Key Takeaways

  • The advent of remote hybrid work models has decreased office usage dramatically, likely leading to rising downtown office vacancy and asset distress, especially in the class-B and -C segments.
  • Office owners, lenders, and municipalities dependent on commercial real estate tax revenues must find alternative uses for redundant office space. Conversion of obsolescent office space to apartments may be an answer to these problems, while simultaneously addressing the pressing need for housing in major metropolitan areas.
  • Growing distress in the office market increases the number of potential candidates for conversion but only a few will be viable. Investors must be aware of the characteristics that make offices suitable for conversion.
  • Developers will need to source equity equivalent to $100 per square foot or more to finance a conversion. In most cases, sponsors will employ historic preservation tax credits, low-income housing tax credits (LIHTCs) or New Market Tax Credits to supplement the investor equity portion of the capital stack.
  • A recent Biden administration initiative to permit local governments to use unspent American Rescue Plan (ARP) funds to encourage development of affordable housing may become an important source of conversion project soft debt. As office-to-apartment conversions address a confluence of problems facing urban America – housing shortages, deteriorating municipal revenue bases and empty downtown streets – a compelling case can be made for deploying unspent ARP funds to advance these objectives.    

Remote Work Disrupts the Office Market

Americans are moving past the pandemic and returning to a more normal or familiar pattern of daily life. One habit that many may not fall back into is the time consuming and often costly commute to the office. Millions of office workers continue to work remotely, and few will return to the office setting full time. These workers will adopt a hybrid approach, dividing time between remote work and the office.

Consequently, downtown office usage remains only about half of pre-pandemic levels and at the current pace will not reach capacity for a decade or longer, leading many business leaders to reassess the amount of office space they will need in the future. A CBRE survey of office tenants found that half plan to reduce space usage in the next three years. Although presence in the office may return to fashion at some point, tenants are likely to trim office space footprints as leases expire.

In the process, hundreds of older downtown office buildings may be rendered economically obsolescent. Property values could decline, leaving owners and lenders in search of strategies to restore property cash flows. At the same time, cities could find themselves needing novel ways to replace lost real estate tax revenue from distressed office buildings in order to revive once bustling downtown streets.

Adaptive reuse to multifamily residential is the most frequently mentioned solution to each of these problems. While a glut of vacant office spaces may be collecting downtown, the country has a substantial housing deficit. Conversion to residential use represents a pathway toward addressing both issues simultaneously.

Conversions to Multifamily on the Rise

Indeed, the office-to-residential adaptive reuse trend has gained considerable momentum. Conversions have increased at faster than a 25% annual pace since 2020, and currently about 75,000 units are underway or planned, according to Yardi Matrix, the most ever.

Still, office adaptive reuse projects are devilishly complicated and difficult to execute, involving complex permitting, engineering, architectural, and funding challenges. So, where should one begin to launch a reuse project?

Target Asset Price

Identifying potential market and property candidates is a great place to begin. Although the volume of distressed office assets is increasing, only a small percentage are viable conversion candidates.

The first test of viability is price. For a conversion to pencil out, the purchase price of the property plus conversion costs, less available tax credits and grants, must not be greater than the cost of ground up construction including demolition expense. In most markets, offices generally trade to higher prices per square foot than apartments. In Downtown Los Angeles, for example, second tier offices command prices above $600 per square foot, compared to about $320 for B-grade apartments, rendering it unlikely that an economic transaction is possible without substantial subsidies unless the target property, whether used for office or industrial purposes, is both functionally obsolescent and subject to material deferred maintenance issues. [1]

Developers must identify niche markets and properties that are exceptions to this price rule. Chicago – one of the most active conversion markets – is a good example of a favorable market. Class-B offices of more than 50,000 square feet in and around the Loop trade to prices equating to about $170 per square foot. Properties outside of the Loop and deeply distressed assets can be acquired under certain circumstances at prices in the $100 per square foot area. Conversely, prices of class-B apartments in the Loop hover near the $400 mark and in neighborhoods west and north of the Loop in the $250 to $350 range, suggesting that the prospects for a successful conversion are good.

