San Francisco has an empty
office problem, and it starts right here in the
core of the city's downtown. There is 27 point
1,000,000ft² of empty office space in the city. Early in the pandemic, a lot
of office sector workers started working from home. And here we are three years
later, many of them are still working from home at
least some of the time. All of that has led to a
large reduction in the demand for office. We see a
lot of companies downsizing. We see a lot of companies
not renewing their leases at all and consolidating. Nobody's going to the
office. We need more housing supply. Why not just turn
all the office buildings into apartments? Not quite as simple as it
sounds. Not every office building
makes for a great conversion. Not every
conversion should be done. Not every building should
be converted. Many American offices are
sitting empty. New numbers showing
94,000,000ft² of empty office space in Manhattan. That is an all time record. Huge investors like
Blackstone and Brookfield are staring down defaults
in their office portfolios. Meanwhile, finding an
affordable apartment can feel impossible, which has
a lot of mayors talking. We have a great opportunity
to change the mix of uses in the downtown. Make it Easier to convert
unused office space to housing. So the thing about office to
apartment conversions is it sounds like a great idea. Nobody's going to the
office. We need more housing supply. Why not just turn
all the office buildings into apartments? Not quite as simple as it
sounds. Not every office building
makes for a great conversion. Not every
conversion should be done. Not every building should
be converted. In some cities, the laws are
making conversions difficult. It was about 3% of the New
York stock that we we saw as being convertible, and that
took into account differential of price
between offices and apartments, which has not
actually diverged as much as people may think. But in places that have a
lot of older office buildings, there's a lot of
conversion activity happening. Some big cities are looking
at incentives for developers who convert buildings into
housing. Nobody does things in the
real estate world out of the goodness of their heart. We have to find ways to
either require or incentivize these things to
happen. What's stopping cities from
converting more offices into apartments? And what
challenges do developers face when taking on these
massive endeavors? The office conversion trend
is heating up in a small group of cities led by
Washington, D.C. and Philadelphia. We are right now in the
Poplar Building in Philadelphia. The building
was built approximately 100 years ago as offices and
manufacturing space for Strawbridge & Clothier's, a
giant department store in the last century. This building is one of
several conversions conducted by the post
brothers. Physically may have had some
characteristics that people might think would make for
a tough conversion. For instance, it's 100ft
wide by 400ft long. That means lots of dark
interior space. The first consideration for
a lot of these buildings is about access to light and
air. That's why you see in some
situations, real creative redevelopment of these
buildings where people are driving a core into the
middle of the building to allow for additional
windows in the middle. We took a building that was
a perfect rectangle, carved it into an E. It's extremely complicated. It's expensive. You also have issues of
where does a plumbing lines run. And you know, it
sounds silly, but you got to have a bathroom in every
apartment or more than one. And if you only have a
single line of plumbing or a single area of plumbing,
because think about the offices. The bathrooms are
only in one part. It's going to be much more
expensive to convert that. Builders call this technique
remassing and it comes in different levels of
intensity. The Poplar in Philadelphia received a
light touch. We have units that are 50ft
deep as opposed to the typical 25 to 30ft deep. We're able to make them
work with things like what are called borrowed light
bedrooms, or interior bedrooms with a light, and
make really attractive layouts, even though the
floor plate might not seem ideal. Converted apartments tend to
be pricey, much like other real estate in the US. In a hot market where
there's a lot of demand for housing and a lot of
growth, such as Denver or San Francisco, that
conversions could potentially address maybe
10% of the housing need. That still leaves the other
90%. And so there's clearly a
need to think bigger about how we're going to build
more housing. Back in Philadelphia, the
typical household makes enough to afford about
$1,300 in rent a month. At the Poplar, single
bedrooms can rent for $2,000 a month. Then there are
projects like The Atlantic, where units can rent for 3
to $6000 a month. It was a 1920s Beaux-Arts
office building. We finished the conversion
in 2019. There, for instance, we
made a lot of structural modifications as an office
building. It had old mechanical
systems that took up basically the entire roof
area. When we're making those
