Examining office to residential conversions in the District

The pandemic and its effects on commercial office buildings have reinvigorated the debate on conversions–specifically changing the use of a building from office to residential. In the second quarter of 2021, office space carried a 25 percent value-premium over residential properties. Given the value and tax rate differentials, each square foot of commercial office space in the downtown areas creates 2.5 times the property tax compared to each square foot of multifamily residential space.

Is this valuation difference too big of a gap to bridge for property owners and developers? Is the loss from commercial property taxes too high to be compensated in other ways? What other things should the city’s policymakers consider in discussing conversions?

Employment centers in the District of Columbia have long been a source of economic activity and city revenue. Office buildings not only bring in businesses that pay corporate franchise taxes, but they also bring in workers, create employment for those who staff these buildings, and support surrounding retail and restaurants. The historically high demand for an office with a D.C. address is itself a source of revenue: This year, 1,921 properties classified as “commercial office” are estimated to contribute to the city coffers $1.35 billion in real property taxes (44 percent of all taxes collected from all types of properties) and an $88 million in Business Improvement District taxes.¹ In fact, this high value is the most important contributor to the cost of doing business in the District of Columbia: According to a recent report from the Office of the Chief Financial Officer, the main driver of tax burdens on the District’s corporations is the high property taxes.

But even before the pandemic, there were signs of trouble. Rents remained high in the city’s major employment areas such as the Downtown, East End, as well as newly-developed parts including NoMa, Capital Riverfront, and Southwest Waterfront, but in some submarkets, vacancy rates were on the rise, hitting about 12 percent across the entire city. Since then, all key office submarkets in the District have experienced increases in vacancy rates, and overall vacancy stood at over 14.9 percent at the end of June 2021.² Importantly, for the first time in a very long time, year-over-year growth in rents has been negative across all submarkets, suggesting that the period of “musical chairs” when tenants moved from older buildings (for example in the Central Business District or East End) to newer office buildings (in Navy Yard, NoMa, and Southwest Waterfront) is coming to an end, and demand is depressed across the entire city. This is also evidenced in Tax Year 2022 assessments, which showed a nearly 8 percent decline for all commercial property across the city, and much greater declines for office properties across key employment centers.

The increased vacancy rates, together with the impact of the pandemic on commuter activity, expectations about the future of remote work, and the presence of a significant number of empty office buildings across downtown, have sparked much conversation on the future of commercial buildings and potential ways to adapt the makeup of office dominant spaces.

Given the chronic housing shortages in the District of Columbia, and the high demand for housing, office conversions could be one of the fastest ways of generating new housing, because they do not always require significant structural reconstruction, excavation, or sheeting or shoring. But so far, they have not been a significant source of housing units—market rate or subsidized—in the District of Columbia.

Over the last two decades the District has seen a handful of successful residential conversions

Even prior to the pandemic, office environments were being redefined, with changing telework trends and a shift to shared workspaces – increasing vacant office space, and high demand for housing. Commercial to residential conversions present a novel approach to address these issues, with an opportunity to produce both affordable and market rate housing units and tackle soaring vacancy rates.  The conversion of hotels provides another physically practical avenue of commercial conversions as hotel buildings are already constructed to fit residential needs.

According to 2019 data collected by the Downtown D.C. Business Improvement District, since 2002, the District has seen 18 conversions (including under construction), and among those, 11 are residential conversions. These created 2,459 units.³ Among those, 272 or about 10.6 percent are affordable, but this is largely due to a single project (Jubilee House with 176 units, which benefited from subsidies) that was entirely dedicated to affordable housing. In fact, among the conversions completed before 2019, only 23 out of over 1,371 units were affordable.

There are five other residential conversion projects that are in the works, with 1,342 planned new residential units, 9 percent of which will be affordable. As the map shows, residential conversions happen where residential demand is strong: along Wisconsin Avenue in Ward 3, in Kalorama and along Georgia Avenue in Ward 1, in West End in Ward 2, and near the Wharf and Navy Yard in Ward 6.

What are the considerations for residential conversions?

Office to housing conversions are rare since they require a set of specific characteristics to be financially viable. These characteristics include a prospect of higher net operating income for the provider under residential use, a building structure that is amenable to a residential transformation, and a regulatory environment that does not hurt the viability of a conversion project.

Net operating income and asset value

For the landlords, the most important consideration is­­ the net operating income from their building, which, together with the cap rate, determines the building value. In the District, on average, the valuations for commercial buildings carry about a 25 percent premium over residential buildings. The larger the gap between commercial and residential valuations, the more profitable it is to renovate and re-lease office buildings, as well as the more difficult for residential developers to compete to acquire them.

Even if operating income under residential use could be higher due to a decrease in empty space in the short-term, the overall earning potential of such buildings are significantly reduced, especially if landlords expect demand for office space to bounce back. As such, to maintain the higher value of their building, property owners might be more willing to bear the more temporary loss of rental income from vacancy.

