Downtown Innovation

To say that the U.S. economy and American cities took a punch to the gut as a result of the pandemic would be an understatement of colossal proportions. The loss will amount to more than $14 trillion by the end of this year, according to a recent Stanford University report.

Downtowns and the commercial real estate market took a major hit from COVID, losing hundreds of billions of dollars in value, with thousands of office buildings around the country even now only partially full because of the shift to remote working.

One solution, which cities from New York to Chicago to Denver to San Francisco are trying as a way to revitalize their downtowns, is lowering barriers that have made it difficult to convert moribund office buildings into residential housing.

Santiago Ferrer, a managing director and partner with the Boston Consulting Group, said the situation for many downtowns is dire, but they can rebound if government agencies, developers, lenders and other key entities — including occupants — work together. “I think cities will be different in the future,” he said. “However, it doesn’t have to be a doomsday scenario if people act.

“The biggest struggle for me is coordination. There needs to be a strong civic alliance where everyone comes together and acts in unison. In some cities, that works better than others.”

Even if they do all get on the same page, he said converting office buildings into apartments won’t happen overnight. “At the fastest, it will be a five-year process. But it could be a decade because you can’t bring all this new capacity onto the market right away. The built environment takes time to change.”

Ferrer said a recent survey found that many office buildings are at risk of becoming “zombies, with low use, high vacancy and rapidly diminishing financial viability” and rising interest rates are compounding the financial pressure for building owners, whose rental income stands to drop 35 to 45 percent as corporate leases expire in some cities.

“Higher borrowing costs coupled with lower valuations could leave some owners owing more than their buildings are worth, leading in turn to a wave of defaults that suddenly make lenders the owners and managers of these buildings,” he said.

In February, he said a fund managed by Brookfield Properties defaulted on $784 million in loans on two well-known office skyscrapers in downtown Los Angeles, “which was seen by some as a turning point for the U.S. office market.”

In New York City — where the office market covers 400 million square feet — many office buildings are only half full on some days.

Another recent study by researchers at Columbia and New York Universities said the value of the Big Apple’s office buildings could fall by nearly $50 billion in coming years because the lowered demand for office space may well be permanent.

Ferrer said the problem is also acute in Los Angeles and San Francisco, where weekday office building use has fallen to around 40 percent.

In New York City, the official office vacancy rate rose to a record 16.1 percent in the first quarter, representing more than 76 million square feet, according to a report by commercial real estate firm JLL.

That vacancy rate means about 84 percent of available space is leased. However, it doesn’t mean it’s being used. New York’s actual office occupancy rate is about 49 percent, according to Kastle Systems, which tracks card swipes through its security systems.

As a result of this drop-off in San Francisco and Los Angeles, public transit revenue has plummeted by 80 percent or more, and office property values and tax revenues may drop by as much as half, according to an analysis of public data done by the Boston Consulting Group.

Providing incentives and easing regulatory burdens are key.

So, what are cities to do? Experts say two key answers include providing incentives and easing regulatory burdens to make it easier to convert office buildings to apartments.

They can also try other options, ranging from adding more mixed-use development in their downtowns to building casinos (New York), adding a soccer stadium (San Francisco) and creating other amenities to attract visitors and residents.

That should help counter what some call the “urban doom loop,” a vicious circle in which lower office-building use leads to less spending at surrounding businesses, closures and, as leases turn over, less rent revenue.

“This leaves less money available for building improvements, which further decreases property values and resources for maintenance and upgrades,” Ferrer said. “As vacancies persist, businesses that cater to office workers close or relocate, creating more vacancies and often causing public safety problems that cities struggle to address with diminished tax revenues.”

These new workplace and financial realities will require property owners, city leaders and lenders to take action to reimagine downtowns.

These new workplace and financial realities will require property owners, city leaders and lenders to take action to break the cycle and reimagine downtowns, Ferrer said. Recommendations include:

• Establish a Baseline 
  This means assessing the likelihood of office buildings for low occupancy and default, then estimating the resulting budget shortfalls from lower tax revenue.
• Encourage Use 
  Cities should evaluate land-use rules to ensure they don’t impede downtown revitalization. They should invest in public spaces and keep them safe, with a special focus on transit. They should also encourage government workers to return to office buildings to boost the vitality of downtown corridors.
• Support New Uses 
  Zoning and development regulations should be revised to allow for more downtown housing, hotels and retail and office space. Incentives such as tax breaks and subsidies can boost conversions to residential use, affordable housing and energy-efficient retrofits.
• Replace Lost Revenue 
  City leaders can delay property reappraisals. They can make better use of public spaces for art, music and theater programming to draw people downtown to spend time and money. They can find new sources of revenue such as tourism and arts and culture districts.