major structural modifications, it's to
allow for really high quality amenities. The Post Brothers portfolio
includes 12 buildings in the Mid-Atlantic with plans for
expansion. We're generally 96% occupied
at all places, and there might be 1 or 2 weeks where
there's downtime between the old tenant and the new
tenant. That's what we call frictional vacancy. So
that's really the only vacancy we have. There's a very different
story unfolding in office districts. Office vacancy rates are
pretty high right now in terms of historical
context, the highest that we ever recorded. And that was 19.3% vacancy
rate on average. And that was a really
stress period. New York's hovering around
12-13% right now. That's a bad sign for
investors. Well, some of the office
REIT stocks have been really hammered down over 50% just
because of the back to work, which is not going as well
as some might have expected. How the streets feel in
downtowns has changed a lot in the past three years. Not all of those changes
are permanent. It is necessary for
downtowns and cities to address that perception. Though many offices are
quiet, they're not completely empty. That's a
challenge for developers. I think the actual vacancy
status or occupancy status is really the single most
important prerequisite for conversion, much more so
than, for instance, the physical layout, you know,
the floor plates or the systems or anything like
that. If there's a clear path to emptying out the
office tenants, it really can't be converted to
apartments. When a developer looks for
an office to convert, they're looking for certain
criteria. For example, older buildings tend to make for
better conversions, but the typical US office is newer,
bigger, and not vacant enough to be converted yet. These are massive problems
for city mayors. We have millions of square
feet of unused office spaces that is right now ready to
be converted into housing. This just makes sense. Office vacancies also affect
government finances. New York City offices
generate roughly $6 billion in taxes each year. School districts will tend
to rely heavily upon property taxes. The transit authorities,
like MTA in New York, will tend to. Rely a little bit
more on property tax. New York has experimented
with office conversions in the past. In the years
after September 11th, a wave of these projects rippled
across lower Manhattan. We looked historically going
back to 2000 and the number of conversions we were able
to identify that did happen in New York. There's a 50
something of them, and it turned out to be about 2.5
conversions per year. Well, there's no question
that rule changes in lower Manhattan help to spur, uh,
new life in that part of the city. And, you know, the
the result has been a success. The residential
population has tripled. That created tens of
thousands of new units and really turned the battery
and that surrounding area into a residential
neighborhood. The government's policies
can determine whether or not these projects happen. In Manhattan, commercial
buildings generally can take up more space than
residential ones. That condition, and many
others can change the financial outlook of a
project. So the number one issue in
New York is zoning. Washington, D.C., for
instance, they have kind of very technocratically
thought out the zoning, and you can effectively convert
any office building by right to residential in New York. That's very much not the
case right now. And unfortunately, in New
York, the zoning is dictated at the state level and not
the city level. So there's been a lot of
fights with in New York trying to get this changed. There's a lot of people
paying attention to the issue. This is what it takes to get
it done. People are reading through
50,000 pieces of paper to actually get housing built
in our city. If we have zoning rules and
other impediments which are keeping housing from being
constructed, shame on us. Especially when you are so
seriously seeing people suffering in New York City
and beyond. In Philadelphia, a ten year
tax abatement brought more development downtown. This policy saved home
renovators and investors more than $1 billion in
taxes, but just over half of those breaks went to owners
of high value properties. If it was a conversion, you
basically were taxed on the value of the shell that you
bought, but not any of the money you put into fixing
it up. So that's been hugely
valuable. Post brothers has two major
conversions in the works in D.C., where the local
government also wants to increase tax breaks for
downtown developers. That's Washington, I think
that is, frankly, one of the easier markets. When you look at, for
instance, the West Coast markets, San Francisco has
the highest GDP per person of any metropolitan region
in the country. Office buildings there are
just four years ago were valued north of $1,200 a
foot. Four years ago it had the
highest residential rents in the country, a higher than
Manhattan. We don't think San Francisco is going
anywhere, or there will be a huge opportunity set in
downtown San Francisco. Critics of these policies
