What It Really Takes to Convert an Office Building Into Apartments

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1:27Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal. And I'm Tracy Alloway. Tracy, I think everyone sort of knows that in many cities, but definitely in New York City, there's sort of this weird, like, there's two simultaneous real estate problems. Yes. And they sort of complement each other in a weird way. Right. Okay. So rents are too high. There's a shortage of housing and we have a bunch of empty office buildings. And there's a sort of obvious solution, which would be take all the empty office buildings and convert them into preferably affordable housing. And yet it seems to be very difficult to do that.

2:02I thought it sounds super easy. Just like, oh, we're going to turn these offices into homes now. Just live in like an open plan trading floor or something. Yeah, it sounds nice. It sounds all right. You know, put up some walls so people have some privacy. Okay, but on a – actually, this reminds me. When I was at university, I had a friend who lived in a warehouse in London. Oh, really? And they built their walls out of cardboard to segment it. Hopefully, that's not what we're doing here. But on a serious note, there are a number of difficulties, it seems, in doing this. And there are sort of physical ones around the actual layout of these former office buildings.

2:34But there's also regulatory, financial. And I hear people talk about it in a sort of abstract manner. Yeah. But today, I think we're going to dive into them in a little bit more detail. Right. So, you know, we joked around, but everyone says it is very difficult to convert an office into a residential building. But again, you know, the opportunity is there, but we really understand, like, what are the constraints? What are, like, the real physical constraints? And how big is the opportunity? Because in theory, like, clearly more can be done. But, like, how much are we, like, moving? Can this move the dial is, like, a really interesting question.

3:07Yeah. And the other thing I kind of struggle to understand is New York itself is a city with a long history of carving up older buildings into new types of apartments. And so I wonder why it seems to be so much more of an issue this time around. Well, I'm very excited because today we do, in fact, have the perfect guest. You know, lots of people have been talking about this question really, you know, since the pandemic struck. But our current guest has been working on it for a long time since well before it was trendy to talk about. So the perfect guest. We are going to be speaking with Joey Kalele.

3:41He's the managing director of the Van Barton Group, which has been involved in the office to residential conversions for about a decade. So, Joey, thank you so much for coming on OddLots. Thank you very much. Thank you for having me. What do you do at the Van Barton Group? So I'm within the asset management group, and we oversee essentially the execution of the business plan once we acquire assets. different buildings. So I'm going to start very broad, but then hopefully we can sort of get more into like each one of these difficulties or problems. But what are the constraints around converting office buildings to residential?

4:17Yeah. For starters, it's the zoning. So is the building that you're looking at within a zoning district that allows for it to be converted? Okay. That's number one. If that checks the box, there are essentially a whole list of things that you go through. And for me, and when I evaluate these, the structure and the light and air and the possibility of light and air and bringing that in to create residential units and ceiling heights. So on a kind of concrete floor to the underside of the structure above, what is that height? And if that height is less than a certain distance, say if it's less than 9 '6", or if it's 9 feet, then once you factor in all of the MEPs, the mechanical systems that need to go in above.

5:08Is this like plumbing, electric? Plumbing, sprinkler, electric, all those things that need to go in the ceiling above. Yeah. Then you drop your ceiling down. And if that goes below eight feet, really, that makes it very difficult to do, especially in New York, where you're not going to be able to market units that have a finished ceiling less than eight feet. So the ceiling height after the zoning district is one of the most crucial. So let's say, OK, there's a building. It's in an area that can be zoned. Theoretically, the zoning allows for the conversion. Someone calls you up. I say, Joey, come check out this building.

5:45how long does it take for you to like size up whether it's even worth exploring further you walk into the building and like what are you looking for broadly and hoping to see on that first uh that first walkthrough very quickly really 10 hours really yeah you can go through it and see the the ceiling heights okay the depth of the floor plate the the actual you know floor plan and the depth of that and then the structure because if the depth is is great and it works out then you wouldn't need to do any structural reconfigurations. And the depth just means like, you know, like here we're in the Bloomberg offices and we have this like huge newsroom, which is very nice.

6:25But like space in the middle of that would not make for a good unit because it would not be exposed to any windows. Correct. Correct. You'd have to make structural modifications to the building to be able to make that happen. So I think one of your famous conversions is downtown 180 Water Street. And you solved that depth problem by basically creating a sort of like inner atrium courtyard. Is that right? Yeah. We ended up cutting a 30 foot by 40 foot hole in the center of the building. Wow. 20 something stories went all the way. And that created a courtyard, essentially, for light and air to come down on the inside.

