330 Million Square Feet In Vacant Office Space Won’t Cure Housing Shortage

The world is awash in empty office space as workers scramble for scarce and expensive places to live. Why not solve both problems by converting the empty offices to apartments?

Experts told me some office buildings could be converted — to luxury condominiums.

Meanwhile, bigger office buildings with a central elevator shaft are unlikely to be economical to convert to housing. Office to affordable residential housing conversions may be require subsidies.

As this problem is being sorted out, investors should explore bullish bets on home builders and bearish ones on office building owners who are increasingly handing back the keys to banks.

Too Much Office Space

The pandemic wreaked havoc on office building occupancy rates.

Workers are not commuting to the office five days a week. Indeed, the office return rate nationwide is 50% of pre-pandemic levels, according to Kastle Systems, which tracks security swipes in office buildings. Despite management efforts, workers are likely to keep working from home and occasionally visiting an office.

There is more office space than corporate landlords need and they are on the hook repay billions — with some returning the keys to the lender. Here’s how much:

• Vacancy rate: 18.6%. In the first quarter of 2023, the average U.S. office vacancy rate was 18.6%, 5.9 percentage points higher than the last quarter of 2019, according to Cushman & Wakefield. By 2030, C&W estimates that 330 million square feet of U.S. office space could become obsolete.
• Vacancies rising. Bloomberg estimates that more than 17% of the U.S. office supply is vacant with 4.3% available for sublease. While these averages mask wide differences across the country — with San Francisco’s nearly 25% vacancy rate leading the pack and Silicon Valley vacancies at 17% and rising, according to the Wall Street Journal — C&W expects unleased office space to keep rising until the second half of 2023.
• Billions in landlord borrowing coming due. The Mortgage Bankers Association estimated $92 billion in debt for office buildings will come due in 2023 and another $58 billion will come due in 2024, according to Bloomberg.
• Some landlords handing back the keys to lenders. A PIMCO-owned landlord defaulted on nearly $2 billion in debt for seven office buildings in San Francisco, New York City, Boston and Jersey City, according to Bloomberg. In February, Canadian asset manager Brookfield “walked away from two prime office buildings in Los Angeles after defaults on $784 million-worth of loans.” according to fDi Intelligence. Mark Rose, CEO of global real estate advisory firm Avison Young, has never seen the level of office givebacks this high, noted CNN.

In January, people working from home were hurting the New York City economy. As Columbia Business School Professor, Stijn Van Nieuwerburgh, told the New York Times
NYT
, “On an average weekday, nearly half of New York City’s workers stay away from the office; on Mondays and Fridays, the share is even higher. Subway and bus ridership are down by one-third from pre-pandemic levels. Major crimes rose more than 20 percent last year, and more than 300,000 people left the city in the first year of the pandemic, taking a total income of more than $21 billion. If office values decrease in proportion with usage, city revenue from property taxes will drop by $5 billion a year.”

Too Little Housing

At the same time, there is not enough housing for all but the wealthiest people. The housing shortage keeps home prices high — out of reach for most people. Despite the high mortgage rates, housing starts are surging. It remains unclear whether that will result in enough affordable housing to satisfy demand.

Here is evidence of too little housing and efforts to satisfy the demand:

• Millions too few housing units. Freddie Mac estimated the U.S. is short about 3.8 million housing units — both for-rent and for-sale, according to Axios. The U.S. has 142 million housing units, the Wall Street Journal reported.
• Median house prices rose 40% since January 2020. The median home price, at $419,103 — though down 3.1% in the last year, according to Redfin
  RDFN
  — is 40% higher than it was in January 2020. Contributing to the high price is a 39% drop in homes for sale since 2018, Redfin reported.
• Housing starts surged 21.7% in May. Construction on new American homes jumped 21.7% in May, as home builders started work on single-family homes to meet strong buyer demand. Housing starts rose to a 1.63 million annual pace last month from 1.34 million in April, MarketWatch reported.

Builders are feeling optimistic about the housing market. Richard Moody, senior vice president and chief economist at Regions Financial
RF
Corporation wrote in a note, “To say that we did not see this one coming would not even come close to capturing the degree to which the May residential construction data caught us off guard.”

Challenges In Converting Office Space To Housing

Will builders close the gap between demand and supply? Or could all that excess office space be converted to housing?

The short answer is that office space conversions are most likely to satisfy the demand of those seeking luxury apartments rather than affordable ones. In addition to changing the zoning restrictions to allow conversion from office to residential use, here are the common reasons it is challenging to convert existing office space into housing:

• Engineering impediments. “The large floor plates of many commercial office buildings built in the late 20th present challenges to conversions including limited access to daylight throughout most of the interior of each floor (in violation of most residential building codes),” Justin Steil, MIT Associate Professor of Law and Urban Planning, wrote in a June 20 email.
• Need to update plumbing. Although some cities such as Portland, Oregon, Washington, D.C., and Chicago are streamlining approval processes and facilitating conversions, office buildings need more water and sewer lines to accommodate one or more bathrooms per residential unit instead of one or two bathrooms per floor in a typical office building, Steil noted.
• Considerable office conversion costs mean apartment prices must be high. It costs so much to make these retrofits that they make the most financial sense in cities with high rents. “It will cost $200 to $300 per square foot to retrofit. Either the building must be inexpensive for this to make sense or the apartments created must be expensive. Conversions into luxury apartments are happening in cities with high rents like Manhattan, San Francisco, and Boston,” said Joseph Gyourko, Wharton School Professor, in a June 21 interview.
• Affordable housing conversion could only work with government help. Conversion of office buildings will not solve the affordable housing problem without “additional municipal action,” Steil said. Such action could mean giving up tax receipts during the conversion process. “Cities will be losing out on the real estate tax for two years until people are living in the apartments,” Kosta Ligris, MIT Sloan School of Management Lecturer, told me in a June 21 interview.
• Many office buildings will not make it. “The really good buildings will be fine. The older ones are hard to retrofit. Work from home will average one day a week which will reduce demand by 20%. There will be a decent number of buildings that won’t make it. I don’t see conversions happening for the middle class. There will be a massive number of landlords handing back the keys. What will happen to the regional banks that lent them the $40 million to $50 million?” Ligris concluded.

Van Nieuwerburgh is optimistic government subsidized construction of new housing downtown and the conversion of commercial buildings into apartments can help Manhattan. “In a best-case scenario, we remove 30 or 40 percent of the office stock in New York City, turn it into wonderful housing. New York City has all these great amenities, it’s a wonderful place where young people want to live, regardless of where they work,” he told the Times.

What Investors Should Do

Investors should consider bullish bets on home builders who will profit by meeting the demand for housing while betting against office landlords and banks that lend to them.

Home builders worth evaluating include KBHome, PulteGroup
PHM
, and Lennar
LEN
— which are at or near all-time highs. Investors should consider whether these stocks could keep rising.

Office landlords that might suffer include Brookfield Corp — which has lost nearly half its value since peaking in November 2021. Investors should assess the future creditworthiness of such companies.

Banks, about which I wrote in April, that could be exposed include Valley National, East West Bank and Synovus Financial. Investors should evaluate whether they are likely to experience higher rates of loan defaults.