Breaking the Municipal Doom Loop: Reviving Downtowns through Office-to-Residential Conversion by Donahue Peebles III
The pandemic’s tumultuous effects have sent shockwaves through our cities, particularly within their vibrant downtowns — once nurturing grounds for economic vigor, cultural richness, and community bonds. Yet, these bustling cores have been rattled by the seismic shifts brought about by the COVID-19 pandemic. A decline in office occupancy rates has cast a long shadow over downtown property values, reducing property tax receipts and creating fiscal instability within our cities. These dynamics set in motion a perilous cycle that threatens our cities’ fiscal stability and overall well-being, we call it: a Doom Loop. To navigate this crisis, we must harness the power of data-driven solutions and seize the opportunity to strategically repurpose office spaces into residential units.
The data lays bare the grim statistics that imperil our cities. The pandemic’s far-reaching effects on our downtowns have wreaked havoc on property values. The national vacancy rate ballooned by a staggering 120 basis points year-over-year, reaching 17.8% by the end of September increasing over 80% since 2019.
The consequences are most pronounced in superstar cities like San Francisco, where the vacancy rate reached an alarming 24.2%, surging by a daunting 450 basis points over year-ago figures. Austin witnessed a concerning 360 basis point increase in vacancies, rising to 21.2%, likely fueled by recent high-volume deliveries.
The surge in office vacancy rates has a profound and interconnected impact on both asset values and property values, ultimately eroding municipalities’ fiscal positions. High vacancy rates reduce revenue and therefore net operating income, causing asset values to plummet. This loss in value is exacerbated by hawkish monetary policy, as benchmark interest rates are highly correlated with market capitalization rates. The federal funds rate has risen 5.25% since February of 2022, placing upward pressure on investors benchmark returns and therefore downward pressure on building value, keeping net operating income constant. Adverse market conditions have made sellers less willing to transact, in fact, during the pandemic, transaction volumes in major U.S. cities fell by a staggering 57%, and average sale prices per square foot dropped by 20% in real terms from 2019 to 2022.
This decline in asset values exerts immense downward pressure on property values in the vicinity. As a result, municipalities find themselves in a precarious fiscal situation: property values yield ad valorum tax revenues which have become an essential component of their revenue streams, responsible for financing essential services and infrastructure projects. For example, property taxes make up 46% of New York City’s revenue (33% in New Hampshire and 38% in New Jersey).
With reduced property values, property tax receipts dwindle, creating a domino effect that can force local governments to make tough decisions, potentially reducing services and resources available to their communities. The intricate relationship between soaring office vacancy rates, diminished asset values, and declining property values underscores the urgent need for innovative strategies like office-to-residential conversions to reinvigorate downtown areas and safeguard the fiscal health of municipalities.
To extricate ourselves from the “doom loop”, we must consider innovative and data-driven solutions. One approach is the conversion of underutilized office spaces into residential units: two asset classes with divergent trends.
Balancing Supply and Demand: Many downtowns currently suffer from an oversupply of office spaces and an undersupply of residential. This mismatch of asset classes diminishes property values. By repurposing some of these spaces into residences, we can help restore equilibrium in the real estate market.
Conversion of certain office buildings to residential use will clearly reduce the supply of existing offices but also increase demand for offices in the immediate sub-market. Proximity to housing is highly desirable to office tenants. Transforming downtown cores to vibrant, mixed-use communities will solve both the demand and supply stories.
There is clear, national demand for housing, median sales price of houses in the United States increased nearly 30% since the COVID-19 Pandemic, such growth has proven inelastic despite benchmark interest rate increases. Median US Asking Rent has grown 15% since the COVID-19 Pandemic and continues to track upward despite quantitative tightening.
To expedite this transition, municipalities should consider data-backed incentives for property owners and developers willing to convert office spaces into residential units. These incentives may include targeted tax relief, strategic zoning adjustments, or streamlined permitting processes. Many cities including New York and Washington D.C. have already debuted various incentive packages.
Cities face a formidable challenge, but it is not insurmountable. By strategically transforming underutilized office spaces into vibrant residential communities, we can infuse vitality back into our downtown areas, bolster property tax revenue, and safeguard essential services. The time has come to reimagine the use of our urban spaces and embrace innovative, data-driven strategies to ensure the resilience, vibrancy, and sustainability of our cities in a post-pandemic world.
Empty spaces and hybrid places | McKinsey
DiNapoli: NYC’s Property Tax Bills Rise Along With Burden on Working- and Middle-Class Homeowners | Office of the New York State Comptroller
State Property Taxes: Reliance on Property Taxes By State (taxfoundation.org)
Vacancy rate of downtown and suburban offices U.S. 2023 | Statista
Federal Funds Effective Rate (FEDFUNDS) | FRED | St. Louis Fed (stlouisfed.org)