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Aug 21, 2023

Serving a repurpose

PublishedAugust 30, 2023byStephenie Overman In Alexandria’s Old Town North, a collection of three brick office buildings built in the 1980s is being transformed into Tide Lock, a community of 234

PublishedAugust 30, 2023byStephenie Overman

In Alexandria’s Old Town North, a collection of three brick office buildings built in the 1980s is being transformed into Tide Lock, a community of 234 luxury apartments and condominiums featuring Potomac River views and space for retail and a nonprofit music school.

And last summer in the city’s Alexandria West neighborhood, tenants began moving into two, 14-story former office buildings that have been converted into Park + Ford, a 435-unit modern apartment complex with 115,000 square feet of office space.

Faced with a glut of vacant office space generated by a mix of high inflation and low post-pandemic return-to-office rates, some real estate developers in Northern Virginia have begun turning to office-to-multifamily (OTM) adaptive reuse projects.

This year, the inventory of U.S. office space shrank for the first time in recent memory, going back to at least 2000, according to data from Jones Lang LaSalle (JLL). Ground has been broken for less than 5 million square feet of new offices as of late July, while 14.7 million square feet of office space was removed from the market, as aging and vacant buildings are demolished or repurposed.

Meanwhile, in April, the amount of available office space for lease across the nation hit a high not seen since the 1980s savings and loan crisis, according to CoStar Group, a Washington, D.C.-based provider of real estate data and analytics. And with more than half of leases signed before the pandemic not yet expired, office vacancies are expected to increase. The national office vacancy rate is projected to rise from 13.2% to over 17% by late 2026, according to CoStar.

And while leasing of new office space increased from 57.4 million square feet in the second quarter of 2020 to 97.5 million square feet in the second quarter of this year, according to CoStar data, the amount of space being leased has shrunk significantly. Due largely to hybrid work policies, companies’ needs for space have shifted dramatically. The average U.S. office space leased in the second quarter was 3,275 feet, nearly 20% smaller than before the pandemic.

Empty office buildings in city centers mean fewer customers for downtown businesses ranging from food trucks and restaurants to urban transit systems. The typical office worker now spends $2,000 to $4,600 less per year in city centers, according to research released in April by Stanford University.

One silver lining, according to Dallas-based real estate services firm CBRE, is that there are “new opportunities for restaurants in growing office markets and the suburbs of many major coastal cities.”

The main reasons for these high vacancy rates, according to a report by Curtis Dubay, chief economist for the U.S. Chamber of Commerce, are that “workers just don’t want to go back to the office, and employers can’t make them because of the tight labor market.” Plus, “interest rates have risen sharply in the last 18 months, and they won’t be going down soon,” which puts a damper on commercial real estate demand.

Virginia Realtors Chief Economist Ryan Price agrees with that assessment. “As companies are coming back to work, occupancies are coming back up, but slowly. The hybrid model is pretty sticky,” Price says. Additionally, amid inflation and fears of a 2024 recession, some companies are reevaluating “their space needs and looking to downsize,” Price says.

Adding to the problem, nearly $1.5 trillion in commercial real estate debt will be coming due by the end of 2025, according to commercial real estate data and analytics provider Trepp. Many of these mortgages are interest-only loans for which borrowers have been making only interest payments during the life of the loan, with the principal due at the end. And CoStar estimates that as much as 83% of outstanding securitized office loans won’t be able to refinance if interest rates remain at current levels.

This has led to a landscape some media outlets have deemed a “commercial real estate apocalypse,” with communities, financial institutions and commercial real estate businesses all seeking solutions.

Northern Virginia, like the rest of the Washington, D.C., region, has been hard hit by these trends.

The outlook for Northern Virginia’s economy and office market remains “heavily dependent on and intertwined with the nation’s defense budget” and the government contracting industry, according to a JLL report: “While defense contract awards are up significantly year-over-year, [office] absorption remains negative, ending a 20-year correlation. This trend is expected to continue into next year as leasing remains subdued, particularly large-block leasing.”

Of the office activity that does occur, the research finds that the corridor “stretching from Old Town through National Landing and Rosslyn Ballston corridor, out to Tysons and the toll road, is expected to capture a disproportionate share of demand.”

Tide Lock and Park + Ford are among the OTM conversion projects developers have taken up in the region in recent years in response to the office space glut.

Real estate investment company USAA Real Estate (now Affinius Capital) and national real estate developer Lowe joined to convert the former Park Center office complex at 4401 Ford Ave. in Alexandria into apartment community Park + Ford, a project that started just ahead of the pandemic.

Drawing on its experience with a prior office-to-residential conversion, The George in Wheaton, Maryland, Lowe capitalized on the brutalist buildings’ 10-foot ceilings and large floorplates to create larger-than-usual apartments, along with remote worker-friendly amenities such as coworking common space and a pet spa. Maryland-based Whiting-Turner handled construction, with design from D.C.-based Bonstra | Haresign Architects.

Park + Ford was developed in response to “growing interest among young professionals … for an apartment community with more room for working and family, along with style and convenience,” says Mark Rivers, an executive vice president at Lowe. “As we began welcoming residents, we found that the pandemic only fueled demand for precisely the environmentand residences that we have created at Park + Ford.”

The cost of OTM conversions varies considerably, according to CBRE, ranging from $100 to $500-plus per square foot, depending on the original layout, existing conditions and scope of work.