Ferrer said property owners, for their part, need to evaluate their commercial real estate portfolios and decide how to revive or relinquish zombie buildings. He said commercial office properties will fall into one of five categories:

1. Continued high occupancy and profitability.
2. Viable with a moderate decline in income.
3. Appropriate for conversion to housing, hotel or other uses.
4. Suitable for redevelopment with public support.
5. Unsuitable for reuse or subsidies and subject to default.

“Making these decisions will be difficult, but necessary. The pandemic created a permanent change in workplace behavior, so even a national economic rebound or a pause in interest rate hikes will not solve the problem for many buildings. Our analysis suggests that a third or more of U.S. office space won’t be needed.”

Lenders should work closely with property owners and city governments to try to prevent a wave of building defaults that could force them to become the owners and managers of zombie buildings, setting off a spiral of declining property values. “They will need to manage risk, restructure loans near or in default, and develop markets where they can sell those loans. They’ll also have to evaluate and finance reuse and redevelopment projects as downtown districts take on new functions,” he said.

“The U.S. office market faces dramatic upheaval over the next three years, forcing the nation to deal with moribund office buildings in stressed urban neighborhoods. Given the stakes, cities, owners and lenders must rethink how we use commercial buildings after the pandemic and what we want for downtowns.”

The National Association of REALTORS® (NAR) has been working with a dozen other real estate groups, including the Real Estate Roundtable, lobbying Congress to provide tax credits of up to 20 percent for owners of office buildings to readapt or convert them to housing and other uses.

“We see this as a way to revitalize downtowns at a time when buildings in many cases are half empty or more and downtowns seem like they are dying because nobody goes there anymore to work,” said Evan Liddiard, who directs tax policy for the NAR.

“Late last year, the group came up with parameters for legislation we wanted to see and sent it around to many members of Congress,” he said. “Since then, we have been following up with key members of the tax writing committees to see if we can get them interested in introducing legislation to do just that.

“We have interested bipartisan members on the House Ways and Means Committee who are working together to develop the legislation. But it’s not quite ready to be introduced yet.”

The group is also speaking with members of the Senate Finance Committee, which is the counterpart to the House Ways and Means Committee. “Many states and local governments are finding ways to subsidize readapting old buildings, too, and we’re hopeful Congress will move forward on this because it’s important, especially for housing,” Liddiard said.

In San Francisco, which has been hard hit by the shift of the tech sector to remote work, Lily Langlois, the city’s principal planner and downtown economic recovery lead, said “there is a strong appetite right now to try some new things because our downtown is clearly struggling.”

According to Newmark Research, San Francisco’s office vacancy rate stands at 25.6 percent. That means only 75 percent of office buildings are being leased and actual use is only 41.6 percent.

San Francisco passed adaptive reuse legislation to facilitate the conversions of older buildings.

In July, the San Francisco Board of Supervisors passed adaptive reuse legislation to facilitate the conversions of older buildings by significantly lowering affordable housing and other impact fees, as well as waving planning code requirements that make more sense for new structures. “So, if you have an older building and you want to convert it to housing, you no longer need to provide things like open space or bike parking,” Langlois said. “We’re trying to take advantage of the older, historic buildings that exist today in a way that doesn’t feel prohibitive to the conversion project. We want to limit the requirements that are needed.”

Langlois said the city also has also issued an RFI (request for interest) for adaptive reuse projects, “asking sponsors to come forward and tell the city what they need, whether that is additional legislative changes or financial support.”

She doesn’t expect conversions to happen overnight. “Overall, the development pipeline in the city is slow. And, we haven’t gotten a large number of projects right now because the financing is really challenging. But we want to be prepared when things improve.”

San Francisco plans to conduct a survey of its office buildings downtown — many of which are historically significant and in conservation districts — to determine which ones are suitable for conversion to apartments and other uses. It is also looking at what other cities — such as Denver and Chicago — are doing to revitalize their downtowns.

“Our mayor’s Roadmap, which is updated every six months, has a number of strategies, including enhancing the public spaces we have downtown, providing more places to gather for events and activities and providing opportunities for programming.

“Our downtown has really strong community benefit districts (CBDs), that have ideas and plans to support activation, so we’ve been trying to support them.

