The flight to quality? In the office sector, it’s more than a group of buzzwords. It’s reality. A growing number of companies are seeking less office space but in amenity-filled Class-A office buildings.
And those office buildings that lack amenities such as on-site fitness centers, rooftop decks, high-tech conference rooms and outdoor gathering spaces? They are struggling to attract tenants, leading some owners to consider converting these office spaces into other uses, most often multifamily.
But how realistic of a solution are these conversions? When does the cost of converting office space into apartments soar so high that the expenses outweigh any benefits? And what will happen with those Class-B and Class-C office spaces that are increasingly vacant today?
We spoke with Ryan Masiello, one of the founders of New York City-based real estate technology platform VTS about the state of the office sector across the United States. His thoughts? These remain challenging times for the office sector. And that flight to quality? Don’t expect to see that trend slow anytime soon.
How real is the flight to quality we hear so much about in the office sector?
Ryan Masiello: There is no doubt a pronounced flight to quality across most of the core U.S. markets. The office rents that are being achieved in trophy buildings are on average 13% higher than they were pre-COVID, which is astounding.
And are companies that are either in these higher-quality spaces or moving to them tout their amenities and quality when trying to bring their employees back to the office?
Masiello: For highly competitive companies, work culture is important. Getting people back to the office is critical to that. If you have a space where people want to spend time, that is important. Landlords are making sure that they have the right amenities in their buildings. They want their tenants to have a great experience from the moment they walk in the door.
What amenities are important in the office space today?
Masiello: One of the things that doesn’t get talked about enough are flex spaces and conference spaces. A lot of companies are shrinking their office footprints. They are justifying paying more money in rent-per-square-foot by taking up less space. But they still need that flexible workspace if they expect a higher number of employees in the office on a given day. They are seeking, then, buildings that can accommodate that need for flexible space. This type of space has become very important in today’s market.
Outside of that, food and beverage has become extremely important. Workers want access to healthy, quality food. It’s not enough that a building have a restaurant or bar. It has to be a high-quality operator.
Then there are fitness facilities. They have long been a popular office amenity, but they are even more important today. Outdoor spaces are key, too. Employees want to be able to work on rooftop decks or other outdoor spaces.
Just look at the Fulton Market area in Chicago when it comes to outdoor space and amenities. You’d be hard-pressed to find a building in that market that doesn’t have that flexible space or outdoor space. Fulton Market has become one of the most over-amenitized markets in the country.
Where does that leave Class-B and Class-C office spaces, then, that lack many of these amenities?
Masiello: There will always be a market for Class-B space. You have non-profits, government agencies and other big-space users that will always gravitate toward those buildings. A certain subset of the Class-B market will be fine.
The reality is that in markets like New York City, there are not enough residential buildings. Office conversions to multifamily buildings will be part of the equation when you are looking at Class-B and Class-C properties. There won’t be as many of these conversions as people think, though. The cost of converting an office building is often restrictive. If the government steps in and offers financial incentives, that can help. But it’s still a tough proposition from a capital perspective.
If you look at the stock of office buildings out there, there is only a small subset that makes sense to even think about for conversion to residential.
What makes an office building a good candidate for a residential conversion?
Masiello: A lot of the same things that make it a great candidate for office tenants. It’s about the efficiency of the floorplate. For an office tenant, you can lease out a full floor. You will have to break that floor into multiple units, though, if you are converting the building to residential. So you’ll need an efficient floorplate that is easy to break into apartments.
With residential buildings, their tenants want some of the same amenities that they expect in a great office building. It helps to have a fitness center on one of the lower floors. It helps to have some of the same type of common areas and common spaces that you might see in a commercial office building.
How about the location of the office buildings? Are there any types of locations that make especially good sense for a residential conversion?
Masiello: There are certain submarkets that offer the live/work/play model. In New York, for example, you can look at the Midtown South neighborhood. You can walk to work there or public transportation. It’s a neighborhood where it is easy to grab a bite. I think of Fulton Market in Chicago as the same thing. People want neighborhoods in which they can walk to restaurants, entertainment and public transportation.
When you look at the overall U.S. office market, are you seeing any positive signs?
Masiello: Most U.S. office markets are still heading toward more office vacancies, according to predictive models. However, there have been some signs of life across the board. Look at a market like San Francisco, which has been in a tough spot. Demand for office space in San Francisco is up 32% year-over-year. We are starting to see a subset of the tech industry, AI, heat up. That might be the spark that we need to gain momentum in the office sector.
In the Midwest, you can look at Chicago, which still faces challenges in the office sector. But that is a market, too, that is starting to stabilize. Maybe for Chicago it means that we are approaching or have reached the bottom. That would be a great place to be, because then you can start trending up again.