Last summer, I wrote about the contraction in office space occupancy as the cultural shift of Work from Home tightens its grip on America’s office space industry, despite efforts by high-profile employers to corral their far-flung workforces and bring them back to the office in hopes of greater collaboration and efficiency. Some like J.P. Morgan Chase and Walmart have basically issued an ultimatum: Get back into the office or find another job. But the fact is that the “Return to Office” initiative has been slow to take hold, with many companies not even trying to reverse the cultural sea change. There is a general agreement in the office landlord community that some undefined percentage of employees will never return to their offices full time, a conundrum for owners of large swaths of vacant commercial space.
With this comes the fear of further defaults on office building mortgages that have not come due yet, but as they do in the years ahead, banks are bracing for a cascade of write-downs and worse, repossessing buildings they can’t do anything with. A report on the health of the industry from the third quarter of 2024 paints a grim picture: the majority of U.S. office real estate investment trusts (REITS) ended the second quarter with relatively weaker operating metrics, with the demand for office space declining further as reflected in the sector’s continued dip in occupancy rates.
Nine office REITs reported quarter-over-quarter declines in their operating funds from operations (FFO) per share during the second quarter. Operating FFO per share improved sequentially for seven REITs while remaining flat for three during the fourth quarter. Looking at the sector’s recurring Earnings Before Interest, Taxes, Depreciation, and Amortization, the proportion of REITs with sequential losses are even higher, with 12 posting quarterly declines during the second quarter. The remaining 10 office REITs logged quarter-over-quarter gains during the same period.
Typewriters To Toasters
Repurposing office buildings has been an unattainable challenge – until now. The prospect of transforming unused office space into much-needed housing seemed a logical way to resolve both issues. But few conversions moved forward because the cost of acquiring even an aging office building remained too high for the economics to pencil out. Now that office vacancy has reached record levels, sellers are willing to take what they can. That has caused values to plunge for nothing-special buildings in second-rate locations, making the numbers on many of those properties now viable for conversions. Seventy-three U.S. conversion projects have been completed this year, slightly up from 63 in 2023. But another 309 projects are planned or under way, with about three-quarters of them office to residential. In all, about 38,000 units are in the works.
In the first six months of this year, half of the $1.12 billion in Manhattan office-building purchases were by developers planning conversion projects. And while New York, Chicago and Washington, D.C., are leading the way, conversions are also popping up in Cincinnati, Phoenix, Houston and Dallas. A venture of General Motors and Bedrock recently announced a sweeping redevelopment of Detroit’s famed Renaissance Center that includes converting one of its office buildings into apartments and a hotel.
But this office-to-residential trend won’t solve the office crisis, or even make much of a dent in the U.S. housing shortage. And many obsolete office buildings don’t work as conversion projects because their floors are too big or are limited by other design issues. The 71 million sq. ft. of conversions that are planned or under way only account for 1.7% of U.S. office inventory, so conversions are making a small dent into the problem of White Elephant buildings.
For the last many decades, especially since World War II, office building construction has been an important driver in overall concrete production, and now it has essentially ground to a halt. Producers must look to data centers, energy infrastructure, and other new trends in the construction mix to replace the lost volume of office building construction, an issue that will linger for decades to come.