Class A office buildings are the newest, most sought after and more expensive commercial real estate. With a high demand for Class A buildings, owners of buildings of lower class have issues retaining or attracting tenants. This makes vacant class B, C, and F buildings, generally older buildings with a lower demand, the most likely candidates for office to residential conversions.

The figure below presents an illustrative example using current market data to show the possible options for owners, and how different financial factors could contribute to the outcome. In this example, the owner had a $60,000 sq. ft. aging office building (Class C) that can rent for $48 per sq. ft., which is the average rate for Class C buildings in the Central Business District in the District. In a perfect world where the vacancy rate is zero, and assuming operating costs consume about 15 percent of operating income, the Net Operating Income after taxes and operating expenditures is $1.9 million, and the estimated building value is $27 million. We obtain this value by dividing the Net Operating Income with the capitalization rate for this building. We use 7 percent in this illustrative example, which is what the tax assessors have used for Tax Year 2022 assessments of similar buildings.⁴

Converting this building to residential use—specifically a Class A apartment building—will garner lower rents; and under similar vacancy and operating expenditure scenarios, would reduce Net Operating Income by $490,000 per year. However, because at present the market prices risk in the residential market at a much lower rate (reflected in the lower cap rates), the overall building value is greater, by about $1.6 million. For this owner, conversion to residential could pay off if the cost of converting the building does not exhaust this potential value increase of $1.6 million.

However, the owner also has another alternative: to renovate the building as a Class A office building. Under this scenario, given the high rents such buildings could generate, the owner can increase the Net Operating Income from the building by $295,000 and add $8.2 million to value, again if the owner can fully rent the building and keep operating costs at 15 percent.

In the real world, the decision to renovate, convert, or rebuild will depend on additional factors that the owner must take into consideration above and beyond the handful of factors we included in our stylized example. These factors all operate at the margin and can make or break a decision to convert for a given building. They include:

• Expectations about the future demand for office versus residential: A higher trajectory of rents for residential relative to office, an expectation of lower vacancy rates in residential unit relative to office, and lower cap rates, signaling lower risk in the residential market, for example, would make the conversion more attractive.
• Current vacancy rate: Conversions would be easier for commercial office buildings that are currently empty, or near empty. Existing leases on a property make it harder to convert because the owner would have to terminate these leases early—a costly endeavor—or wait for them to expire, which would have a high opportunity cost.
• Construction costs: Higher construction costs or bottlenecks in construction will make major renovations, including conversions, more difficult.
• Financing costs: An increase in financing costs, due to higher interest rates, higher perceptions of risk will impact the attractiveness of conversions.
• Policy risk: The owner would consider tax risk (for example, are commercial tax rates more likely to change or increase?) and regulatory risk (for example, how would building standards change and increase the cost of construction?
• Subsidies: A government subsidy for conversion, on the other hand, will increase Net Operating Income for residential use relative to baseline, and make conversions more attractive, but it would come at a double cost to D.C.: First, the city would have to cover the cost of providing the subsidy. Second, the city would potentially see a lower future tax revenue from the building, given that the tax rate on residential properties is half of the rate on commercial properties.

Building characteristics

Even when the finances look viable, the building structure could be a barrier. A major cause of reluctance toward residential conversion is the underestimation of the costs of such projects, and that the cost savings from keeping existing structures do not outweigh the risk. This becomes increasingly important if the conversions require significant changes to the building beyond what it would take to renovate the existing office space. Architectural elements that are common in office buildings can make conversions a difficult task for developers. For instance, the floor plates of a building are often a great challenge when looking at converting office to housing, since apartments are legally required to have natural light access in each unit. Or since bathrooms tend to be clustered in one area of office buildings, the limited plumbing lines can be an obstacle, as a residential building in contrast would require bathrooms and plumbing in every unit. For a change in the occupancy use, residential buildings would have to coordinate units and systems around the structural floor assembly in a different way. It might need a different placement of elevators, require façade redesigns, rerouting or rebuilding of electric and plumbing lines, different HVAC loads on the roof, and higher capacity utility lines – all of which will impact the cost for developers.

Public policy

Public policy itself can prevent conversions. For example, land use restrictions may require that the owner seek a change in allowable use, which could be a time consuming and costly process in D.C..

On the plus side, in the District, for many areas with potential growth, zoning permits 50-100 percent more floor area ratio (FAR) for housing, which can facilitate both conversion of the existing office to residential use, as well as new housing. However, sometimes the regulations for non-commercial use can complicate conversions, and there are many mixed-use corridors where zoning and height and density requirements are not enough to persuade office to housing conversion, when the current uses have stronger value. These various obstacles lead to many property owners being discouraged from residential conversions.

Even when permitted, any requirement to include affordable units in the conversion, for example through Inclusionary Zoning (IZ), will make conversions less attractive. Under the District’s new Inclusionary Zoning expansion, any mixed-use and residential project that is up-zoning through a map amendment to residential, must set aside 10-20 percent of its residential space for the affordable IZ units(IZ plus),⁵ and the Office of Planning has introduced amendments that would expand the regular IZ program to previously exempt zones⁶ (IZ XL), including non-residential to residential conversions.