say they're unnecessary developer handouts. Supporters hope the
additional supply will calm the housing markets in
expensive major cities. The US needs about 7
million more market rate homes at affordable price
points for extremely low income renters. The vast majority of people
who are eligible to receive housing assistance never
receive any. The scale of the problem is
much bigger than the resources that most
governments at any level, are prepared to dedicate to
it. You know, there's 500,000
new apartment units needed in New York by 2030, in
order to remain kind of an equilibrium between supply
and demand. We only forecast 38,000
more per year going up to there, which will fall well
short of that 500,000. And it's important that we
enable this opportunity for the sake of our commercial
office stock and for the opportunity to create new
housing. But we do project that over
the next ten years. We could create, uh, 10 to
20,000 units of housing. Uh, and that is our best
projection. But also, we recognize that
a lot of this is due to factors we'll relate to,
factors that are well outside our control. Questions like interest
rates. Questions like an
individual, property owners risk tolerance or building
layout. So we know that there's
real complexity here. Our rules are in the way
and we need to fix that. San Francisco has an empty
office problem, and it starts right here. And the
core of the city's downtown, there is 27 point
1,000,000ft² of office space in the city. And to put
that into perspective, let's take a look at San
Francisco's largest building, the recently
completed Salesforce Tower. There were nearly 20
Salesforce towers worth of vacant office space in the
city. San Francisco's downtown is
among the most vibrant in California and across the
country. It's suffering right now. It's emptier than it has
ever been in my experience. San Francisco and many other
parts of the country, we have seen a significant
rise in the amount of vacant space at office buildings,
and it's to a point where we have a pretty big surplus,
and that will take a number of years to be able to work
off that excess. We're never going to get
back to what we were before the pandemic. We're going
to be different. We're going to evolve. We're going to recreate
opportunities that may not have existed in San
Francisco. San Francisco has close to
90,000,000ft² of office space inventory, and over
27 million of that is currently vacant. Mayor London Breed has seen
this dramatic change while she has been in office. So San Francisco has a
vacancy rate right now at around 25%. And before the pandemic, it
was extremely low and almost nonexistent. The issue started with the
pandemic because prior to the pandemic, in the city
of San Francisco, our office vacancy rate was about 4%,
which meant that 4% of all the space, the millions and
millions of square feet of space that we had in the
city were vacant. And this issue was costing
the city a lot of money. How has the economy been
affected by the empty office spaces in the city? Well, the economy has had
some major impacts. We are facing an over $700
million budget deficit, mostly as a result to the
challenges around our empty office spaces as well as
we're seeing businesses close in the financial
district. Historically a city that
thrived off of commuters, San Francisco is no longer
that. It's even referred to as the
work from Home Capital of America, with 46% of
workers working from home in 2021, up from 7% in 2019. With many workers no longer
commuting to the city, the local economy continues to
suffer and office vacancies continue to rise. The city is now
experiencing its highest office vacancy rates in
nearly 30 years, and as leases run out, many
companies are opting not to renew. So how does San
Francisco solve this problem? One local
legislator suggests tackling two of the city's largest
issues head on. Well, what we can't do is
just leave these buildings empty. Uh, that would be
bad for our city's downtown. It would be a total waste. There are some obvious
things that we can look at, where we can meet some of
the other needs that we have and actually solve another
problem that we have. And that's our housing
crisis. San Francisco is tied with
Boston as the second most expensive city in the US to
rent, ranking behind only New York City, with a
median price of a one bedroom costing $3,000, and
the average sale price of a home in San Francisco was
$1.35 million in November of 2022. To address this
problem, the city has adopted the housing
element, which requires 82,000 units of housing to
be built by 2031. In order to reach that
goal, San Francisco needs to build more than 10,000
units per year starting in 2023. But that's proving to
be easier said than done. The system is broken, and I
have been trying to work with the legislative body
of this city to change it, and sadly, in many
instances, most of the members refuse to do so. In the next eight years, we
have to build 82,000 units. It's going to require that
we make some major changes that I know our legislative