“There is also the idea of transforming downtown into an arts, entertainment and culture destination zone, making it easier to both permit nighttime activities, but also provide the space and incentives for more activities to give a reason to be there when they aren’t working.”

She said the city wants to grow and diversify the city’s workforce so it is not as heavily dependent on technology. “We want to bring different jobs downtown and support and start businesses through streamlining. We have a grant program called Vacant to Vibrant which is matching empty ground-floor space with businesses that want to do a pop-up. The first round of applications has been announced and there are 15 to 18 that are coming into downtown for a trial period to activate buildings that currently don’t have a ground-floor tenant.”

The mayor also has suggested tearing down the downtown Westfield center mall, where Nordstrom’s flagship store departed in late August, and using it for a soccer stadium, which could help revitalize the downtown core and be used for concerts and other activities.

The city would also like to diversify the financial district with university buildings, medical and dental offices as well as a lot more housing. “Our downtown is very unique in many ways because it is very flexible,” Langlois said. “You could almost have any type of use.”

Langlois is optimistic that the city’s downtown will bounce back. “We just had such a vibrant downtown before the pandemic so what happened feels particularly devastating in many ways. But we are being proactive and are looking for solutions to the problems we’re facing to bring life and activity back to our downtown. More housing is certainly part of that.”

In Denver, the pandemic had a massive impact on the Mile High City’s downtown, said Jennifer Ramsey, an adaptive reuse administrator with Denver’s Department of Community Planning and Development.

She said Denver also has a large homeless population, which also has affected the downtown area. In August, Mayor Mike Johnston declared a state of emergency to deal with the problem and find housing for those on the streets and in encampments.

The pandemic caused a “major dip in use with many fewer people coming downtown and we are still seeing some of the after effects, with the Upper Downtown vacancy rate hovering around 28 percent,” Ramsey said. “In addition, the utilization rate within many buildings is not 100 percent.

“We’ve also observed a pretty significant reduction in street traffic, so in that sense there are less customers and fewer people enjoying our great parks and visiting the convention center and our arts complex that have traditionally been pretty big draws to outside traffic and national traffic to our downtown.

“We have seen a rebound in some of that traffic to the convention center events, for example. However, we haven’t yet seen a return in terms of shopping interest.”

Ramsey noted that even during the pandemic, the city invested $150 million to begin renovation of its primary downtown thoroughfare, the 16th Street Mall. “That will be done in the next year, and we’re hoping to see a lot more interest in retail downtown.”

To bring more residents to the city’s core, Denver is hoping to rebalance office space with housing and stores, eventually turning Denver’s Central Business District into a Central Neighborhood District that is less reliant on cars and more pedestrian friendly.

“We believe there will be less demand for cars and parking in the future. We are looking to consolidate parking and free up that space for other uses,” she said. “We’re also creating more tree cover and other design interventions that could make downtown Denver a much more walkable environment.”

To move the rebalancing effort along, Denver has launched a pilot program for two areas of the city, including downtown, that will push a number of adaptive reuse projects through review process to understand which code changes will most effectively support adaptive reuse.

“We hope this will help stimulate the conversion of offices into apartments,” she said. Denver already has a leg up in this effort with its progressive zoning code that allows office to residential conversions without rezoning and also exempts residential conversion projects from parking requirements.

The city is also working with the Downtown Denver Partnership to provide funding to encourage greater retail diversity, get smaller businesses into former downtown retail spaces and encourage pop-ups.

A downtown with more residents is more vibrant.

Ramsey said she is convinced that a downtown with more residents is more vibrant than one dominated by offices. “Absolutely! We want more people living and working and playing downtown and using it 24/7.

“In downtown Denver, there is about 10 percent residential, and we are looking to increase that to 30 to 40 percent to get more stability in tenancy and create a more vibrant downtown feel.

“We still have a pretty heavy tech center and lots of diversity in professional services as well as government. So, from an office standpoint, we do have more diversity than other cities. But we really are looking at increasing residential opportunities here as well.”

Ramsey said the pilot program is focused on the Upper Downtown area and its older, less utilized office towers. Some older office buildings that have good potential for conversion to apartments may become available because of the “flight to quality” trend in which office tenants are moving out for newer digs with more bells and whistles.

“The program provides an accelerated review period and a dedicated project coordinator to assist those projects through the process of getting approved,” she said. “We are also working with them to identify other incentives that would be appropriate like code changes or different approaches. We are really interested in learning what long-term changes the city can enact to support adaptive reuse in the future.