Other markets where Central Business District office property values have come under pressure recently also may give rise to conversion opportunities. This is particularly true in West Coast technology hubs, most prominently in the San Francisco Financial District and to a lesser degree Downtown Seattle and Portland.      

However, as conversion hard and soft costs are likely to average $100 to $200 per square foot [2] and generous reserves for construction contingencies are essential in adaptive reuse projects, even a gap of the size available in Chicago may be insufficient. Price differentials of $250 per square foot or more may be required in the absence of third-party subsidies.

Suitable Designs

Many office designs are unsuitable for residential use. Modern office buildings typically are designed with deep, rectangular “floorplates” that create long distances between windows and the interior. Residential spaces require natural light and ventilation, limiting the depth of apartment units to about 40 to 50 feet, often leaving a great deal of interior space that must be paid for but after conversion will generate little income. Pre-World War II offices, on the other hand, generally have shallower floorplates, higher ceilings and exterior façades that feel more residential, making them better suited for conversion. Insufficient natural light and window issues can be remedied architecturally by cutting out an atrium or air shaft in the core or removing and replacing a largely windowless façade, but only at substantial cost. Design remediation on this scale will only be feasible in high rent markets like New York or San Francisco. In markets where space costs and rents are lower, excess floor space can be rationalized by employing it for common amenities that do not require natural light, such as entertainment centers and game rooms, assigned storage, or exercise studios.   


It is the nature of distressed assets that vacancy rates are typically high. How high is high enough? Developers should bear in mind that remaining office tenants must be bought out and relocated before construction can begin on floors targeted for conversion. Negotiating and executing lease terminations and relocations can be an arduous, costly, and time-consuming undertaking. Therefore, the vacancy rate

and the remaining lease terms must be considered. Conversion to residential is unlikely to be the highest and best use of an asset that is less than 25% or 30% vacant – a rate of 50%or more is ideal.

In markets like Dallas where conversions of high-rise structures encompassing one million square feet of rentable space or more have become more common, mixed-use strategies may make lower vacancy situations more viable. When only a portion of available space will be converted to residential use, existing office tenants can be consolidated in vacant space reserved in the conversion plan for office use rather than relocated to another building. 

Comparable Rents

Likewise, assets may not be good conversion candidates unless pro forma apartment rent per square foot is as high or higher than in-place office rent. Otherwise, a standard renovation program will be more appropriate. Fortunately, markets where apartment prices per square foot are materially higher than the prices of office space often satisfy this criterion. In Chicago, class-B and -C office rents average $33 per square foot per year, while comparable apartment rents hover near $37 per square foot per year. Comparisons in sunbelt growth markets generally are not as favorable but may support conversions. For example, respective class-B and -C office rents in Dallas and Atlanta average $25 and $27 per square foot per year, while similar apartment rents work out to about $24 and $23 annually, gaps that may not preclude conversion so long as office vacancy is high and rents at distressed office targets fall below market average.

Rezoning and Permitting Challenges

In many jurisdictions a conversion project will need to be re-zoned from commercial to residential use. However, most Central Business Districts do not require fulfillment of a development approval process for residential applications. Rather, in these situations entitlement to construct residential structures is granted “by-right,” meaning that a developer need not grind through a complex entitlement procedure to pursue a project that is a legally permitted use.

Still, conversion projects will be required to comply with the building codes that apply to the intended end purpose. Codes applicable to residential properties in some cases vary materially from commercial standards, necessitating complete retrofits of plumbing, electric, and HVAC systems. Municipalities with long, convoluted zoning and permitting processes and regulatory complexities may require special expertise and therefore larger budget contingencies.  

Funding Conversion Equity

After identifying a viable asset for conversion, how can the acquisition and renovation expenses be financed? Initial funding in most cases will consist of equity, preferred equity, and a construction or acquisition and development loan. Bear in mind that even in a market with favorable cost characteristics the sponsor will be required to source equity capital in the $100 per square foot vicinity.

