WHITE PAPER: Examining the Feasibility of NYC’s Commercial-to-Residential Conversion Proposal

WHITE PAPER: Examining the Feasibility of NYC’s Commercial-to-Residential Conversion Proposal 3 Feb 2021

By Brandon Polakoff

 

On January 11, 2021, Governor Cuomo delivered a bold State of the State Address in which he threw support behind a proposal that allows property owners to transform underutilized hotels (throughout most of New York City) and Class B/C office buildings (Midtown + Midtown South) into affordable and supportive housing. At first glance, this certainly seems like a logical and praiseworthy strategy to overcome an affordability crisis in the housing market coupled with expected increases in office vacancy due to COVID-19 (I would argue hotel occupancy will rise relatively quickly). However, from a bird’s eye view, there are major obstacles that need to be considered and addressed. Simply put, converting commercial use to residential use is not an easy task, and I am having a hard time wrapping my head around its ability to solve our housing crisis on a large-scale basis, let alone its overall feasibility.

 

Zoning/Code Compliance + Feasibility

As an investment sales advisor, my job starts by analyzing the highest and best use for a prospective client’s property. The first step involves reviewing a property’s zoning district (including special districts with additional nuances) and Certificate of Occupancy. 

Oftentimes, a commercial property’s zoning district does not permit residential use or does so at a lower floor-to-area ratio given its position in a commercial district. The latter can be quickly spotted along C5-3 and C5-5 sections of 5th Avenue and Madison Avenue in Midtown or Hanover Square in the Financial District, which have a 15 commercial floor-to-area ratio and 10 residential floor-to-area ratio. While a prominent land use attorney I have spoken to believe that under the proposal a commercial property can be converted to residential as-is, or at an FAR, that is greater than zoning permits, they are not certain. This needs to be explicitly addressed.

Next, if you would like to obtain a new Certificate of Occupancy to legalize residential use, you must file an Alteration Type 1 (Alt-1), which involves a change to the use, occupancy, or egress of a property. To the Governor’s credit, the proposal does amend Section 277 of Multiple Dwelling Law and Zoning Resolution Article I, Chapter 5 to allow for more lenient light and air requirements, which would otherwise be very burdensome. In addition, his proposal seeks to expand the number of buildings eligible for conversion under Section 277 of Multiple Dwelling Law. However, this modification is not all encompassing. There are other prohibitive requirements such as egress, open space, and distance between buildings that need to be considered. I also spoke to the land use attorney about this matter. While his reading is that the proposal overrides these zoning requirements, he cannot say with certainty his reading is correct.

This is a long way of saying it is not so simple, and once more, it must be addressed in black and white fashion.

Furthermore, ask owners of office properties in the Garment District how arduous the process has been to convert their “fashion manufacturing” spaces to legal offices since the area was rezoned in 2018. The same challenge will arise if owners in SoHo and NoHo are forced to modify their Certificate of Occupancy when live-work units no longer require artists as residents (provided this rezoning passes in 2021 or beyond). Obtaining approvals and sign offs is a cumbersome, lengthy process.

Let’s now factor in the costs involved. It is extremely expensive to convert a commercial property into a residential property. First, you must demolish walls and move plumbing stacks, electrical risers, and gas lines. From there you must create efficiently laid out, code compliant units and install new kitchens and bathrooms. Finally, the Department of Buildings must sign off on the work completed, which does not happen overnight.

Is a conversion doable? Maybe. Is there a strong return on cost? Probably not. In fact, my gut tells me that maintaining the existing commercial building and charging reduced office rents (or nightly rates if you believe the future of the hotel industry post-COVID-19 is bleak) is your best option.

 

Taxes/Affordability

Another major challenge that a sophisticated real estate professional will bring to light is taxes, which play a key role in property expenses.

Many office leases involve pass through expenses such as taxes, which relieves the office property owner of a significant amount of financial responsibility. This is very different from apartment buildings, in which the property owner is responsible for the full tax bill plus future increases.

Once a commercial building is converted into a residential building, the property will be re-assessed. One could expect that a new tax bill will range between 30 to 40 percent of effective gross revenue, which greatly diminishes the value of the property. Furthermore, buildings over 10 residential units are placed in Tax Class 2, which has no limit on annual tax increases. In a city facing a major budget deficit, this becomes very problematic.

Even more, let’s not forget about the emphasis Governor Cuomo places on affordability and supportive housing, which also hasn’t been properly laid out. While I fully agree that New York City is facing an affordability crisis, by applying restrictions on income potential and not offering proper tax abatements, converting commercial buildings to residential buildings simply will not pencil. Even more, if affordability requirements are extensive, it is very likely that property owners will also require subsidies to make the conversion a viable investment. I find it very hard to believe that both sides will agree on this topic, which could very much lead to an ineffective proposal.

 

Net Square Footage vs. Rentable Square Footage

When renting a residential apartment, a tenant only pays for the actual space they inhabit, or the net square footage of their apartment. Conversely, office properties charge tenants for common spaces such as the building’s lobby, elevators, stairwells, shafts, and mechanical areas, which generate what is termed a loss factor. By applying this loss factor to a tenant’s usable (or carpetable) area, commercial property owners are able to artificially increase the amount of space their tenant pays for. This is a win for office.

 

Union Hotels

It is safe to assume that most hotels facing the greatest financial strain are union-operated hotels (New York City has more than 200) due to outsized wages and benefits. As a result, in theory, it makes a lot of sense for union-operated hotel owners collecting very little revenue today to sell to buyers that plan to convert to residential (if not execute the business plan themselves). However, there is major catch. When converting a union-operated hotel to a residential property, you cannot simply cut ties with its employees. There is an extensive amount of money owed through severance, which is calculated by multiplying hourly wage, hours worked per year, and years of service. Furthermore, there is a cost associated with unfunded pension liability. Finally, once converted to residential, the property must employ workers from the residential union 32BJ. This is not to say that the conversion will not pencil due to severance, unfunded pension liability, and a newly established 32BJ staff, but it definitely needs to be factored into the analysis.

 

Historic District

Good luck with the Landmarks Preservation Committee! It will take no time and they will love your plans!

  

Conclusion

Overall, in theory, I love the proposal. It makes perfect sense and I am certain many will call for it to pass as soon as possible. However, when you properly scrutinize the plan’s potential shortcomings, it grows clear that it will not have far-reaching success. If we really want to successfully expand affordable housing, the only solution is a drastic, yet sensitive, increase in density across New York City. However, I will save this conversation for another day!