7:01And then there were studios and two or three bedrooms that had their bedrooms up against that. What was it that made that plausible? So, okay, so you see, it's called the floor plate is the term, and this is like sort of, yeah, okay. So if we're on the sixth floor or seventh floor of a building, that's the floor plate. The horizontal slice of the building. So it was 180 Water Street? Correct. Okay, so 180 Water Street in its previous version did not have like a suitable floor plate, but you understood that there was an opportunity to cut a hole in it. Correct. It had a suitable floor plate at one point in time for office use.

7:39Right. For residential, it did not. In evaluating that, I came up with the plan of cutting that hole in the center. Can you just talk a little bit more about that hole cutting? How did you sort of recognize that, yes, it's currently only capable for offices, but actually we can make the math work if we cut a giant hole down the center of a building? Talk a little bit about that evaluation. So with a lot of things, just about everything is possible, but it would cost a lot of money. So you have to evaluate the structural modifications that it would take to create that and ultimately what you're going to do with that building at the end of the day.

8:19Create the residences, how much money you're going to get on the rent, and then eventually sell that building one day. And so when you evaluate that, especially in that courtyard area, what's the spacing of the column bays? from column to column? And does it allow for enough space to be able to cut that in without really cutting out any other structural steel columns or supports? Which when we cut that out, we still had to reinforce the rest of the structure and do quite a bit of that. So when you're looking to convert an office building to apartments or something like that, How much of what you're looking to do is based on, I guess, people's preferences on where they live versus regulatory requirements about, well, you have to have so many fire exits and you have to have this number of windows and that sort of thing?

9:13So we look at it, we look at it, if in Barton, much differently in terms of you have to obviously look at the code requirements and have to build that within your plan. But we take it much further in terms of we have a little bit more of like a hospitality approach to our multifamily buildings, our residential buildings, in that we look at the entire life cycle of the day and the resident and really put ourselves in the shoes of the resident and not just in 2023, but in 2033 and beyond. So we try and incorporate as much technology and components that set this building up so that it's very much marketable at every point in time.

9:57Can you talk a little bit about, you know, again, I'm thinking about finding the right contractor, the right construction company that even knows how to like cut a hole in the middle of a building, which seems tricky. Like I imagine that's not something that every construction company can do. But can you talk a little bit about like, how many entities out there that can do that? And then maybe like, all right, the costs in 2023 for that, I assume are really a lot higher than when you started on 180 Water Street, both due to inflation and supply chain constraints. Can you talk a little bit about sort of operational constraints of, okay, theoretically, yeah, this is a cut-hole-able building, but actually getting someone to do that?

10:36Yeah. You have to find the right team members. And since we've been in this space for a while, we've kind of brought on board and continued to work with, for the majority of it, I'd say probably 70 % of our team members are repeat team members. So when you say team members, These are contractors and people you work with. And some of them. Okay. We have the vision and know how to execute. We bring on our consultants and our other team members to really evaluate those nuts and bolts pieces of cutting the holes and doing those things and be the experts in their field. and finding the experts is difficult.

11:15And it takes years to create that team that you're comfortable with to cut a hole in a building and know that everything is going to go as planned.

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13:23I wanted to ask you a little bit more about the financing because all of this, you know, cutting holes in the middle of buildings sounds very expensive. And it does seem like a lot of the office conversions are often aimed at a sort of premium segment of residential. And this has been one of the criticisms. Yes. So how does that fit in with the decisions on whether or not to go ahead for these projects? Is it just a fact of life that you have to create more expensive apartments that are going to pay for this? Or could you do this on a more affordable basis? You could do it both ways, right? Ultimately, it comes down to what your basis is in the building when you purchase it.

14:03and if you have a low enough basis when you buy that on a per square foot basis and knowing we've done this a while, we know what it'll take to convert a building. So if that basis is a certain amount, we layer in the amount that it takes to convert it and we know at the end of the day where we're going to end up on a per square foot basis and our all-in basis. And so you can determine based off of that initial basis which way it really needs to go. So if the basis is a certain amount, say if it's$300,$400,$500 a foot, if you're buying a building at$500 a foot and it's going to cost you$500 to convert, you know you're in$1 ,000 a foot.

