On October 12, 2021, DC Policy Center Executive Director Yesim Sayin Taylor testified before the Special Committee on COVID-19 Pandemic Recovery to share information on how the district can encourage office conversions in residences. You can read his testimonial below or download a PDF version here.
Hello, Allen Council Member, Gray Council Member and Special Committee on COVID-19 Pandemic Recovery. My name is Yesim Sayin Taylor and I am the Executive Director of the DC Policy Center, an independent, non-partisan think tank that advances policies for a strong and vibrant economy in the District of Columbia. Thank you for giving me the opportunity to testify about recovery.
Today I will be focusing my comments on conversions, specifically conversions from commercial office to residential use. The pandemic and its effects on commercial office buildings have reignited the debate on conversions. And recent data from OCFO suggests that the difference in value between commercial and residential use is decreasing (see data in appendix). Will this encourage more owners and developers to consider conversions? What can the city do to facilitate the path of conversion?
According to 2019 data collected by the Downtown DC Business Improvement District, since 2002, the District has recorded 18 conversions (including under construction), and of these, 11 are residential conversions. These created 2,459 units. Of these, 272 or around 10.6% are affordable, but this is largely due to a single project (Jubilee House with 176 units, which received grants) entirely dedicated to affordable housing. In fact, among the conversions made before 2019, only 23 units out of more than 1,371 were affordable.
Five other residential conversion projects are underway, with 1,342 new residential units planned, 9% of which will be affordable. As the appended map shows, residential conversions occur where residential demand is high: along Wisconsin Avenue in Ward 3, in Kalorama, and along Georgia Avenue in Ward 1, in the West End of the ward. 2 and near the wharf and Navy Yard in the neighborhood. 6.
For owners, the most important consideration is the net operating income of their building, which, along with the cap rate, determines the value of the building. In the district, on average, ratings of commercial buildings carry a premium of about 25 percent over residential buildings. The larger the gap between commercial and residential valuations, the more profitable it is to renovate and re-let office buildings, and the harder it is for residential developers to compete to acquire them.
The decision to remodel, convert, or rebuild will depend on additional factors the homeowner needs to consider beyond the handful of factors we’ve included in our stylized example. These factors all operate at the margin and can make or break a conversion decision for a given building. They understand:
- Expectations regarding future demand for office space relative to residential: A higher rental trajectory for residential versus office, an expectation of lower vacancy rates in residential versus office units and lower capitalization rates, signaling lower risk in the residential market, for example, would make the conversion more attractive.
- Current vacancy rate: Conversions would be easier for commercial office buildings that are currently empty or nearly empty. Existing leases on a property make conversion more difficult because the owner would have to terminate those leases earlier – an expensive endeavor – or wait until they expire, which would have a high opportunity cost.
- Construction costs: Higher construction costs or construction bottlenecks will make major renovations, including conversions, more difficult.
- Financing costs: An increase in financing costs, due to higher interest rates, higher perceptions of risk will have an impact on the attractiveness of conversions.
- Policy risk: The owner would consider tax risk (e.g. are commercial tax rates more likely to change or increase?) And regulatory risk (e.g. how would building standards change and increase the cost of construction?
- Subsidies : A government subsidy for the conversion, on the other hand, will increase net operating income for residential use over baseline and make conversions more attractive, but that would cost DC twice as much: First, the city should cover the cost of providing the grant. Second, the city would potentially see a drop in future tax revenue from the building, given that the tax rate on residential properties is half the rate on commercial properties.
Architectural elements common in office buildings can make conversions difficult for developers. For example, the floors of an apartment building are often a big challenge when converting office space to housing, as apartments are legally required to have access to natural light in each unit. Or since bathrooms tend to be clustered in an area of ââoffice buildings, limited plumbing lines can be a hindrance, as a residential building, on the other hand, would require bathrooms and plumbing in every unit. For a change in occupancy use, residential buildings should coordinate the units and systems around the structural floor assembly in a different way. This may require different placement of elevators, require a facade redesign, re-routing or rebuilding of power and plumbing lines, different HVAC loads on the roof, and higher capacity utility lines all of which will have an impact. on costs for developers.
For example, the owner may have to request a change in permitted use, which could be a lengthy and costly process for DC.
Even when allowed, any requirement to include affordable units in the conversion, for example through inclusionary zoning (IZ), will make conversions less attractive. As part of the district’s new inclusionary zoning expansion, any mixed-use and residential project that is over-zoned through a residential card amendment, must set aside 10 to 20 percent of its residential space. for affordable IZ units (IZ plus), and the Office of Planning introduced changes that would extend the regular IZ program to previously exempt areas (IZ XL), including non-residential to residential conversions.
Many of the factors that will determine whether or not a conversion will take place are beyond the control of the District. But the city can help by clarifying the political objective it wants to achieve through conversions: is it to increase the number of dwellings? Is it to create a more mixed environment in parts of the city where it’s made up of office buildings? Is it to revitalize parts of the city that have old buildings or little street level activity? Is it to create affordable housing? These goals can sometimes go against each other.
Affordability clauses could break down conversion forms and may require grants. The question then becomes, what is the right mechanism for the city to generate the greatest number of subsidized units?
As noted, there are too many building specific factors that could make or break a conversion. So, rather than setting a general policy, we recommend allocating a certain amount of the Housing Production Trust Fund for conversions and then holding a ‘conversion competition’ inviting developers and owners to submit their conversion proposals, including the affordability commitments they propose to meet. , and the necessary grants they would need to make it happen. Grants can then be directed to projects that promise the greatest value.
Appendix 1 – Residential conversions in the neighborhood since 2002
Annex 2 – Change in the valuation of office buildings
Appendix 3 – Vacancy rate and rental growth for commercial office buildings
Annex 4 – Employment compared to January 2020, selected sectors
DC Policy Center Fellows are freelance writers and we welcome the expression of a variety of perspectives. The views of our fellows, published here or elsewhere, do not reflect the views of the DC Policy Center.