It’s no secret there is a shortage of rental apartments in the United States. A slowdown that began during the financial crisis of 2007-08 depleted supply, and the problem has been exacerbated by the supply chain woes of the coronavirus pandemic.
Residential construction, which sped up to meet the pandemic-induced demand, has been curtailed by this supply chain volatility, which has driven up prices of core materials like lumber, steel and metals. Meanwhile, a longstanding labor shortage is also contributing to the backlog. The United States faces an underbuilding gap of at least 5.5 million homes over the next decade, according to a study commissioned by the National Association of Realtors. Historical market equilibrium translates to a supply of roughly 1.5 million new units annually, the study said.
The supply problem is leading developers to consider alternatives to building new homes from the ground up. Property conversions, which require less time, materials and labor, present viable solutions to the shortage, particularly in the multifamily housing sector.
A pickup in conversions had begun prior to the pandemic. A recent analysis by RentCafe, a nationwide apartment listing service and blog, estimates that 20,100 multifamily units were set to be converted in 2021 according to Yardi Matrix data, nearly double the amount in each of the three previous years. As the pandemic’s impact on real estate continues, a surplus of condo, hotel and office space could lead to even more conversions to multifamily units.
Condominiums
In 1961, the National Housing Act was passed to promote affordable homeownership in multifamily buildings, giving birth to the condominium market. According to the Survey of Market Absorption of New Multifamily Units conducted by the U.S. Census Bureau, 68% of existing condos were built between 1970 and 2000, with nearly 20% built from 2000 to 2010. But valuations are relatively stagnant. In 2005, the median sales price of a condo was $228,200, according to National Association of Realtors data. Prices subsequently declined, not recovering to 2005 levels until August 2016, according to Redfin data. The aging supply of condos and their limited appreciation following the financial crisis represent an opportunity for investors.
Meanwhile, the burden of repairs at declining condo properties may present an incentive for condo boards to embrace conversion sale opportunities. Upkeep remains the responsibility of homeowner associations, which may lack the time and expertise to address it. If improvements and repairs are left unattended, condo owners may have to make additional payments for capital improvements beyond their association dues. Inconsistent participation in associations due to changes in ownership and subletting of units often add to the challenge.
The supply problem is leading developers to consider alternatives to building new homes from the ground up. Property conversions, which require less time, materials and labor, present viable solutions to the shortage, particularly in the multifamily housing sector.
Investors with capital, time and real estate management knowledge are uniquely qualified to improve the conditions of these properties, while at the same time providing much-needed housing for the multifamily rental market. They can provide above-market prices to condo owners trying to recoup their initial investment.
Timelines and local laws are considerations for investors seeking to convert condominium buildings. Also, it may take time to gain control of the homeowners’ association to commence the project. Local property laws should be assessed for friendliness to conversions. In Chicago and Florida, for example, new restrictions to deter conversions have been enacted.
Hotels
Hotels represent another area of opportunity for conversions. The extended-stay and limited-service subsectors of hospitality, in particular, are promising because they are already configured to support the structure of a multifamily property.
These hotels typically fall into the midscale hospitality category, a sector whose oversupply prior to the pandemic continued through 2021, as the chart below shows. Demand consistently falls between 45% and 57% of available rooms nationally. Another plus: midscale hotels are typically located in suburban areas with limited affordable housing—a long-term challenge in the United States.
Perhaps this oversupply could be a cure to the undersupply of housing. But this investment type is not without challenges, including zoning and approvals from local governments to repurpose the property. Having a keen sense of the local government’s appetite, as well as supply and demand dynamics of the area, will make for a smoother conversion.
Office
Much has been written about the future of office space, another category ripe for conversion, especially in urban areas. While offices are set to remain integral gathering places for corporate life, the pandemic has prompted a clear and potentially permanent shift to remote and hybrid work patterns, making it likely that the reduction of office footprints will continue. Net absorption, the measure of space utilization by square footage leased, highlights the next multifamily conversion opportunity.
Net absorption of office space has declined since 2018, recently hitting the lowest point since 2000 at more than 20 million square feet, according to data from CoStar. National inventory has been holding steady at approximately 8 billion square feet since 2006. And while the open architecture of many commercial office buildings clearly requires more effort to convert to residential space than other property types, that additional work is offset by a distinct advantage: location, location, location!
According to a recent study by the National Association of Realtors, the lure of office-to-residential conversion is reflected in the differential between office and apartment rents. Consider that rents for Class A apartments are up nearly 11% through the third quarter of 2021, according to CoStar data. Conversely, average yearly market rent growth for offices was just 1.15% through the third quarter of 2021. The growth differential between these two sectors presents a compelling conversion argument for office property investors facing low occupancy and limited rent growth.
Meanwhile, lagging business performance during the stop-and-start recovery of a volatile pandemic economy has made city governments more open to new ideas to revitalize empty spaces. But not unlike conversions in the hotel space, local zoning and permits can present challenges when repurposing office space.
Support at the federal level may help speed the office conversion trend. In July 2021, the Revitalizing Downtowns Act was introduced to the Senate; this legislation proposes to reimburse developers for 20% of the expense of converting older office buildings to residential, hotel or mixed-use properties. While this bill is still pending, the December 2021 passage of President Biden’s $1.2 billion infrastructure bill is encouraging; it supports the need to address aging U.S. infrastructure, including many urban offices. Urban office space may be the answer to the continued need for urban housing.
The takeaway
The expansion of multifamily housing supply through conversions of condominium, hotel and commercial office space—while not without challenges—represents an opportunity to bring each sector into better balance within the real estate ecosystem.