14:43That's a pretty hefty price today. And so you know that you would have to get very high rents, market rate rents, to be able to make that pencil. If you're able to purchase the building at a much lower basis, it gives you much more flexibility. And then, you know, layer into it the need, in my opinion, for legislation to be able to make that easier. And so then you can target different segments of the market. So it's not all at the luxury end of the spectrum. So just on that basis, what is the, you mentioned legislation, and my understanding is there is, or maybe there was, some tax credit support for doing these kind of conversions.

15:26Can you lay out what would you expect to see in terms of government support for doing this at the moment? So as of now, there isn't any incentive. But there were debates in New York State legislature to incorporate some sort of a tax abatement as part of this. And for that tax abatement, there would be a certain amount of units within that converted building that would be affordable. I think that's fantastic. We need that. that'll help the housing crisis and that'll that'll target a market that it really needs that housing that is not there another end of it is the date and I don't know if you've heard about the date within zoning being able to kind of convert buildings as of right so downtown in the financial district south of Murray Street it was in the early 90s they changed that date to 1977 So buildings in specific districts south of Murray Street that were built prior to 1977, you could convert those as of right completely to residential.

16:34And it could be market rate. Here in Midtown, it's 1961. What is the basis of these dates? Like, I don't quite understand. Like, what is it about a building? What happened in 1961? So like liability in 1965, they're uncomfortable with offering the carte blanche. What's some of the intuition or logic behind some of these constraints? It's very much arbitrary. Okay. And at that point in time, yes, it worked to help alleviate some of the vacant office space in the financial district. But the way that that really needs to be and the mayor's task force and others have been a proponent for is changing that date to 1990, for instance.

17:20Why even have a date? Why not just say, yeah, if the market says it's doable and if the market would value this particular plot of land more as housing than as office, like what is the logic behind having a date? So there are a couple of things with that. One, they proposed in 1990 with a rolling date. So then in 2050, we don't have the same problem, and we're saying we need to change the date. So it always cycles out. But one thing within zoning and changing some of the districts, say in Chelsea, some of the manufacturing areas, they're only zoned for manufacturing right now. An issue of just changing that to residential is do we, and they need to study this and they really do.

18:06And they need to put the time in on this. And I don't think it's a good idea just to flip the switch and allow for residential to go immediately without studying. Do we have enough schools and hospitals and markets? All of those things are the components of why there is a date in these areas. Interesting. So just on the idea of maybe getting more government support, more tax credits, a loosening of some of the restrictions. One of the criticisms that you hear in New York specifically is that property developers already make a lot of money. And while this might help on the housing front, alleviate the housing shortage, we're basically giving them even more money.

18:48What would be your response to that? Or how could you alleviate some of those concerns? Yeah, I think it's easier to say that from the outside looking in. But ultimately, the risk that we're taking on in converting these buildings and making these investments is our risk. And we should get paid for that. It's not to say... Is it a risk though in New York if you make a bunch of really nice apartments? It is always a risk, no matter what. And yes, New York is a fantastic market and the best market, in my opinion, to ever do this. Because not only that we feel strongly, Many people feel strongly about the market here and residential and multifamily.

19:28So yes, it is a great market to do it. But there is still risk with it. There are cost overruns that could potentially happen in the conversion. There are numerous operational things that could happen after the fact and during lease up and things like that. New product could come online and compete with you. Recessions could hit. Other things could hit that could bring the prices down from when you started the discussion of that project. So let's say you got the, you know, the legislator cooperated and changed the tax code and they moved up the dates and a bunch of other stuff happened that was sort of favorable from a policy perspective.

20:06Like, OK, how much do you think just office to resi in general could like move the dial in both directions? Because that's sort of the big question here. And it sounds like, you know, you've done you've done a handful of projects, but, you know, they it doesn't seem like it's a possibility everywhere. And there are lots of buildings that, as you say, you can like walk in and say, no, this is not going to work. So like how much is this in terms of when people talk about there being a crisis of office, you know, people not going to the office, et cetera, like that? How much could it move the dial in your view?

20:39It's going to be one piece of the puzzle. It's not going to be the solving piece. This won't solve the housing crisis altogether. together. But not many things on a broad brush will. But doing these things will certainly help and will certainly get more units on the market. How closely do you follow the sort of return to office headlines? Like, you know, if you see a news article that says, Jamie Dimon says everyone at JP Mortgage should come in four days a week instead of three, do you immediately start incorporating that into your like forecasts and expectations for rent? No, but we follow it very closely.