Investor equity can be supplemented by sources of public or public/private partnership monies. A common source of public funding is the historic preservation tax credit (HTC). The HTC is a federal tax credit owners of certified historic structures may claim in an amount up to 20% of qualified rehabilitation expenditures. The work must meet a “substantially rehabilitated” test whereby renovation costs in any 24-month period must exceed the adjusted basis of the building. Most economically viable projects involving an acquisition of a property for conversion will satisfy this test.

A certified historic structure is defined as a building the National Park Service verifies is consistent with the historic character of such properties or the district in which it is located. Many buildings older than 25 years or designed in a manner associated with a recognized architectural style or school will qualify.

In addition to the federal HTC program, 37 states provide complementary historic tax credit preservation incentives. State incentives range from 10% to 50% of qualified costs, constrained by annual and per project allocation caps in some instances. Eighteen states cap credits at 25% of qualified basis, covering up to 45 %of cost basis, and 13 states allow a maximum of 20%.

Texas and Virginia have the most clearly defined, easily navigated programs. Texas has been the most active user of the development tool, having funded 240 completed projects from 2015 to 2020, representing $1.8 billion of qualified expenses and $2.6 billion of total investment.  

Developers electing to set aside all or a portion of the project for low-income households may pursue Low-Income Housing Tax Credits (LIHTC) in lieu of HTC. LIHTCs are distributed by the IRS to states on a pro rata population basis. State housing authorities allocate the credits to applicants based on a set of priorities disclosed in a written plan. Allocations are competitive but many states award bonus points to projects located in high opportunity and difficult to develop areas, criteria that most downtown office conversions would satisfy. New Market Tax Credits (NMTC) also may be available, either alone or in conjunction with HTCs or LIHTCs. NMTCs are federal tax credits allocated by the Department of the Treasury to Community Development Entities (CDE) to encourage investment in low-income census tracts (LICT). CDEs sell the credits to raise funds to make debt and equity investments in active businesses operating in LICTs, including multifamily rental housing where at least 20% of units are rent restricted and occupied by low-income tenants. [3] Qualifying multifamily properties must contain a commercial, job creating component—retail, health care, office, food service, etc.—with a cost basis equal to at least 20% of the financed property.

The NMTC cannot be used for improvements in a property that also received LIHTCs. But developments may be able to receive both credits by splitting the project into separate legal entities with their own governing documents. This condominium structure is frequently used in mixed-income apartment developments occupied by both affordable and market rate tenants.

Many Central Business Districts do not qualify as LICTs, but surrounding census tracts often do, particularly those with an industrial character where distressed office and industrial buildings often are found. In addition, Empowerment Zones are in most cases eligible, providing investors with another layer of economic and tax benefits.    

While scarce now, soft dollar funding from municipalities may become a meaningful source of capital in 2023. Facing office property value declines estimated to be as much as $552 billion over ten years (according to recent research by the National Bureau of Economic Research) some large American cities are considering emulating a Calgary, Alberta program that subsidizes residential conversions with a view toward offsetting lost office real estate tax revenue and reviving its once vibrant downtown neighborhood. An executive action by the Biden administration announced in October 2022 could provide a portion of the needed funding. The initiative grants state and local governments authority to use unspent ARP funds for loans to residential projects that set aside at least 20% of units for affordable housing. As of March 2022, cities and counties had not expended, allocated, or budgeted about $65 billion of these funds, enough soft dollar financing to launch dozens of conversion projects.