body is not going to be open to, but if they don't,
what's going to happen? State support for
affordable housing is going to be taken away. Tax
credits and all the things that we enjoy to support
the ability for us to build housing in the first place
in San Francisco is going to be taken away. We have to
get aggressive with building more housing, and that's
going to take a lot of hard and courageous decisions. With the housing deficit and
an office surplus office to residential conversion
could potentially be a long time solution to address
both problems. This is not a simple thing. It's not just, you know,
something you can do for cheap or super easily. It's a challenging thing to
do, but it can be done. There are over a dozen
cities all over the country that are doing it. From 2016 to 2021, there
have been 218 office conversions in the US, and
so far in 2022, there have been 42 completions with 21
under way. However, 46% of those
conversions have been from office to lab, with only
17% being converted into multifamily buildings. The rents that you can get
for a life sciences lab space are much higher than
office space, so it makes that conversion financially
viable. We have high demand for
residential still, but not at the price that would be
required for a developer to do that. From a financial
perspective. And current market
conditions, developers lack incentives to build
housing, and strict regulatory policies often
mean that affordable housing initiatives need to be
government led. In Calgary, Canada, the
government is focusing its conversion efforts on
housing. The city is working with Gensler, one of the
world's largest architecture firms, to revive its
downtown core. Calgary was facing a bit of
a crisis with vacancy, so they had to even pre-COVID,
an office vacancy of about 38%. And what that meant
was they had around 12,000,000ft² of empty
office buildings, and that was spread across the whole
city. But they wanted a way of looking at it to see
really if residential conversion was viable,
then, if it was, which neighborhoods would benefit
from it most. Through an algorithm,
Gensler found that Calgary had about 6,000,000ft² of
office buildings that would be good candidates for
conversions. And now the city has
started the process of converting its downtown. Gensler estimates that
after the completion of the first batch of office
buildings, the downtown population will increase by
24%. There's a lot of cities
still talking about it, and they actually moved from
concept to action in about three months. One of the
really interesting things that Calgary did a good job
of is just making it very clear and very simple how
their program works. It's two things. You go
straight to building permit and it's $75 a square foot,
and I can explain it in in 10s. Calgary is just one of many
examples of office conversion efforts taking
place today. In the US, New York City,
Detroit and even Kansas City have all launched similar
initiatives. So could we see something
similar in San Francisco? San Francisco in particular,
I think actually has a real opportunity to do something
like this, because you have a office market which is
seeing an increase in vacancy, especially around
the core, and you're actually seeing a housing
market that is maintaining strength. You know, people
have been talking about a housing crisis in San
Francisco for a long time, and this is a good way of
slightly redressing that balance. Has the city received
applications to convert specifically from office to
residential? Not at this time, but we are
working and engaging with the business community to
help them to understand what is possible. I think that
there are a lot of businesses, property owners
in particular, who were not completely aware of how
easy it could be to convert. And projects like this have
taken place in San Francisco before. We met with Mark Babson,
the president of Emerald Fund at 100 Van Ness, an
apartment building that his firm converted from an
office. We have been developing
housing in San Francisco since 1979. 100 Van Ness is at 1972
office tower, 400ft tall, over 400,000ft² of office
that triple A owned and operated for many years. We
took over in 2011 and then from 2012 to 2015,
converted the building from office to residential. Emerald Fund undertook the
biggest residential conversion in the city to
date, building 418 new units of housing, and its
conversion was largely driven by conditions
similar to what we see today. This was an outgrowth of the
Great Recession, and for three years they were
unable to sign any new leases, and you had a 35%
vacancy rate, much like today in the area, in the
Civic Center area, we evaluated what makes more
sense converting the building to residential or
keeping it as office, and our analysis said to
convert it to residential. While the decision to
convert the building was easy, the actual project
was a big undertaking. I think it cost us, I think
that our construction costs were somewhere in the $125
million range, which is less much less than it would
cost. Today we decided to strip down the building.