Where are such conversion projects feasible?

Structurally, office buildings with the most potential for conversions are those with specific characteristics other than vacancy, such as the lack of renovation for many years, outdated floor configurations, or structural similarities that enable adaptation to residential use. As shown earlier, vacant Class B, C, and F office buildings present the most likely options for conversion. Since developers respond to the relative prices, conversion projects are more financially viable in suburban and emerging markets than in core markets, where land costs and office rents are lower. In downtown D.C., rents remain high enough that it is still more profitable for developers to try to re-lease buildings as office, and values are high enough that residential developers have a hard time competing to acquire office assets.

In its 2019 assessment of commercial to residential conversions, the D.C. Office of Planning found that conversion opportunities in the District are limited, but identified certain feasible markets. The potential for such projects is highest in the Rock Creek West Planning area, and somewhat possible in the Near Northwest and Upper Northeast Planning Areas. In Rock Creek West, property values of Class A residential buildings are quite comparable to those of Class A offices, and worth significantly more than Class C office buildings, a circumstance further compounded by the declining demand for office space. Moreover, the structural configuration of office buildings there provide an advantage: they often use lower proportions of their lots compared to centrally located buildings, and therefore the operating income of residential versus commercial is also similar, adding to the favorability of a conversion taking place. The Near Northwest and Upper Northeast Planning Areas also see more favorable Class A residential prices than Class C office, though to a lesser extent.

Lastly, zoning codes in the District allow for more residential density than commercial, and a change to residential would reduce the permissible building area per floor, which could lead to some areas remaining unused in a full residential conversion. However it does provide an opportunity for mixed use conversion. Conversions can also make use of physical structures in place, such as surplus parking, greater FAR and fire ratings, and the appeal of higher ceilings, or concrete walls for renters.

Potential pathways for residential conversions

Until recently, the prospect of converting to residential uses was not an appealing one for many building owners. But with changing circumstances – specifically the impaired demand which has reduced rents, increased vacancies, and negatively impacted building values– there is likely an increased interest in conversions from landlords, as well as the government.

What this analysis shows is that the decision to convert from office to residential relies on too many specifics for each building, making it difficult to rely on a single, general policy on conversions. There are many factors working against property owners that would need be addressed for successful projects, whether it is amenable building conditions and footprint, vacancy rates, or future expectations of value. As highlighted, many of these determinants for owners and developers to evaluate are too shifting for there to be a general policy suitable for all conversion projects. The most important thing the D.C. government can do is articulate its policy goals: is it to increase housing units? It is to create a more mixed-use environment in parts of the city where that are made up of office buildings? Is it to revitalize parts of the city that have old buildings or little street level activity? Is it to create affordable housing? As shown, these goals can sometimes work against each other. Another consideration for policy makers would be the tradeoff between the possible tax impacts from conversion projects, the subsidies developers may need to be financially incentivized to opt for such conversions,⁷ and the ability to generate and diversify the housing supply and increase the personal income tax base by attracting more households to the District.

1. This information is based on the Integrated Tax System Public Extract retrieved from opendata.dc.gov on September 9, 2021. The 1,921 properties are those classified as Commercial Office-Small (Use code 51), Commercial Office – Large (Use Code 52), Office Condominium (Use Codes 56,57, and 58), and Office – Miscellaneous (Use Code 59). Among these, the 996 buildings classified as Large Commercial Office Buildings account for 95 percent of the total taxes collected from office buildings.
2. This is an estimate that is the weighted average of vacancy rates across different submarkets tracked by CoStar.
3. This excludes the mixed redevelopment of the Fannie Mae site since this project goes far beyond the transformation of a single office building into a residential building.
4. Tax Year 2022 Pertinent Data Book for the District of Columbia pages 4-5.
5. The exact percentage of space to be designated to affordable units is based on bonus density to be used as well as construction method used. The maximum amount of 20 percent would always apply when an un-zoned or production, distribution, and repair (PDR) zone is rezoned.
6. IZ XL would include following zones: R-3 in the Anacostia Historic District; RA-5 and RA-10 (Dupont Circle); CG-1; MU-13 in the Georgetown Historic District; MU-27 (Naval Observatory); and NC-6 (Eighth Street) in the Capitol Hill Historic District; and would apply to stick-built buildings up to 85 feet, and to concrete/steel buildings taller than 85 feet.
7. The Office to Housing Task Force found that developers of residential conversion hoping to include affordable housing units could be assisted through current federal incentives, especially increased Low Income Housing Tax Credits for projects located in Difficult to Develop Areas and Qualified Census Tracts. Other direct subsidies would be needed for conversions that include affordable housing requirements. Such subsidies could come through various programs such as the Housing Production Trust Fund, Local Rent Supplement Program, property tax abatements, project-based subsidies or grants.