Green Financing Options

Thorough renovations of commercial HVAC, water, and electrical systems can reduce ongoing operating expenses. With the assistance of federal, state, and local governments, green energy incentives may serve as a source of project financing. In states and municipalities with approved Commercial Property Assessed Clean Energy (CPACE) programs in place, developers can separately finance up to 100% of the acquisition and installation costs of renewable energy systems. Under this program, a local PACE administrator funds and administers a sustainable energy investment in a commercial property. The CPACE investment is repaid over a 10- to 20-year period in the form of an addendum to the development’s real estate tax assessment. Because the investor has a tax lien on the property the applicable interest rate is lower than commercial rates. Energy cost savings derived from renewables may equal or exceed the period costs of the assessment. The recently expanded Federal Renewable Energy Tax Credit (FRETC) program also may significantly reduce the cost of acquiring a money saving renewable energy system. Last summer, Congress passed and the president signed into law the Inflation Reduction Act (IRA) authorizing $369 billion of expenditures on programs to enhance residential energy efficiency and provide for climate resilience and energy security. The legislation increased the FRETC and extended bonus credits to affordable multifamily rental communities. In addition to a standard 30% credit for installation of renewable energy generation systems (solar panels and battery storage in most cases) the IRA grants properties that participate in a federal affordable housing program (and some workforce housing properties) a 20% bonus credit and a further 10% bonus to properties located in a LICT. Using these credits, properties servicing an affordable tenant base may defray as much as 50% of the cost of a renewable energy system.   

Municipal Sustainability Incentives to Forward Office Conversions

Municipalities may share in the cost savings generated by privately-owned green energy and water conservation systems. Municipal bond investors are progressively integrating environmental, sustainability, and governance (ESG) considerations in their investment decisions. Cities that improve ESG scores by reducing carbon dioxide emissions or elevating water conservation efforts can earn meaningful bond interest cost savings. Adaptive reuse strategies are among the best ways to score ESG rating gains. ESG compliance may provide city governments with a tangible incentive to encourage adaptive reuse projects and CPACE financing programs.

In similar ways, conversions preserve and enhance urban landscapes, yielding demonstrable benefits to cities. Obsolescent but architecturally pleasing older buildings that might otherwise be demolished or left vacant are instead preserved and enhanced, creating attractive street space with cafés, terraces, and patios that attract constructive social activities rather than social decay. Rehabilitating aesthetically pleasing structures brings humanistic elements to downtowns that might otherwise feel sterile, alienating, and dangerous. Achieving status as a 24/7 city has measurable economic and social benefits, providing additional incentive for municipal governments to support the adaptive reuse movement economically and regulatorily.      

Construction and Permanent Debt

Conversions also require an acquisition and construction loan and, if conventional financing is employed, a forward commitment for permanent debt. A forward commitment is an enforceable pledge by a lender to deliver a loan under agreed upon terms (including a rate lock) upon the satisfaction of certain conditions such as successful completion of construction and lease up. The acquisition and construction loan can be sourced from a commercial bank, a syndicate of lenders, a finance company, or a debt fund. Bank and finance company lenders also may extend forward loan commitments but they are most frequently provided by lenders associated with Fannie Mae or Freddie Mac.

Fortuitously, the annual capacity of Fannie Mae and Freddie Mac to extend forward commitments for residential projects that set aside at least 20% of units for low- and moderate-income households was expanded by executive order last year. Each enterprise is now authorized to extend up to $3 billion of forward commitments without limitation by applicable lending volume caps.

Projects rezoned for multifamily use may be eligible for an FHA 221(d)(4) guaranteed mortgage loan, a construction loan that converts to a fully amortizing fixed rate permanent loan upon stabilization. This loan guarantee can be used to fund market rate projects but is most frequently endorsed for affordable housing transactions.

Once completed and stabilized, converted apartments become readily financed with permanent debt from a variety of capital sources. These include not only the GSEs, but also life insurance companies, CMBS conduits, commercial banks, and other private capital providers. The broader sources of capital available to residential properties represents another use case for apartment conversions over non-residential alternatives.

Prospects for the Future

Office to apartment conversions are complex transactions with many financial, engineering, architecture, regulatory, and financing challenges. Moreover, the number of potential conversion candidates is small, and therefore so is the prospective size of the market.

Nevertheless, a confluence of factors is converging that is likely to make the transactions more commonplace in America’s major cities. More than mere interesting investment opportunities, conversions may represent an essential tool for preserving our economically and socially vital central business districts and satisfying the affordable housing needs of urban populations. Lument welcomes enquiries from organizations interested in exploring opportunities in this burgeoning market and looks forward to bringing our talents to bear on your behalf. 