The building was at that time 40 years old. And so the mechanical, the
electrical, the plumbing, none of those systems were
worth salvaging. Office conversions typically
take place in older buildings that are often in
need of major repair or remodeling. In these cases,
developers are already at a point where they are
investing dollars into costly upgrades. While an office to
residential conversion may require the stripping of
the building, in most cases, it's still much cheaper
than building from the ground up. We're finding them in
general to be about 30% less than the cost of doing a
ground up building. Obviously, you're
maintaining the existing structure. In some cases,
you're maintaining parts of the existing facade. While office to residential
conversions can be a cheaper alternative. Many
developers have no incentive to build more housing. Strict housing policies
often mean that what would have been a profitable
project no longer is. The most important thing,
from a developer standpoint is what makes the most
financial sense. What project works. There's a lot of things
that are standing in the way of converting office to
residential. The biggest one being that
the numbers aren't working today because construction
costs are so high. There are things that the
government could do to make it easier. When building housing. What are some of the
barriers that you see in the city? I think some of the barriers
that we see have a lot to do with some of the policies
that exist additional impact fees, community benefit
fees, transportation fees, like you have these laundry
list of fees. And at the end of the day,
the developer and the people who are investing in these
projects, they're going to make sure they make their
money. They pour those expenses into each of the
units. Every time we add another
fee or another requirement, that's another expense for
the average everyday San Franciscan. And why I think
housing has gotten so out of control, unaffordable in
this city. I think also the barriers
are the process and how long it takes to build housing,
all the different requirements. We have so
many laws on the books already in terms of height
limitations, in terms of open space, in terms of
number of units, in terms of everything that you have to
do to build. And then on top of that, we
make people go through an insane process, which takes
an extremely long time. San Francisco already has
the highest construction costs in the world, with an
estimated cost of $350 per square foot for a high rise
apartment. When constructing a new
building, developers either have to pay an affordable
housing fee of almost $200 per square foot, or meet
the inclusionary requirements that require a
certain percentage of below market rate units. That percentage can be as
high as 30%, depending on where construction takes
place. Would the city be open to kind of decreasing
that percentage of affordable housing to build
housing in general? Well, I'm definitely open to
it. We need to be open to that. The decision is not
completely on me, but I plan to propose some decisions
that will help us look at the feasibility, what makes
the most sense, what's fair, what's equitable, and how
can we get these projects done fast so that we can
get this housing built? And that could mean
lowering the affordable housing requirements for
those particular projects to make them desirable. The city has a housing
crisis. Do you think it matters what type of
housing that we are building, or do we just
need all housing right now? We just need all housing. And I'll tell you, you
know, affordable housing sounds good. But when you go through the
process to try and get access to affordable
housing in this city, it is hard and it is really,
really challenging. And the system that we have
tried to repair under state and federal law has been
very, very difficult to work under. And so as far as I'm
concerned, we need to be as aggressive as we can to get
more housing built. The issues are clear and
urgent, and with the housing element deadline set for
January, San Francisco needs to act quickly. San Francisco is a very
resilient city, and we see things turn around and
oftentimes turn around very quickly once we work
through the economic issues that we have right now that
the demand for commercial real estate could start to
grow very quickly. There could be some great
opportunities in the downtown area. But more importantly, as we
see this downtown area start to evolve and more housing
get built there, it's going to be a great neighborhood
for people to be in all throughout the weekend and
the evenings. And so I just think the
possibilities are endless. So we'll see. We're going through a little
bit of rough waters these past couple of years, but
San Francisco will come back strong and I'm looking
forward to the innovative solutions, things like
conversion of office to housing to be part of that,
the resurgence of San Francisco. America's big cities are
facing major problems. From sky high interest rates
to the reluctance of employees to return to
their office, The impact of higher rates
and the banking stress is hurting smaller businesses
across the country. Many of which can be summed
up by a controversial new phrase the urban doom loop. The environment is certainly
shifting on Main Street, and it's weighing on optimism. Losses at the bank level,
right. There's going to be losses
of the investors level. And I think for the cities,
right. They're going to have this
potential, this urban doom loop. Columbia Business School
professor Stan Van Neuerburg coined the term. Here's how it all works. Early in the pandemic, a lot
of office sector workers started working from home,
and here we are three years later, many of them are
still working from home at least some of the time. All of that has led to a
large reduction in the demand for office. We see a