“We’re looking beyond the immediate interest in office to residential conversion downtown to other areas of the city that could benefit from this, too.”

Next up would be extending the pilot program to East Colfax Avenue. Today, the street is lined with an eclectic mix of eateries, bars, brewpubs and shops, as well as entertainment and live music venues like the Ogden and Bluebird theaters. “We want to see how this process can support smaller developers and tenants. It would be a little different focus because it’s a slightly different neighborhood, but it’s important to look at other areas of the city that could benefit.”

In Chicago, the city has launched an effort called “LaSalle Reimagined” that includes converting older office buildings into housing along a five-block corridor in what was historically a monoculture of banks, financial institutions and trading companies.

Peter Strazzabosco, managing deputy for the Chicago Planning Department, said this section of LaSalle has some of the highest commercial and retail vacancy rates in the city at 26 and 35 percent respectively. The LaSalle Reimagined is a “threefold attempt to turn the central Loop into a neighborhood type of environment.

“With the addition of the planned conversion of five projects that have been selected to go forward, more than 1,600 new housing units will be created and 600 of them will be offered at affordable levels” thanks to public tax increment financing.

The program also includes grants to repurpose vacant retail spaces at ground level and in some of the former banking floors near ground level to create more neighborhood-oriented amenities, such as grocery stores, restaurants and cultural spaces.

The element aims to improve what he called the “public realm” along the street. “It’s a very vertical concrete steel and glass canyon that doesn’t have a whole lot of welcoming public areas along its length where people can linger and enjoy passive recreation outside,” he said.

“So, there is city funding to create more welcoming streetscape amenities along the corridor to further promote a neighborhood feel in the heart of the Loop.

“Five years from now, LaSalle Street should have a completely different feel with a 24-hour environment where people are working, living, going to grocery stores, restaurants, shopping and enjoying cultural spaces.”

In New York, the city recently unveiled an Office Conversion Accelerator team that creates a single point of contact within city hall for all projects of more than 50 housing units aimed at turning commercial real estate into residential units.

It is part of the Big Apple’s “City of Yes” initiative, which is designed to increase the amount of affordable housing options. “We are throwing open the door to more housing — with a proposal that will allow us to create as many as 20,000 new homes where the building owner wants to convert offices into housing but needs help cutting through the red tape,” Mayor Eric Adams said in announcing the new effort.

The city also created a consortium called “Get Stuff Built,” also aimed at cutting through New York’s notorious red tape, sometimes known as “kludge,” which generally means an ill-assorted, inefficient system that is difficult to manage.

New York City is shepherding new rules that make it easier for office buildings to convert to housing.

Dan Garodnick, New York City’s Planning Department director, said his role includes “shepherding new rules that make it easier for office buildings to convert to housing. It’s brand new and was just kicked off in mid-August.

“The notion is that we will bring together representatives from a variety of city agencies that have a part in office conversions to help any building that could convert more than 50 units to get through the regulatory process. The goal of the accelerator is to issue building permits in six months or less for projects that have zoning in place. Right now, it takes significantly longer.”

He said the demand for office space in New York City has dropped significantly because of the pandemic. “We have seen a major change in the way that people are living and working in a post-pandemic world.

“It has affected commercial office buildings and their opportunities to fill space. In many cases, it harmed businesses that counted on five-day-a-week worker presence from those offices. Today, we have a 19 percent vacancy rate for commercial office space. At the same time, we are also in the midst of a housing crisis. So, the moment is ripe for us to enable more offices to convert to residential.”

Garodnick said the accelerator program is one part of the broader initiative to change the city’s very strict rules to permit more buildings across more geographies to be eligible for conversion to residential. In sum, we expect our plan to enable another 136 million square feet of office space to be eligible for conversion and about 20,000 apartment units to be built over the next decade. And because it would be a permanent change, this would continue to happen over time.”

He said the city is also looking at allowing housing in a Midtown neighborhood that is zoned as a manufacturing district. “Residential is currently prohibited there, but we think there is an opportunity for us to enable a more mixed-use experience, a 24-hour neighborhood in that part of Manhattan.”

“Deciding which office structures are suitable for conversion to housing is building-by-building determination. Some will be a fit for this program and others will not,” Garodnick concluded. “But we know that vacant space is doing nothing for anyone. We want to do more to activate our streetscape, enhance our tax rolls and put our buildings to their best possible use.”