Market Case Study: Central Dallas

Central Dallas satisfies most of the critical criteria of a fertile office adaptive reuse market. Vacancy in late-2022 among office buildings of 50,000 square feet or larger averaged 30%, and roughly 25% of the inventory was at least 30 years old and more than 30% vacant. Considering properties in this age and occupancy cohort nearly a dozen buildings were configured with adaptable floorplates and currently offered space for lease at $20 per square foot or less.

By contrast, class-B/B+/A- apartments in the Downtown and Uptown submarkets were 94.3% occupied in December 2022 at an average annual rent of $26 per square foot, according to Yardi Matrix. In fact, adaptive reuse apartment buildings make up 20% of the core submarket inventory of buildings 50 units and greater, including two steel and glass office buildings lacking exterior residential appearance. Average occupancy in the adaptive reuse sample was 92.6% at rents averaging $24 per square foot.

Population growth in the 3.35 square mile Downtown and Uptown area has been rapid – increasing by nearly 10,000 (93%) since 2010 – and is likely to continue to increase at a good pace as workers migrate to the Dallas area. Converted office space was a crucial element facilitating this growth and may become more so as sensitivity to the costs and climate impact of ground up construction rises. 

Currently, five office conversion projects are underway in Dallas. The latest will carve 293 high-end units from the 1.3 million square foot Energy Plaza building on Pacific Avenue. On Elm Street, the same developer will convert a vacant 1.3 million square foot tower into 324 luxury apartments, a flagship hotel, and renovated office space and a second will convert the circa 1906 masonry brick Dal-Tex Building. Also in the Main Street District, a developer will convert space in Santander Tower to 228 apartment units, with a similar proposal in the works for the top floors of Bryant Tower near the convention center.

Market Case Study: Downtown Fort Worth

Overall vacancy in the Central Fort Worth office market was about 20% in late 2022, considerably lower than Dallas. Unlike Dallas, however, vacant space in Fort Worth is concentrated in older buildings, the subset of office towers most conducive to conversion to apartments. Among Downtown office buildings constructed before 1975, vacancy averaged about 32% in December 2022.

Of eight older, high vacancy buildings, seven are designed with shallower floorplates readily convertible to apartments. Four of these are masonry brick construction with handsome architectural details that lend themselves readily to residential use.

Office rent represents the greatest impediment to Central Fort Worth conversions. Data provider CoStar reports that asking rent for space in each of the most easily converted buildings is $20 per square foot or more, and the average rent in the subset is $24 per square foot—higher than several newer steel frame Central Dallas buildings.

By the same token, apartment and office rents in the Downtown area are closely comparable. The average asking rent of 25 professionally managed Downtown area apartments averaged $23 per square foot in December, according to Yardi Matrix. Three of these properties were adaptive reuse renovations, where asking rent averaged $21 per square foot. It seems that revenue gains from conversions to apartments could be modest. This has not deterred developers from pursuing conversions, however. Two office building of gross rentable area of more than 150,000 square feet each were purchased in January by separate developers intended for conversion to apartments. In-place office rents in each case were thought to be in line with Downtown apartment rents and neither seems to be substantially vacant. Moreover, the investors appeared to have paid prices per square foot consistent with similar upper mid-range multifamily assets that traded in the last three years. Evidently, developers not only are confident in the conversion model but downtown submarket prospects as well. 

[1] In fact, the Central Los Angeles office inventory contains many buildings of this nature dating to the first half of the Twentieth Century. Several such buildings were purchased for renovation or repurpose at prices between $200 and $300 per square foot since 2020.

[2] Based on an estimate made by Jeffrey Havsy, et al of Moody’s Analytics, April 7, 2022.

[3] For this purpose, “rent restricted” units are those where rent is limited to 30 percent of the adjusted family income, and “qualifying low-income households” generally are households earning 80 percent or less of Area Median Income.