21:18We also invest in commercial office. We have many office buildings in our portfolio. So we follow that very closely. Here in New York City? Here in New York, also in San Francisco, Seattle, Los Angeles. So we follow it very closely. Can we take a minute to talk about some of those markets from an office, just a pure office perspective? Because people are so gloomy on it. If you look at the shares of the publicly traded proxies, I guess, for some of these markets, pretty down in the dumps. There are challenges. New York is well ahead of many of the markets that I just mentioned. And I think that it comes down to the city and the administrations within those cities and making sure that they drive that traffic to their central business district.

22:08And for instance, San Francisco, it's seen better days. Yes. And we're looking at a lot of different opportunities there where we could potentially convert because you have people out eating at restaurants. There are places that are busy and packed. Not all the offices are occupied, though. Here in New York, we've seen that return. We've seen a lot of people come back into the office. We really saw the residential multifamily takeoff in May of 2021. That's when we really saw that trajectory. And it's helped with all the return to office. and with Jamie Dimon saying four days a week or five days a week for managing directors.

22:51And that's what we need. This might be a slightly weird question, but I remember the other big crisis in commercial real estate was sort of post-2008 when you had the death of retail and the dead malls all over America. And there was a move then to try to convert some of that space either to new community facilities, facilities, gyms, and things like that, or in some cases, residential. How successful, I know this isn't your area of expertise necessarily, but how successful were those efforts and what can they tell us about the current situation? Yeah, I think it's area dependent because some of those areas where you're able to change a mall to more of an outdoor mall, put some multifamily on top of those retail shops and maybe some parking below it, that creates a whole new life cycle in a whole new area with entertainment, living, and then you can bring in some office components too.

23:50And so I think there are some clear distinctions that separate the two. But I think the whole idea of breathing life into these areas is the key. And what we're doing downtown in our conversions is really breathing life into these buildings and neighborhoods. And once you do that and you bring people into those areas, then it just kickstarts everything else. It kickstarts the retailers. And then, you know, even offices want to be there. I lived in the financial district for, I think, four years, from 2011 through 2015. And it was like picking up. But now when I go down there, like there's just like so much more and like around the seaport and stuff like that.

24:31Yeah, the tin building. I was like, oh, yeah, it's really nice. And I was like, oh, man, I kind of wish I, no, I really like, I mean, it was a good time. Can you talk a little bit about business and the constraints in the pandemic high inflation period that we've experienced? Because again, as we talked about, you've been doing it a long time, but everyone who's doing any sort of construction in 2022, 2023 has probably seen headaches. Can you talk about those headaches and have they abated at all? Have they eased in any way? Yeah, I think we saw a run up of pricing, certainly in 2022. and a lot of time trying to get people signed on with a contract.

25:11They were very busy. They didn't necessarily have the time for this or that. And that kind of also goes back to building that team, making sure that you have the repeat contractors or vendors. But we certainly saw the increase in prices of things. You also saw the whole crisis with shipping containers and the price of those skyrocket. How did that affect you? So we actually had it around that same time as when we were purchasing our glass for 160 water, the project that's currently being converted to residential. And we were looking to locally source as many products as possible, but we couldn't get this glass locally.

25:52So we needed to go to Spain. And during that time, shipping containers were extremely expensive. It was hard to get things going. We also saw a trucker strike in Spain. So we had to really - Remember the perfect storm era? That's like that. You really have to go through every iteration and create backup plans. So we made sure that we had a private escort for our glass to the docks and to make sure that it got on the containers when it was supposed to and to us. Because you have to follow every piece that closely. because if not, it could get lost in things. The same thing with our generator, even though it was made in the Midwest here in the US.

26:35We had weekly calls with our contractors and the manufacturer because of parts being an issue and what goes into the generator. So we had to really press them and say, hey, we'll fly out there. We want to come out there. We want to visit the plant, make sure everything's on track. And it was that pressure that really made sure that they understood that this was a very high priority for us. It's kind of crazy you have to go chasing generators in this day and age. But since you mentioned glass, I have to ask, what's the deal with windows in New York? Sorry, that went very Seinfeld all of a sudden.

27:13What's the deal? What's the deal with windows in New York apartments? No, but this is one of my pet peeves about New York real estate, which is, and I sort of alluded to this before, but you have a lot of tenement buildings that have been cut up into smaller apartments, into these traditional railroad apartments, and the window is always at the end in the bedroom, which apparently is also required by legal statute. But my preference certainly as a renter would be if I'm going to choose one room in the apartment to not have a window, it would probably be the bedroom. So why is that? And would loosening those type of requirements help these conversions?