Can CRE conversions answer the housing inventory crisis? Not so fast.

A post-coronavirus shift in how people live is underway, given the necessity of remote work over the past year demonstrated productivity can continue without an office. That revelation stands to shake up commercial real estate in ways analysts are just starting to understand.

Offices are not going to go back to 100% the way they were. Neither will hotels in some markets,” Ana Bozovic, founder and owner of Analytics Miami and LiquiditySolutions, said in an interview. “People have this tendency to think that the present is sacrosanct. But things always change and history never goes backwards.”

In the opening quarter of 2021, dollar volume on commercial leases fell for the fifth consecutive quarter and office occupancy rates fell for the fourth consecutive quarter, according to a National Association of Realtors report. Office vacancy hit 16.4%, rising from 13% year-over-year and the highest level since 2010. Additionally, 70% of companies surveyed by NAR downsized their office space in 1Q 2021, up from 69% and 62% from the previous two quarters.

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At the same time, the pandemic’s historically low mortgage rates prompted a rush of home purchase activity and amplified the need for more housing, especially at the affordable level.

This juxtaposition of circumstances between residential and commercial spaces could seemingly align as a problem and solution, given that developers could ideally convert offices and hotels into residential properties. But multiple roadblocks stand in the way.

Getting conversions done at scale would require support from federal and local governments, given that zoning restrictions and the redevelopment costs hold back much of the construction, said director of real estate investments for the Bernstein Cos. Phil Aftuck. The Washington, D.C.-based investment company specializes in redeveloping commercial real estate and is in the middle of converting the Mark Twain Tower in Kansas City, Mo., and the Textile Building in Cincinnati into 200-unit apartment buildings. Both were vacant office buildings bought out of foreclosure.

Activity regarding conversion projects has picked up recently as a result of large office spaces becoming increasingly unnecessary in urban centers around the country, Aftuck said. While this type of construction has the potential to open up more housing, its complexity creates long project timelines. Retrofitting a building for something other than its original intended use usually takes about 16 months and sometimes upward of two years, Aftuck explained.

“You need a developer who understands it and a financing partner who is comfortable with the risk. You need to comply with regulations, you need tax credits so it pencils out, and you need a general contractor and subcontractors who have done it before and understand what they're doing,” Aftuck said in an interview.

Getting into the nitty-gritty of local politics requires expertise with the unique and sometimes arcane municipality laws — headaches that will most likely keep many private investors from funding CRE conversions. Thus, activists for affordable housing have taken up efforts to urge local governments to finance them.

For instance, on June 4, protesters gathered in Buffalo, Albany and New York City to advocate for the passing of the Housing Our Neighbors with Dignity Act. The act would use $100 million set aside by the state to convert distressed hotels and vacant commercial space into deeply affordable housing, with at least half the units allocated for homeless residents. The New York Senate passed the HONDA bill on June 10, allowing the state’s Housing Trust Fund to start financing the conversions.

“You have to have land, labor, materials, capital and demand. If you take away any of those things, it all comes crumbling down,” said Chase Gilbert, CEO of Built Technologies. “Municipalities can be more supportive at reducing the friction associated with getting new projects approved — because that's the real bottleneck.”

Investors like Bernstein Cos. seek out buildings in metro areas that have state programs in place providing tax credits to those taking on these redevelopments. They tend to be in secondary cities with rising rents and demand for more affordable housing.

Increased federal tax breaks could combat the high costs of conversions. Through its commercial board of governors, the Mortgage Bankers Association is lobbying for the low-income housing tax credit to be expanded, as well as the creation of middle-income, commercial real estate refurbishment and neighborhood homes tax credits.

“It's more of a community development conversation to take assets that would be eyesores if they’re not converted and [it’s] a real challenge to get past if there isn't a reuse for a particular mall or other piece,” said Jamie Woodwell, the MBA’s vice president of research and economics. Since they don’t require ground-up construction and already have a footprint, conversions would be less invasive for those communities as well, he explained.

Of course, ending the housing inventory and affordability dilemmas through commercial redevelopments will take time and creativity. But another way to influence more builders to get involved would be to treat it similarly to renewable energy, according to Bozovic.

“It's going to have to go the way of solar power where you decide that it's for the greater good — especially if it's tied to affordable housing, since that crisis is not going away — and you have some type of government incentives for it,” she said.

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