lot of companies downsizing. We see a lot of companies
not renewing their leases at all and consolidating. And with this demand
decline for office comes declines in the revenues
for the owners of those offices and value the
clients in these offices. Declines in property values
reduce property tax revenues for the city because cities
have to balance their budget. They now need to
cut spending. That means less money for
public safety, for sanitation, for
transportation, for education makes the city a
less attractive place to live. When people migrate
out, property values fall more less money, more
people moving out, and the city gets into an urban
doom loop, or its fiscal health spirals down. At the height of the Covid
19 pandemic, remote work policies prompted many
employees to leave their city and move to new
states. These population outflows
have long terme implications for cities, which rely on
tax revenues for funding. Property tax revenue in New
York City is about half of all tax revenue. Commercial property tax
revenue is about 10% of all tax revenue. So if the
value of that falls by 40%, we're talking about a 4%
hole in the budget. So if New York City's
budget is $100 billion per year, that's a $4 billion
shortfall that has to be made up somewhere else. Rich people pay a
disproportionate share of income taxes. In New York, for example, a
few thousand taxpayers are paying half of all taxes. Migration has become easier
because you can leave the city without leaving your
job. So if a few rich people or
families leave, that could leave a large hole in the
budget. The technology sector has
been more permissive to remote work, so those
cities tend to be affected the most. You know, think
of places like San Francisco, Seattle, West
Coast City, sort of more generally. The urban doom loop isn't
just a theory. It's playing out in the
real world, with landlords finding themselves
financially underwater and regional banks facing a
credit crunch. So when I'm a landlord and I
want to buy a building, typically I'm going to buy
it with a combination of my own money, my equity and a
piece of debt. Because real estate is such
good collateral, banks are generally willing to lend a
lot of money. So typically there will be
60, 65, sometimes even 75% debt and 25% equity. So that would be a typical
financing structure for a commercial real estate
building. And then typically the debt will be fixed
rate. The only difference is I'm not paying off any
principal, which means that ten years later when my
loan comes due, I need to refinance that loan. Now, normally that's not a
problem because normally the value of my office will
have gone up, which in these past ten years. But what if
it hasn't? What if the value of my
office has in fact gone down? So now the bank will
look at that office all over again and reassess it. And to the extent it's even
willing to give me a new loan, it's going to only
want to give me a smaller loan. So now, as a
landlord, I'm going to have to make a tough choice. Either I come out of pocket
and put more money into the deal, because the loan that
I'm getting now is smaller than the one I need to
repay from ten years ago. So I put in more equity in
the deal, or I walk away and I have the right to do
that. I can send the keys to the lender and just walk. A lot of the debt is
non-recourse, which means the bank has no recourse to
my other assets. I can just simply take this
one office building that I've borrowed against and
just send the keys to the bank. The bank now owns the
building. So banks are facing this
deterioration in basically the credit quality of these
commercial mortgages that they have on their books. So these smaller regional
banks that have done a lot of local commercial real
estate lending, they're now tightening the screws on
the credit for the local non-real estate firms as
well. That is sort of a
traditional credit crunch. Commercial real estate is a
very large asset class. There's about $5 trillion
of commercial real estate out there. And whether you
know it or not, you know your pension fund might
very well have an exposure to commercial real estate
directly or indirectly. There's also a part of the
equity market called the REIT market, which is the
publicly listed real estate space. And again, a lot of
folks have exposure to that through a mutual fund,
through an exchange traded fund. And those rates,
especially the office reads, have fallen on hard times
in the last several years. Their stocks are often down
50, 60, 70%, sometimes. Occupancy of office getting
to 30% below pre-pandemic levels. The office sector certainly
is going to experience more pain than any other sector
in the next 2 to 4 years. With only a small percent of
desks occupied around the world five days a week and
trillions of dollars of commercial and office debt
about to come due in the next couple of years, it
really makes you wonder how it's all going to shake
out. So are we really doomed, or
is there a way for cities to pull themselves out of the
loop? The fundamental problem is
that we have too much office the only. A solution in the
long run is to get rid of some of the excess office
we have and repurpose some of that space. The solution
you hear about the most is apartments. Turns out that
that's easier said than done, because a lot of our
large offices are very big buildings. By my own
calculations, only about 10% of office buildings are
physically suitable for conversion to apartments. But that's just one of the
options. You could think about more medical office
space. You could think about more
entertainment spaces, more hotel space. There's a lot
of creative things we could do with the land. This is
nothing new. Cities have always
reinvented themselves throughout the ages, and
it's now basically our next challenge is to get rid of
some of that defunct office space.
