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As the commercial market falls apart, these three assets could be your next big opportunity

The majority of offices in the United States are still vacant. According to JLL the nationwide office vacancy reached a peak of around 20% in the first three months of 2023. While big tech companies press workers to return to work, the hybrid model of working has led to a rise in commercial office delinquencies. According to Trepp, an analytics firm in real estate, the rate of office delinquencies increased by 125 basis points to over 4% in May.

According to experts, this is a sign of trouble for both the commercial real estate and the wider economy. Morgan Stanley analysts predict a drop in the value of commercial properties by up to 40%. This would be similar to 2008’s financial crisis. Fred Cordova of Corion Enterprises believes that the crash has already begun. While most companies agree that the office sector is in a state of stress, others are more optimistic about the future of commercial real estate. UBS Global Wealth Management, for example, says the problem can be managed and that a crash similar to 2008 is unlikely.

Peter Margolin, National Broker Network manager at Alliant Credit Union agrees. Margolin says that while he does not believe the CRE market is going to crash completely, he believes certain markets will struggle more in the future than others. This cycle is different than 2008 in that capital markets are open and liquid, even if they’re not as liquid as last year. There are still lenders in the commercial real estate sector, such as Alliant, who are lending to specific asset classes and demonstrating a strong demand for borrowers with good credit.

According to the FDIC, commercial real estate was historically considered a high-risk asset. Investors who took a risk by purchasing commercial office spaces are now in a tight situation, as the demand has dropped. However, there is an option. Margolin says that property owners should have the option to reuse unoccupied office spaces in a creative way.

Repurposing Vacant Office Space

The demand for retail space is recovering from the pandemic recession, while the outlook for self storage remains positive. Multifamily housing demand is expected to decline, but in some markets housing shortages and increasing rents still make it attractive for investors.

“Multifamily and residential products for older buildings that are less amenitized

conversions. It can be market-rate rental, workforce housing or student housing.

Senior housing and affordable housing depending on the location and market

Micah Solit, Senior Project manager at Project Management Advisors, Inc., a national real estate advisory company, says “demographics” Micah Solit, senior project manager at Project Management Advisors, Inc., a national real estate advisor firm. Matt Silvers, vice president at the firm says, “Other options for conversion are hotels, and depending on building sizes and configurations, self-storage and document storage as well as technology uses like life sciences.”

What kind of work is involved in these conversions? Can the costs be recovered? What are the best times for commercial real-estate investors to convert office space and what are the worst? We spoke to several experts on the subject of commercial real estate so that you could evaluate your options.

Mixed-Use Retail

Since reopening, the retail sector has shifted from shopping malls to services. The mixed-use retail sector is growing as people look for more amenities near their homes and workplaces. Mixed-use spaces may also be popular due to the slowdown in homebuying. Sean Slater Senior Principal of RDC says that mixed-use is the future, the present, and even the past. This is especially true in areas where multifamily housing, such as New York, is in high-demand. Investors are converting Class B and C properties to mixed-use spaces.

According to Slater, converting office space into mixed-use retail is more effective than converting office space into retail. Slater says that multi-level retail rarely works, and office space is seldom at street level. A mixed-use approach would be the best option. Street-level retail and Food and Beverage, with smaller office and residential lease spaces could diversify vacant buildings without going too far in the residential-only transformation.

The future of the economy will also benefit. Slater says that office space remains in demand and could even become oversupplied if too many urban class A office properties were converted into residential housing. He says that a “patient approach” and diversification within buildings would create a more stable marketplace.

Investors can expect multifamily renters to pay more for a building with a lot of amenities. There are challenges to be overcome, such as finding the best management for a building with multiple uses.

Self-Storage

Rents in the self storage sector are on the decline, but the outlook is positive when compared with other commercial properties. Investors who hold onto properties with low occupancy rates may benefit from converting office space into self-storage.

Margolin says that while it may be difficult, converting office floors to residential use can be very rewarding. In some cases, self-storage may command higher rents for really outdated spaces than offering them for office use. He says that lower floors, with less desirable views, would make ideal storage locations.

Investors who decide to convert office space into a self-storage facility face obstacles. Margolin says that the good news is there’s likely to be plumbing and lighting in place for conversion into storage. The bigger question is how much work it will take to remove the flooring, walls, furniture and other items to make the floor suitable for storage. The next largest cost would be to design storage units that fit the floor plates, and to be able to transport materials up to these floors .”

Margolin adds that obtaining financing has become more difficult, but still not impossible. When the economy becomes more uncertain, it is natural for traditional lenders to pull back. This creates an opening for non-bank lending firms and private equity firms who can enter the market and work with traditional lenders in order to offer note on note financing packages and A notes. Margolin says that financing is still available for borrowers with good credit scores on properties with solid fundamentals.

Multifamily Housing

The costs of making the switch are too high to make it a common solution. Solit says that investors should be aware that conversions can cost more per unit than new developments. It is still a viable option under certain circumstances. Owners must be granular in their analysis of the project’s economics and identify the market for more residential units. They also need to determine a path for re-entitling the building for the new use .”

States that want to encourage conversions have eliminated fees, implemented more flexible zoning changes, and provided tax incentives to developers. However, a report by Moody’s in 2022 notes that the office property value would need to plummet significantly for conversions to be worthwhile. In certain areas, however, it may already be the case that an office-to-multifamily conversion is a good solution.

Solit says that location is an important factor. Investors will be looking to minimize the regulatory and jurisdictional hurdles which could make a conversion difficult. However, there must also be housing demand, as this drives rents and values. If the location is good, the building should have a high vacancy rate so that owners can avoid lease purchase agreements.

The building itself is also important. Operable windows and high perimeter density are important.

Conversion-friendly features include shallow floor plates, which give owners more space for future living. Solit says that a good street frontage, and enough space around the building will also help with conversion. Silvers says that older, smaller structures are more suited for conversion than larger, ultra-modern buildings .”

The Bottom Line

Repurposing an office can be a risky, costly, and challenging process. Some investors may need to adapt in order to minimize their losses, especially with the increase of vacancies and delinquencies even within Class A office buildings. Mixed-use retail conversions, particularly in areas with a high demand for work-live-play space, seem to be on the rise. However, self-storage or pure multifamily conversions can also be viable options. Commercial real estate remains unpredictable. Prices could continue to fall, but demand for office space might also rise. Before making any drastic moves, it’s important to assess your personal situation.

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