The quote in the headline from Dunder Mifflin regional manager Michael Scott, played by Steve Carell on the sitcom The Office, seems to be the philosophy many investors have adopted when it comes to the New York City office market. As a result, 2022 was an active year for office sales with dollar volume citywide jumping 60% year-over-year to $9 billion, a post pandemic high.

Observations on the New York City Office Market

To understand which investors are buying office properties and why, I separated the market into three broad categories:

• First, flight to quality. Superior buildings with extraordinary Manhattan locations are doing very well. Last year, these included 475 Fifth Avenue, which RFR purchased for $290 million, and 444-450 Park Avenue South and 245 Park Avenue, which SL Green acquired for $455 million and $1.77 billion, respectively.
• Second, specialty use. Exceptional companies see tangible value in building their physical space in Manhattan to enhance their corporate culture. Examples of these assets include Google’s
  
  GOOG
  $2 billion acquisition in 2022 of St. John’s Terminal in Lower Manhattan, which will be converted into a “Groundscaper”; JPMorgan Chase’s
  
  JPM
  construction of a new 2.5 million-square-foot headquarters in Midtown Manhattan; and the partnership between Citadel, Vornado Realty
  
  VNO
  Trust and Rudin to construct a 1.7 million-square-foot tower in Midtown East.
• Third, buildings in transition whose owners are trying to figure it out. A PWC
  PWC
  study estimates that between 10 and 20 percent of the office product may need to be removed or repurposed, which includes converting offices into residential use or adding a coworking component.

Anatomy of Office to Residential Conversions

Given New York City’s perpetual lack of housing supply, office to residential sounds like a great idea for many office buildings. However, very few buildings are good candidates. In fact, there are several factors that must be considered including:

• Zoning. Many office buildings are not included in residential zoning and unless New York City adopts an efficient rezoning strategy, these buildings cannot be converted.
• Building structure and floor plates. Residential units have light and air requirements that must be met.
• A path to vacancy. Conversions must allow for renovations without having office tenants in place.
• Low cost office acquisitions. A sale price of $300 a square foot in many cases but never more than $400 a square foot is necessary to make the numbers work. This is a challenging task to find in New York City as office buildings in Manhattan sold for an average $1,088 price per square foot last year, Ariel’s Manhattan 2022 Year-End Commercial Real Estate Trends report shows.

At one time, New York State offered the 421-g Tax Incentive Program to offset costs, which encouraged more than 15 million square feet of conversions from office to residential use in Lower Manhattan between 1995 and 2006. Unfortunately, the State Legislature did not renew the program.

Developers GFP Real Estate and Metro Loft Management are leading one of the largest office to residential conversions ever undertaken at 25 Water Street in Lower Manhattan, Tom Ortinau, Head of Acquisitions at GFP Real Estate, said during Ariel’s recent Coffee & Cap Rates event. Last December, the developers acquired the 22-story, 1 million-square-foot commercial office building where all five tenants agreed to vacate the property within a couple of months of the acquisition closing.

When completed, Ortinau said 25 Water Street will be one of the largest apartment buildings in Manhattan with more than 1,300 residential rental units and top of the line amenities.

“The economics of conversions are similar to development,” Ortinau said. “Conversions are not a savior for someone who bought a building for $800 per square foot and is now trying to save their basis after their tenants left.”

Residential conversions are generally not a great plan for an office building’s current owner because the acquisition value for that scenario is typically materially lower than the value of the building as a leased office asset, Ortinau said. For owners of office buildings who want to optimize the value of their property, “the only way to weather the storm right now is to be realistic and meet the market. If the market for leasing is down by 30% you must follow the market down and do deals at that level. If you’re holding out for where you thought the rents were three to five years ago when you bought the building, you’ll be stuck with vacant space, which typically doesn’t work out well for the owner or the lender.”

Painful Now, Lucrative Later

Transitions are painful, and no doubt office assets will continue to face challenges. The demand for office space has changed in many ways post pandemic. Tenants want to modify their workplaces to accommodate employees, increase productivity and encourage collaboration and creativity. Therefore, many office building owners will be forced to adjust to the new reality while businesses adapt and re-imagine their space or build a ground-up dream campus.

Recently we have seen several major firms struggle to continue their operations in office assets worldwide. These are not smaller owners, but the likes of RXR, Blackstone
BX
and Brookfield, all of which represent the most capable owner-operator outfits when it comes to office. There are two main reasons for concern: 1) the fundamental shift in office use as noted above 2) mortgage maturities or resets at the same time both vacancies and interest rates are rising. As a result, re-pricing of office assets is expected to continue in the short-term, probably for the next 18 months.

Return to Office

There is good news in the office sector, however. Office attendance was close to 50% of pre-Covid occupancy at the beginning of 2023, which is a significant improvement over the 37% in attendance that was recorded the year before, according to Kastle data. A separate Real Estate Board of New York (REBNY) analysis found that average visitation rates actually surpassed 60%, in 2022 especially in Class A buildings.

Manhattan’s monthly leasing volume totaled 4.43 million square feet in January, more than double from December and an increase of 93.8% year-over-year, with the availability rate remaining steady at around 17%, according to Colliers.

Industry observers are projecting slow but steady growth in office occupancy for several reasons:

• Employer/employee job market shift – as layoffs increase, employees might feel compelled to show up at the office more often.
• ‘Pandemic’ fatigue and productivity boost – a recent survey showed that 75% of employees want to be back in the office.
• New York City’s buildings offer unique facilities and locations. Offices attract employees who want to be in the City during the day for various reasons including accessibility to retailers and restaurants and building amenities that encourage attendance vs. work from home.

Steven Roth, Chairman and CEO of Vornado, which has paid over $2 billion in cash to pre-fund 100% of the development and construction costs for office buildings loaded with amenities in the Penn District, is bullish on New York City and the office market. “…call me crazy, but I think companies that embrace work from home will be left behind,” Roth said on a recent Vornado earnings call. “And I think it’s absurd to think that years from now tens of millions of Americans will be working from home alone at their kitchen table.”

Longer term, there are several other factors that will benefit the New York City office sector:

• Low supply of new office construction.
• Better understanding of tenants’ needs and increasing landlord-tenant collaboration.
• New office concepts such as ‘office as service’, flex office as a way of life, co-working brands and platforms that create new demand for office spaces such as Nuveen’s partnership with Industrious.

We are encouraged by subway ridership, which has risen to 63% of pre-pandemic levels. Also, the long-awaited terminal for the Long Island Rail Road finally opened at Grand Central Madison, bringing LIRR commuters to the east side of Manhattan for the first time.

Quality Class A office buildings are continuing to fetch enormous rental prices even when compared to pre-Covid levels. In addition, specialty users lead the way in creating new standards for ‘the dream’ office space. Both quality office and specialty use workplaces that cater to employee needs are evidence that demand for certain spaces is extremely high.

As Michael Scott put it:

“…an office is a place where dreams come true.”