James Sprow | Blue Vault

Sometimes a series of seemingly unrelated articles form a pattern that is hard to ignore. In this case, I refer to articles that appeared yesterday that refer to “repurposing” office properties, a sector of the commercial real estate industry that is still suffering from the effects of the remote working trend. We can attempt to trace the problem of vacant office buildings to the pandemic, but that was just one relatively temporary contributor to the larger, more permanent problem.

Speaking personally, I began working from home long before the pandemic. I found no reason to pay rent for an office when a co-worker with whom I shared the space moved away and began working from home. Our company currently has a large majority of employees working from home, with no apparent loss of productivity or connectivity. This reality has nothing to do with the pandemic and everything to do with improvements in technology. Video conferencing, emails, file sharing tools like Dropbox, all these tools plus many more reduce our need for centralized offices. Our company isn’t the only team to figure that out.

So, today’s headlines remind me of a simple principle from Econ 201: A shifting demand curve affects the equilibrium price. In plain English, there is less demand for office space, therefore office space is less valuable.

Now, back to the headlines:

· Chicago to move forward with plan to revitalize downtown

· Office vacancy rate climbed in Manhattan in February

· Paramount could return two downtown San Francisco office building to lenders

· Kennedy Wilson Supplies $96M Loan for Alexandria Office-to-Resi Conversion

Let’s connect those dots: There’s a surplus of office space in cities around the country. It’s not just a New York, or Chicago, or San Francisco problem. It’s literally an “everywhere” problem, which suggests that there’s more to it than just a temporary over-supply of office space, or a cyclical trend like we see occasionally in commercial real estate when construction gets ahead of demand.

What we’re seeing is the demand for office space dropping and the values of office buildings dropping (down 22% in the last 12 months and 38% from pre-pandemic levels per Green Street Commercial Price Indexes). In response, city leaders and property owners begin promoting solutions. With Manhattan office space running over 22% vacancy rates, there’s been a lot of chatter lately about conversions of office buildings to apartments. Chicago’s leaders are talking about the same ideas. Even locations like Alexandria, Virginia, which haven’t been hit nearly as hard by the downturn in office demand, conversions are being discussed.

As usual, when markets adjust to major changes, governments get involved to “solve” the problems. Vacant office buildings? Let’s convert them to apartments! The only problem is it’s not very easy to convert an office building to apartments. In fact, a very small percentage of existing office buildings, and most of those are the older office buildings, can be converted into a partments. The costs of conversions dictate that the apartments created must be higher-end apartments with relatively higher rents to profitably pencil out the projects.

So the supply side of the equation dictates creating high end apartments at high costs and requiring high rents to be financially viable. What about the demand side?

Demand for office space has decreased, relatively permanently, due to technological changes. How can demand for high-rent apartments created by office conversions be logically anticipated? If the central business districts of our major cities are losing workers, especially highly paid workers, where will the demand for these expensive apartments converted from office properties materialize? If only a small percentage of existing office buildings are suitable for conversions, how can city governments look to investors to solve the vacancy issues?

Governments are very accustomed to using public funds to attempt solutions to competitive market “inefficiencies.” The Chicago headline above refers to millions of tax dollars being used to convert vacant office space into apartments. The fundamental idea is for government to accomplish something that free markets cannot. Government subsidies that are designed to encourage investments that otherwise would not be undertaken almost always create wasteful economic activity. By definition, if free markets consisting of potential investors and property owners, as well as lenders, do not create projects to convert vacant office space to residential units or other alternative uses, we can conclude that doing so is an uneconomic use of resources. Governments can subsidize such activities to make those conversions attractive to investors, but those subsidies don’t change the fundamental realities. Uneconomic allocations of resources remain uneconomic, and that reality isn’t transformed by using taxpayer dollars to make them happen.

The market for office properties in major urban centers will eventually adjust to the realities of technological changes. Markets may take a while to adjust, but they do adjust, as investors, owners and lenders do the painful math of revaluing their prospects. Governments rarely offer solutions to these required readjustments by competitive markets, despite their well-publicized proposals. Subsidies may work for a while, but eventually economic reality must prevail.