Class B office buildings have fewer financing options – Commercial Property Executive

Shortly after the initial shock of COVID-19 and the end of the lockdown, it was apparent that the virus boded well for apartments while signaling disaster for hotels and malls. Offices were the wild card. And two years later, as hospitality and retail recalibrate amid returning travelers and shoppers, offices remain an issue.

At the end of July, an average of 44.7% of office workers in 10 major cities occupied buildings each week, according to a building management company. Castle systems, which monitors key card swipes across the country. While this marked a slight improvement from the previous week, no substantial gains have emerged over the past few months.

Nadir settles down

This is quite disconcerting for owners of Class A office buildings. But the environment is proving particularly challenging for owners of Class B office assets who may wish to upgrade their buildings to Class A standards. and better compete to attract tenants.

Nuvean, a global investment manager, recently completed such a conversion of its headquarters on Third Avenue near Grand Central Station in New York City. Among other upgrades to the $120 million project, the 665,000-square-foot building now includes smart, energy-saving windows and lighting, a food hall, luxury gym, and guest lounge. tenants with Topgolf simulators.

Nuveen and its parent company, TIAA, occupy about half of the building. Nuveen funded the project in cash, with the exception of $28 million in C-PACE funding provided by Nuveen Green Capital (formerly Greenworks Lending). C-PACE funds pay for energy efficiency improvements and are recorded as a tax assessment.

“We wanted to create a sense of place and a sense of pride given that this is our headquarters, and we believe the conversion will create some traction to rent a space that we need to fill,” Nadir said. Settles, Global Head of Impact Investing and Head of New York Regional Office for Nuveen Real Estate. “We have a lot of tailwinds with our location.”

Challenging environment

Source: JLL Research

Nuveen is probably an outlier, though. The current leasing, investment selling and financing climate makes similar Class B to Class A office conversions impossible, Settles and other observers say.

NAIOP, the Commercial Real Estate Development Association, forecast office absorption of 46.9 million square feet in the last three quarters of 2022. But it noted that Class A offices were driving the activity. Indeed, occupancy losses in Class B and C space contributed the lion’s share of the 7.8 million square feet of negative office uptake in the second quarter, according to JLL.

“I’ve seen quite a few cases throughout my career of converting an office B to an office A, but they were all pre-COVID,” said Kelly Layne, senior managing director at JLL’s capital markets group which is based in Houston. “We’re not necessarily in an environment where lenders are jumping for joy and saying, ‘We want to do more office lending'”

Layne Kelly

Additionally, due to higher interest rates and the prevalence of remote work, few Class B sales occur outside of desperation or distress. Opportunistic investors who typically seek such conversions don’t know what Class B buildings are really worth and are waiting for a price revision, the observers add.

“When you have a combination of tough occupancy for convenience spaces and deteriorating cash flow needed to support renovation business plans, it’s a double whammy that has put significant pressure on office valuations in Class B,” said John Alascio, a senior executive in Cushman and Wakefieldof the Equity, Debt and Structured Finance team in New York.

CapEx heavy

Converting a class B space to class A is also complex and expensive. In addition to upgrading power and technology and adding larger conference rooms, gyms, outdoor patios and other necessities to compete, today’s germ-susceptible environment today requires a redesign of air handling systems as part of a larger biophilic design effort, said Charles Krawitz. , Director of Capital Markets and Head of Commercial Lending at Chicago Alliant Credit Union.

“Even if you could convince yourself that you had the right foundation in a property and could afford all the cost overruns resulting from inflation,” he said, “I’m not sure you can do a true B-to-A conversion based on perceived energy demands and amenities that are needed to attract tenants.

New use

Source: JLL Research

Alternatively, Class B buildings could be suitable candidates for life sciences, medical practices or apartment building conversions. All are viable solutions to the oversupply of outdated office space and have advantages over new construction, according to NAIOP, which released a research paper on the subject in March.

However, obtaining financing depends on the dynamics of individual markets and the location of the building. The major life sciences markets of Boston, San Diego and San Francisco have high demand and a limited supply of vacant buildings and sites, NAIOP reported. He also identified Austin, Denver, Houston, Philadelphia and a handful of other markets as growth markets likely to support life sciences conversions.

Housing demand is creating opportunities for larger-scale apartment conversions, and since 2010 developers have turned 222 office buildings into multi-family properties, the NAIOP said. But complexities that create challenges include adding kitchens and bathrooms as well as market limitations.

In Houston, for example, the downtown office vacancy rate remains high due to the last oil crisis about seven years ago, Layne reported. But the town’s lack of walkability and the region’s sweltering summers could work against attempts to convert buildings into apartments, he said.

Meanwhile, in New York City, building codes dictating where windows should be placed, setbacks and other technical details can make conversions difficult, said Jay Neveloff, partner and president of the real estate practice at law firm Kramer. Wine.

“All zoning rules go into an architectural analysis to determine if a Class B building is suitable and marketable as residential, he said. “It’s a major limiting factor for conversions.”

Read the September 2022 issue of CPE.

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