The COVID-19 pandemic has forced Americans to change the way they live and work, with ripple effects felt throughout the economy. More than a third of households report working from home more often than they did before the pandemic, and workers are now reporting to the office about 3.5 days a week, down 30% from the pre-pandemic norm. These changes have put pressure on the commercial real estate market, which is dominated by office buildings but also includes hospitality and healthcare facilities.
Commercial real estate investment in the second quarter of 2023 fell 64% year over year. At the same time, office vacancy rates reached a 30-year high of 18.2%. As shown in Figure 1, vacancy rates continue to rise across the United States. High vacancy rates reduce foot traffic to “office-adjacent” economies, reducing demand for local businesses such as restaurants, dry cleaners, convenience stores, retail shops and beauty salons. New initiatives announced today by the Biden-Harris Administration provide an opportunity to accelerate the conversion of commercial real estate to residential uses and prevent this vicious cycle.
Policymakers in cities such as Washington DC, New York, and San Francisco are taking steps to revitalize their downtowns through the conversion of commercial properties, including vacant offices, hotels, and other non-office commercial space, into residential properties. Proponents of the policies see these policies as an opportunity to revitalize vacant real estate as well as address the long-term supply shortage that plagues the U.S. housing market and contributes to declining housing affordability. As of the end of 2020, there was a shortage of 3.8 million housing units on the market. Rental vacancy rates have fallen over the past four years to their lowest levels since the mid-1980s, most recently at 6.3% in Q2 2023. And as of 2021, 45% of renters are rent-burdened and spend more than 30% of their disposable income on housing. Conversion is also an opportunity to combat climate change. Buildings account for 29% of all greenhouse gas emissions in the United States, and it is estimated that renovated buildings can reduce carbon emissions by 50-75% compared to new construction.
A new federal guidebook shows how federal tools are already being used to enable conversions for affordable housing development. This is not surprising, as cities have also turned to commercial-to-residential conversion incentives to repurpose vacant office space during past macroeconomic downturns. New York worked to revitalize Lower Manhattan’s financial district through zoning reforms and tax incentives in the post-9/11 period. As a result, developers converted 20 million square feet of office space into housing and doubled the local residential population. During the same period, the dot-com bubble allowed Los Angeles to relax zoning restrictions on old commercial buildings, encouraging the development of 12,000 residential units over 20 years. Finally, Philadelphia coupled conversions with 10-year property tax abatements, resulting in 8.2 million square feet of office space being converted into housing and a 54% increase in the city’s downtown population.
Commercial-to-residential conversion projects must overcome physical complexities. Office buildings, especially new construction, are being built on increasingly wider floor plates to meet the demand for open-concept configurations. Residential buildings include features such as windows that open to the exterior and in-unit bathrooms and kitchens, often necessitating changes to floor-to-floor heights, window systems, heating and cooling units, sewer systems, and elevator access. Past conversion projects have often involved designing pre-war office buildings on smaller floor plates, with courtyards and separate offices.
Converting commercial real estate to residential also presents unique financial obstacles. Office vacancies are not uniformly distributed by building age, size, quality or neighborhood, and vacancy statistics reflect vacant square footage even though buildings house many tenants, each with their own lease terms. Commercial real estate conversions to residential face the same zoning constraints that have contributed to the long-standing housing shortage, including density limits, parking restrictions and strict use regulations.
Despite the complexities, a recent study found that 15% of office buildings in downtown areas of the 105 largest U.S. cities are suitable for conversion to residential, potentially adding 171,470 homes, or nearly half of the multifamily units in 2022. Developers say conversions can be completed faster than new construction and cost up to 20% less than demolition-and-rebuild projects.
COVID-19 has created long-term changes in demand for office space, with models suggesting the demand downturn will continue for the next decade. Additionally, the pandemic has caused a “flight to quality” for office space, shifting preferences toward luxury buildings. 10% of U.S. office buildings account for 80% of recent occupancy declines, and buildings with high vacancy rates tend to be older and in downtown submarkets. Facilities with the right building, land use, and economic characteristics can provide a new source of housing in places where it is desperately needed, and adaptive reuse of these properties can have the added benefit of improving the efficiency of existing buildings and reducing emissions.
Several existing federal programs already support commercial-to-residential conversions, and the Biden-Harris Administration aims to further encourage commercial-to-residential conversions through new measures announced today through the Housing Supply and Action Plan. The Community Development Block Grant and new measures, which provide $3 billion annually to support community housing and revitalization projects for low- and moderate-income families, will make it easier to use these funds for acquisition, pre-development, and construction related to conversions. This complements other measures, such as the $86 million grant recently announced by HUD to study office-to-residential conversions implemented since the pandemic. Similarly, the new DOT policy will free up $35 billion in available lending capacity at below-market rates for development projects, making it easier to finance conversions.
Today's announcement also outlines the broad range of federal tools available for retrofitting, including historic tax credits, which have assisted more than 47,000 properties and created more than 150,000 low- and moderate-income housing units since their introduction, with new opportunities continuing to emerge.