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Commercial real estate is in dire straits. At the same time, there’s an acute shortage of residential housing. Surely, the solution is simply to convert offices into homes en masse?
Probably not, at least in the US, according to Goldman Sachs. Its economists estimate that although the office vacancy rate is already the highest since 2000 — and heading much higher — the price of commercial real estate might actually have to fall almost 50 per cent before conversions become financially feasible.
From a report the investment bank sent out yesterday, with Alphaville’s emphasis below:
— The wide adoption of hybrid work caused a structural decline in office demand. The office vacancy rate increased by 4pp over the last three years to 13.5%, the highest level since 2000. We expect the vacancy rate to rise even further in the next 10 years to 18%, as more firms reduce their demand for office space when their current leases expire. As a result, many existing buildings, especially those that are old and low-quality, may become economically nonviable as offices, raising the question of what can be done with the underutilized space.
— At the same time, the U.S. faces a shortage of residential housing. The imbalance between these two markets has led many investors and policymakers to wonder whether underutilized office space can be repurposed to meet the demand for residential housing. In this week’s Analyst, we provide an overview of the office market and assess the feasibility of office-to-multifamily conversion and its economic implications.
— Using CoStar’s detailed dataset on commercial properties, we estimate that around 4% of US office buildings—those located in suburban areas or central business districts, built 30 or more years ago, not renovated since 2000, and currently facing vacancy rates above 30%—might be no longer viable as offices. The average transaction price of these offices has declined by 11% since 2019. In the hardest-hit cities, as many as 14-16% of offices may no longer be viable by our definition, and their average transaction prices have already fallen by 15-35% since 2019.
— Only about 0.4% of office space was converted into multifamily units per year before the pandemic, and so far this has risen only to 0.5% in 2023, suggesting that there are still large financial and physical hurdles to conversion.
— Using a discounted cash flow model, we show that current acquisition costs for struggling offices are still too high for conversion to a multifamily building to be financially feasible once we account for the high additional costs of conversion and financing. For the top 5 metropolitan areas that are most affected by remote work, we estimate that office acquisition prices would need to fall almost 50% for conversion to be financially feasible. This suggests that most of these offices will likely remain underutilized in the near term.
— We estimate that the annual conversion rate from office to multifamily will remain low and only increase slowly to 0.7% in the next four years, delivering about 20 thousand additional multifamily units per year. Because the conversion process is slow and costly, available office space is likely to remain excessive and many buildings are likely to remain underutilized. As a result, we expect new office investment to remain sluggish in the next few years, resulting in a 0.2pp drag on fixed private investment growth, which will only be offset modestly by a 0.05pp boost from increasing multifamily construction.
