Unleashing Opportunities: City Centers - Office to Residential Conversions and Mixed-Use Environments
Although Class B building conversions aren't a new concept, current market conditions have created more complexity around determining whether these transactions are worthwhile. As we consider the realities of shrinking downtown communities and increased demand for housing, our team is evaluating the challenges and opportunities behind office-to-housing conversions.
Bergmeyer Senior Associate and Design Practice Leader Isaac Smith explores the lead-up to the modern need for office-to-residential Class B conversions and why we think low-to-mid-rise transitions work well as a housing solution and incentive to revitalize urban downtown communities.
The Mixed-Use Development at 524-530 Main Street in Melrose, MA, is an example of a recent building transformation aimed at revitalizing a downtown community. Bergmeyer partnered with our client, John Wise of Wise Construction, to revive a property that had lost its history and identity to reinvigorate the location and enhance downtown Melrose. The mixed-use development was designed with the present and future in mind while still honoring its past.
Central business districts boomed in post-war America, complimented by a corresponding residential development boom in the suburbs. Single-use development highlighted the nation’s burgeoning obsession with production efficiency. Spawned by the industrial revolution and refined by wartime manufacturing efforts, the techniques learned transformed the economy. When applied to land use and urban planning, developments ushered in an era of rapid expansion of the nation’s infrastructure and real estate capacity. While the methods proved highly efficient, by the 1970s, these one-dimensional tracts began to lose their shine as we learned that the scaling outpaced sustainable levels and undermined key attributes of human nature and how our surroundings impact us.
While the US Census Bureau officially stopped efforts to define central business districts as official tracts in the early 1980s, their persistence in concept and reality has weathered new urbanism’s attempts to break down these monoliths into more diversified locales. The most obvious point of resistance has been that historically a key driver of value in office real estate has been proximity to other businesses.
As we are thrust further into post-pandemic reality, the question is whether this value remains. As many businesses struggle with convincing their teams to endure commutes and return to the office, it is possible, if not likely, that proximity to talent and where they live will become the dominant concern. If this proves to be the case, the key to stabilizing office valuations in the urban core is injecting housing into existing central business districts and returning them to the dense but mixed-use center city model that faded in the latter half of the 20th century.
The current oversupply of office space and chronic under-supply of housing in the United States represents the first time we have seen market conditions that make this specific transformation realistic and perhaps imperative.
Adaptive reuse has been a staple tool of urban regeneration since the 1960s. We have been doing conversions for decades, and the track record is solid. This is a hot topic now because the market has changed, not because changing-use types on existing buildings is a new idea. Perhaps counterintuitively, most conversion projects are predominantly market risk, not technical risk. Obviously, technical challenges weigh heavily on the ultimate success of a project.
Still, if we put enough design and construction resources towards these projects, we can solve the technical problems that arise. The unknown is if we can recoup the costs of those solutions. This kind of risk is mitigated by expertise operating at the right time while carefully adjusting project parameters.
Adaptive reuse is an optimization strategy. It’s a fine-tuning of the performance of specific assets within the built environment. Optimization within a narrow band is complicated, but when the band of operation widens like we now see with a dramatic shift in office demand, it represents an opportunity. The initial adjustments are easier to make, and success is more likely. This is why we can expect first movers to benefit.
The broadest base of recent success in adaptive reuse is probably the conversion of historic industrial properties to other uses. Despite enormous technical complications in these projects, they worked because the starting valuations of industrial properties were so low relative to other uses. It is very unlikely we'll experience that kind of valuation gap today, but we have the benefit of coming at the problem from two sides. We have too many offices, and we have nowhere near enough housing. As they say, upward and downward pressure creates diamonds.
As these projects inevitably get underway and the supply curves start to balance, the optimization band is going to narrow, and it will become more difficult to make the right adjustments. The technical costs will become harder to offset. Precision targeting is critical.
Class B, by nature, is generally less desirable than Class A, so it seems reasonable that over the long haul, the category value is lower even if it presently shows a slower rate of value decline. Class B buildings possess several characteristics that make them advantageous targets.
Class B buildings tend to be smaller buildings that lend themselves more easily to demising modifications that accommodate smaller residential units. Their size dictates that each conversion project will make a smaller swing in the overall supply curves of each asset type, offering a greater degree of short-term stability while making incremental progress towards right-sizing the market. Their size even indicates the likelihood of fewer active tenants where lease termination negotiations come into play in front-end re-development costs.
Class B buildings tend to be older buildings. These buildings are more likely to suffer from deferred maintenance and are the most in need of dramatic modernization programs to keep pace with environmental performance goals. This means that money can do double duty of modernizing and reconfiguring simultaneously. The older construction types can also be more flexible in some key respects. Masonry-bearing walls are a better fit for the increased fire separations that residential uses require. The floor systems generally allow for easier modifications. Numerous new mechanical, electrical, and plumbing penetrations are needed, which spread across floor plates to units rather than remaining vertically centralized as in an office building core. In some cases, older buildings may even qualify for historic tax credits to help finance projects.
By targeting the center city, we seek opportunities to create the highest likely value swing. Decommission the properties that are the least competitive in the office market and reposition them so they can command the top end of regional residential pricing. This provides the best opportunity to recover conversion costs.
What lies ahead is, in many ways, a less efficient system and one that is undoubtedly more interconnected and complex, but there is resiliency embedded in this complexity. Our system will shift simply because our urban places cannot survive the future as presently configured. Office-to-residential conversions will happen, and when we see a greater number of people take up residence in our business districts, we will begin to recognize the signs that these use types are mutually supportive of each other.
Valuations in one category can only climb as high as they are willing to pull along the others and not fall precipitously when restrained by their compliments. It could be rewarding for many to learn to harness this change in neighborhood dynamics and shift back to a mixed-use city center.
Realistically, it's not a question of "if," and for the first time, it's not a question of "when."
The Takeaway
A re-balancing is pending, and with it comes tremendous opportunity. For a host of reasons, business-to-business proximity will not be the force it once was. We are about to witness this hypothesis repeatedly tested through the remainder of the decade at least.
Mid-rise office-to-residential Class B conversion projects represent the lowest-hanging fruit and the most rapidly available opportunity for investors keen to capitalize. The availability of more urban housing stock presents another solution to solving the housing shortage while being a driving force in revitalizing urban businesses and communities.