural light. Many conversion projects also require the developer to update heating and cooling units to accommodate separate controls for each unit. Also, plumbing must often be overhauled to serve kitchens and bathrooms in each new residential unit, as most large office buildings have central kitchens and bathrooms serving an entire floor.
• Regulatory issues. Dealing with zoning laws, which, in some cities, prohibit or limit housing in office districts, can be very costly and time-consuming. Most cities also maintain building codes that are different for offices than residential buildings, so additional work may be necessary to ensure compliance with those codes.
• Highest and best use. Even with the decline in demand for downtown office space, office rents remain substantially higher than residential rents per square foot. Couple that with the cost to acquire and renovate a property for conversion, and it’s easy to see why only a few conversion projects appear attractive to developers.

Given these obstacles, many state and local governments offer incentives to promote office-to-residential conversions. The federal government has also released a guidebook explaining several new programs designed to promote these conversions, especially near public transit centers and/or where they would reduce emissions.

New federal programs that could enable developers to undertake an otherwise infeasible conversion project include:

• HUD: Office-to-residential conversions are now eligible for direct funding under HUD’s Community Development Block Grant (CDBG) program, and state and local governments can access up to five times their annual CDBG allocation in low-cost loan guarantees to fund conversion projects.
• DOT: Two new programs, the Transportation Infrastructure and Finance Innovation Act (TIFIA) and Railroad Rehabilitation & Improvement Financing (RRIF) programs, offer financing at below-market interest rates for housing development near transportation, including conversion projects. Also, transit agencies may transfer properties to local governments, nonprofits and for-profit affordable housing developers at no cost.
• DOE: The Department of Energy offers loans, guaranty programs and tax incentives to help pay for renovations to reduce emissions and make “green” upgrades to existing commercial buildings. Many of these items are listed in the U.S. Treasury’s October 2023 blog.
• Technical assistance. All agencies listed above offer technical assistance to aid developers seeking to take advantage of these tools. Sometimes, the technical assistance funds may even cover legal expenses.

Additional state and local programs may be available in certain locations, along with other longtime federal programs like LIHTC, opportunity zones, historic tax credits, etc. Developers interested in pursuing an office-to-residential conversion should contact their legal counsel and determine which incentives could facilitate the project.

Russell J. Rutherford is a partner with Burr Forman LLP. Based in Birmingham, he serves as outside general counsel for several unique clients, assisting them with various issues, including litigation, corporate, compliance, government relations and issues specific to charitable, mission-driven businesses.