Zombie office buildings stagger through American cities

Just in time for Halloween, real estate's office property type may be going zombie.

The office sector is going through a transformation as work-from-home and utilization changes take their toll, turning some of these buildings into zombie offices.

Office buildings join the throng of the undead when vacancy rates and unused space under lease drive utilization to 50% or less, according to Boston Consulting Group.

In a May report, BCG pegged utilization of U.S. offices, reflecting vacancy rates and unused office space under lease, at 42% on average. This is down from 70% for key office markets prior to the pandemic, according to Fitch Ratings.

According to CBRE Group data, roughly 50% of total U.S. office space square footage in the second quarter was more than 90% leased, compared with 62% in the first quarter of 2020.

"There are hundreds of zombie buildings in the United States. It's not isolated to one market, and it's in every office class," said Shaul Kuba, co-founder and principal of real estate money manager CIM Group.

Older office buildings may be most at risk, with more than 50% of new vacancies emerging since 2020 in offices built in the 1980s and 1990s, Jones Lang LaSalle data shows. Offices built in the 1980s and 1990s account for 40% of total office space in the U.S., JLL said. Overall vacancy of U.S. office buildings increased 39 basis points in the third quarter from the prior quarter to 21%, according to JLL's third quarter U.S. office outlook.

"There are older office buildings with tenants that don't want to renew leases," Kuba said. "At the same time, owners do not have or want to put capital into the building. So, you end up with a zombie building."

Investors see offices, once considered a major property type, as a problem area in their portfolios.

"I do think there has been a sea change as far as the underlying fundamentals for office," Thomas Toth, a managing director at Wilshire Advisors, told the investment committee of the $446.7 billion California Public Employees' Retirement System, Sacramento, in September.

Office buildings are under pressure and investors may need to invest more money in their office properties to reposition them, Toth said.

Indeed, U.S. and non-U.S. investors say that about one-third of U.S. offices need to be upgraded to meet future occupancy expectations, according to a report on the results of an Association of Foreign Investors in Real Estate investor survey released in October.

AFIRE is the trade group of international investors that invest in U.S. real estate. Of the offices that are expected to be upgraded, 90% of investors anticipate that some of these office buildings convert to residential, industrial, hospitality or vertical farming, the report states.

But real estate executives say that it is not that easy to convert an office building to residential.

"The cost of converting office to residential buildings is enormous," CIM's Kuba said. "Even if you buy cheap, it does not always pencil out to do so. In every case, you need a clear business plan for each property and strong public support — and that is very difficult to do in today's environment."

Kuba believes legislation and tax credits are required to make conversions to residential from office buildings make sense.

"You need an incentive for buildings that are sitting on the market with no demand," Kuba said. "Cities realize that zombie buildings will hurt future tax rolls, so there is a mutual need for incentives."

Even so, office conversions are starting to tick up, according to an analysis of office conversions in major U.S. cities by real estate firm CBRE released in September.

Close to 100 office conversion projects are expected to be completed this year, an increase from the annual average of 41 completed from 2016 to 2022, CBRE found. In sum, across 40 CBRE-tracked U.S. markets, 60 million square feet of office conversions are planned or in progress in 2023, amounting to 1.4% of the total U.S. office inventory, up from 1.2% in the fourth quarter of last year. Nearly half, 48%, of office conversions this year are to multifamily residential complexes, 19% are to life sciences labs and 18% are to mixed-use projects, CBRE said.