GFC 2.0? Not so Fast…

The COVID-19 pandemic has resulted in unprecedented changes in the global economy, and the commercial real estate market in the United States is no exception. Businesses are reevaluating their office space requirements as remote work becomes the new normal, resulting in a significant shift in commercial real estate demand.

Remote Work's Economic Impact on Commercial Real Estate

The COVID-19 pandemic-induced remote work revolution has had a significant impact on the commercial real estate market. Businesses have reconsidered their office space requirements as a result of flexible work policies and many employees working from home, resulting in a significant shift in commercial real estate demand.

Office Space Demand Is Declining

According to Cushman & Wakefield data, as companies downsize their office spaces or move to shared workspaces, average office vacancy rates in the US national market reached 18.6% in the first quarter of 2023, 5.9 percentage points higher than in the fourth quarter of 2019. Between the fourth quarter of 2019 and the first quarter of 2023, office vacancy rates in San Francisco increased from 5% to 24.8%. Furthermore, there has been no new office space supply in San Francisco since the first quarter of 2022.

This decline has reduced rental income and decreased commercial property values for property owners. It has also had an impact on new construction projects, as developers are hesitant to invest in new commercial properties in the face of uncertainty. According to Cushman & Wakefield, up to 330 million square feet of office space in the United States may become obsolete by 2030 due to failure to meet demands for hybrid working, energy efficiency, and environmental, social, and governance (ESG) goals.

Repurposing Underutilized Office Space

The shift in demand for office space has created a need for creative solutions to repurpose underutilized commercial properties. To address the housing crisis in many urban areas, one solution is to convert office buildings into residential units. According to a Brookings study, residential rents in New York City reached historic highs in 2022, and median apartment rents increased in 146 of 148 American cities between 2020 and 2022.

Office buildings can be converted into hotels, science labs, or industrial structures. However, due to the architectural modifications required and the potentially limited demand for such spaces, these alternative uses are less common.

Financial Aspects of Office-to-Residential Conversions

Following the remote work revolution, office-to-residential conversions have emerged as a viable solution for repurposing underutilized commercial properties. However, for developers and property owners, these conversions entail significant financial considerations and risks. Using a data-driven approach, this section examines the financial aspects of office-to-residential conversions.

Conversion Cost

Depending on the age, location, and architectural features of the building, conversion costs can range from $100 to $200 per square foot. According to the National Trust for Historic Preservation, the average cost of converting an office building into residential units in the United States is around $146 per square foot. Costs may rise if the structure requires significant modifications or must adhere to historical preservation guidelines.

Potential Return on Investment

Despite the high conversion costs, the potential return on investment can be substantial, especially in areas with high housing demand. As previously stated, residential rents in New York hit historic highs in 2022. According to an Urban Land Institute study, the median price per square foot for multifamily properties increased by 5.5% between 2020 and 2021, reflecting strong residential real estate demand, while the median price per square foot for office properties decreased by 5.9% during the same period. And by taking into account the steadily increasing average vacancy rate in US offices, from 12.7% in Q1 2020 to 18.6% in Q1 2023.

Risks and Challenges

Converting an office into a residence is not without risk. Developers are concerned about hidden costs associated with structural modifications, zoning requirements, and regulatory compliance, which can lead to delays, cost overruns, and decreased profitability.

Furthermore, the success of a conversion project is dependent on the strength of the local housing market and the location of the property. If residential demand is low or the property is in an inconvenient location, the return on investment may not be sufficient to justify the high costs and risks associated with the conversion.

Role of Government and Policy

The financial viability of office-to-residential conversions is heavily influenced by government policies and incentives. Many cities recognize the value of adaptive reuse initiatives and are changing zoning requirements and offering incentives to encourage office-to-residential conversions. New York City, for example, recently released an "adaptive reuse" study, which resulted in legislative and policy changes to increase the number of office-to-residential conversions.

“GFC 2.0”: Will History Repeat Itself?

The 2008 Global Financial Crisis (GFC) was primarily caused by the collapse of the United States housing market and had far-reaching consequences for the global economy. As the COVID-19 pandemic and remote work cause havoc in the commercial real estate sector, it is critical to consider whether the current situation could lead to a "GFC 2.0" scenario. Using data from previous sections, this section provides a data-driven analysis of the current commercial real estate landscape and the likelihood of a GFC repeat.

Trends in the Commercial Real Estate Market

The pandemic has had a significant impact on the commercial real estate market, with businesses shifting to remote work models and reducing their reliance on physical office spaces. According to the Brookings study, median apartment rents increased in 146 of 148 American cities between 2020 and 2022. These figures, however, point to a shift in demand rather than a market collapse, as was the case during the GFC.

Furthermore, the commercial real estate market has fared better than it did during the GFC. For example, global architecture firm Gensler has assessed 80 million square feet of office space in various cities' downtown areas for possible conversions, demonstrating the market's adaptability in response to the changing landscape caused by the pandemic and remote work trends.

Lending and Financial Stability

The widespread use of risky lending practices, and the subsequent collapse of the subprime mortgage market were major contributors to the GFC. Lending practices in the current commercial real estate market have generally been more conservative. In contrast to the risky lending practices that characterized the GFC, office-to-residential conversion projects require developers to secure financing and ensure the project's economic viability before proceeding.

Government Involvement and Adaptive Reuse

Office-to-residential conversions and other forms of adaptive reuse, as previously discussed, have emerged as viable solutions for repurposing underutilized commercial properties. Government policies and incentives, such as zoning changes and financial assistance for conversion projects, are critical in facilitating these transformations and mitigating their potential negative impact on the commercial real estate market. For example, New York City recently released an "adaptive reuse" study that resulted in legislative and policy changes to increase the number of office-to-residential conversions.

To summarize…

While the current commercial real estate landscape faces significant challenges as a result of the pandemic, remote work, and looming recession, the likelihood of a "GFC 2.0" scenario is still, well, very low. Factors such as more conservative lending practices, a growing trend of adaptive reuse, stringent regulation, and government support reduce the risk of a large-scale commercial real estate market collapse, which could snowball into something similar to the GFC. Most importantly, it can’t be a black swan if everyone expects it…

What do you think? Is commercial real estate the next shoe to drop?