- Real estate experts told BI that the office sector will experience a wave of distress in coming years.
- Run-down, vacant offices could be sold in fire sales as owners cut their losses.
- That might be good news for housing supply as former offices get converted to apartments, industry vets said.
A seismic event is brewing in a corner of the commercial real estate market, with many office buildings facing distress as they approach a wall of maturing debt and struggle against enduring work-from-home trends.
Those factors — which have left some of the worst office buildings nearly deserted — are about to spark a handful of fire sales, potentially kicking off a wave of office-to-apartment conversions that will add more housing supply to the pipeline, real estate pros said.
Richard Barkham, the chief global economist of commercial real estate investment firm CBRE, says he sees an upheaval of Class B office buildings — a segment of office properties that struggle to attract tenants, mainly due to being older and in need of renovation.
These second-tier properties have vacancy rates as high as 80%, he said, predicting that many could be ripped down or transformed over the next decade.
“The banks are going to have to dispose of that real estate,” Barkham told Business Insider in an interview. “So we will see. I think over the next — and this will pay out over two to three years — I think we’ll see a wave of offices going back to banks, and I say, they’ll be firesold and either demolished or converted.”
That chain reaction already looks to be in the works, with banks quietly shedding troubled office properties from their balance sheets and conversions starting to trickle into the mix.
The total amount of commercial real estate loans held by commercial banks declined to $2.9 trillion, down from a peak of $3 trillion earlier this year.
Large banks have been pulling back on lending to the sector, with 74% saying they tightened standards for nonresidential commercial real estate loans in the second quarter of 2024, Federal Reserve data shows.
Meanwhile, the number of office spaces scheduled to be converted into apartments rose to 55,000 in 2024 — the highest number of office-to-apartment conversions recorded in four years, and a 357% increase from levels recorded in 2021, according to Yardi Matrix data cited by RentCafe.
John Vavas, a real estate finance attorney at Polsinelli who works with commercial real estate lenders, has worked on a handful of office-to-residential conversion deals this year. He had never worked on that kind of deal prior to the pandemic, he said.
Offices account for around 20% of the square footage of all CRE properties, and the worst-performing buildings account for around 10% of the total office supply, Barkham estimated.
There’s around 1.2 billion square feet worth of office space that could be spun into residential space, Yardi said in a separate report.
A CBRE analysis of planned, ongoing, and completed office-to-residential conversions since 2016 estimates that 1.38 billion square feet worth of office space could be converted. Barkham said the evolution could take around a decade to fully take place in cities.
To be sure, these kinds of conversions are costly and difficult. In New York, architects have cut holes in skyscrapers to rearrange square footage, and Silverstein Properties, one of New York’s largest commercial landlords, is spending $1.5 billion to convert some of its office buildings.
Still, for landlords facing a glut of unwanted space, it could be worth it to try to covert it.
“There’s a solid base of really badly performing offices that’s going to go bust over the course of 2025,” Barkham added. “It’s quite clear that we don’t need as much office space in the United States as we did.”
The office market’s new era
While most high-quality buildings are being filled, demand for offices has generally sagged since the pandemic, when remote work became much more widespread. The US office vacancy rate was 19.4% in August, according to the data provider CommercialEdge, up 200 basis points from the prior year.
Late payments on commercial real estate loans have climbed to 1.42% in the second quarter, the highest rate in nearly 10 years. Commercial real estate prices, meanwhile, dropped another 9% year-over-year in the first quarter, Fed data shows.
But real estate investors have warmed up to the sector over the past six months, Vavas says, thanks partly to buildings being sold at steep discounts and banks attempting to dump loans from their balance sheets. He recalls a deal he worked on recently, where the property owner priced the building at a 20%-30% discount.
“The people who owned it, the building was heavily vacant and they just wanted to, I think, cut their losses,” he said.
Many defunct offices are expected to be converted into residential properties given the shortage of housing in the US, Vavas says. The office-to-residential conversion is the most common type of conversion project, according to Yardi data, accounting for 38% of all conversions in the works.
“The idea of people being in the office three days a week versus five days a week was the exception, not the standard. And now it’s the opposite,” Vavas said. “If you do that across a company, by definition, your demand is going to drop. And when it drops as a result of this post-pandemic thought of being back in the office, then I think you have to start to look at, well, I have this space. What are the needs for the community, for the location? And in New York, it just happens to be residential.”
Washington DC, New York City, Dallas, Chicago, and Los Angeles have recorded the most office-to-apartment conversion starts this year, with a combined 19,462 conversions in the pipeline, Yardi data shows.
Commutes will likely be shorter on average, and cities with many vacant offices could see more stores, restaurants, and theaters creep into the mix, Barkham says. He notes, though, that changes won’t happen overnight.
“You will see vacant buildings, and you will see see-through offices for some considerable time,” Barkham said.
Read the full article here