Conversion usually calls for reworking of plumbing and electric, and distribution of HVAC throughout the building. But lighting — or the lack of it — is often the biggest challenge.

“A lot of offices have a lot of interior space, where with residential projects, you need to have window access. You need to have daylight without compromising the structure,” says Mwangi Gathinji, vice president of Community Three Development in Washington, D.C., which is building Tide Lock. The company has also completed OTM conversions in D.C. and Maryland.

The answer can be to “cut an atrium in the middle of the building,” Gathinji says, but “you’re always trying to mitigate the amount of chopping. That’s usually where the hiccup is” — cost. With OTM conversions, “there’s a lot of stuff in there that is not known, as opposed to starting from scratch. You have to know if the back-of-the-napkin numbers work.”

Despite the widening gap between office and multifamily vacancy rates, OTM conversions are up only slightly, and there’s no evidence they’ve significantly increased, according to a March 2023 CBRE report. “Construction costs and regulations on residential construction will continue to limit conversions to smaller, older office properties,” the report states.

Still, about 45,000 of the 122,000 apartment conversions in the pipeline nationally are redevelopments of office buildings, according to RentCafe’s Adaptive Reuse Report, released in July.

In response to these trends, Arlington County has been promoting office space repurposing through rezoning and other tools, but Arlington hasn’t seen many conversions to multifamily, possibly because the floorplate in the county’s office buildings aren’t easy to convert to multifamily uses, says Cara O’Donnell, Arlington Economic Development’s director of media relations.

Instead of multifamily projects, the county is seeing rezoned office spaces being adapted creatively, O’Donnell says. “There’s big push for alternate uses — everything from indoor recreation [or] mini-fulfillment space to ghost kitchens and R&D labs. There’s been a lot of rezoning since the beginning of this year.”

In April 2022, the county launched its Commercial Market Resiliency Initiative to modernize county regulations in response to economic shifts. The initiative “gives AED a new tool to chip away at our record-high office vacancy rate,” director Ryan Touhill said in a blog post. “But even more than that, as we move forward in this post-pandemic era and office tenants are trying to determine an in-office vs. hybrid environment, we want to create places in which people want to be. Got a pandemic puppy? Fluffy could be right next door at doggy daycare while you’re at work. Need some produce for dinner? The new urban agriculture business downstairs is the perfect place to pick up microgreens. These are all types of businesses that are already seeing success in other areas of Arlington; we want the flexibility to allow them to succeed in our commercial corridors as well.”

The Washington, D.C., office market reached a record high office vacancy rate of around 20% in July, but 60 buildings, mostly older structures, accounted for 41% of the vacancies, according to JLL.

Over the past five years, the office market nationally has seen “a flight to quality,” with newer trophy office buildings and Class A buildings featuring modern amenities and technologies faring far better than older Class B and Class C office buildings where “the vacancy is extremely high,” says Brent C. Smith, a real estate professor at Virginia Commonwealth University’s School of Business, who is also the CoStar Group endowed chair in real estate analytics.

This pattern holds at the state level, especially in Northern Virginia, according to Price, who says, “newer, good locations near amenities are performing better than Class B or C buildings in suburban, lower-rise office parks.”

The Northern Virginia office market “remains bifurcated,” with vacancy in trophy buildings at only 8.2% during the second quarter of 2023, according to a July report from JLL. Class A buildings had an 18.4% vacancy rate, and Class B/C buildings were 23.8% vacant.

“Real estate has become more aligned with human resources. There’s a direct correlation between recruitment and retention and top-of-the-market amenities,” says Michael Hartnett, JLL’s mid-Atlantic head of research.

For example, a location that is walkable to a Washington-area Metro station “checks a box” for employees who are also interested in mixed-use places where they can live and work, he says.

Northern Virginia’s struggles with office vacancy aren’t mirrored by the rest of the state, however.

Richmond, which has the second highest vacancy rate in Virginia, has only about half as many office vacancies as Northern Virginia, according to Alvin Abston Jr., a senior market analyst with CoStar. With entities like the state government mandating more time in office, “there’s not as much space being thrown back onto the market,” he says.

In Hampton Roads, where land is at a premium, some older office buildings dating to the 1970s and 1980s are being torn down to make way for more in-demand uses such as hotels or convenience stores, according to Robert Wright, a Virginia Beach-based senior vice president with Cushman & Wakefield | Thalhimer.

Scrapping an old, tired building “is the easier path,” he says, but a conversion can work “when the value of an office building is really low.”

Virginia Beach particularly doesn’t fit the picture of a city overstocked with office space, according to Lou Haddad, president and CEO of Armada Hoffler, a real estate investment trust with Class A office properties in and around Virginia Beach’s Town Center.

“You can’t paint it all with same brush,” Haddad says. “We are seeing near-record demand for our office space. Headquarters [space] is over 99% leased. … Portfolio-wide, over 97% is leased.”

A plus for Armada Hoffler, according to Haddad, is that the company has concentrated on the trophy market sector, which typically attracts tenants such as Fortune 500 companies and high-end professional firms “that need that top address” to attract employees and clients.

“It had better be a top-quality property to attract the top people and ask them to work back in the office. B- and C-quality buildings are struggling. Top assets are staying full,” he says. “You have to have a good human environment. It sets the tone.”

Richmond and Norfolk don’t have much Class A space, something that is “a blessing and a curse,” according to Abston. Tech is able to drive office values, and without Class A space, “you aren’t enticing people to these midsize markets. There are fewer tenants related to the tech industry.”

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