Office-to-Residential Conversions: Tax abatements needed to get there

Downtown DC has an office vacancy problem. Overall, the vacancy rate is about 20 percent. It’s higher for Class B or C buildings, which are the older, shabbier and charge cheaper rents. We could see vacancies reach 30 percent within the next two years as the full effects of remote work hit home and major employers stop renewing leases.  This reality is already setting in. WeWork is walking away from its three leases downtown. A property owner near Metro Center handed over the keys to its lender, deciding it was ready to cut its losses and run. The federal government is overwhelmingly not back to the office. One large federal agency said the daily utilization rate of its office space was only 7 percent. All of this means the value of office space is in a tailspin and street-level downtown retail is struggling to stay open. With fewer fun coffee and lunch spots, there’s less reason for workers to make the trek in. Soon the city will feel the pinch in cratering commercial tax revenue.  Residential conversions must be part of the long-term solution. Today’s District Strong welcomed three FC2 Trustees to bring the private developer perspective to the debate. They themselves are working on conversion projects and bring the private developer perspective to the debate. Paul Daugherty is President and Chief Investment Officer of PRP Real Estate Investment, Matthew Pestronk is President & Co-Founder of Post Brothers, and Gary Cohen is Chairman of Willco.  The residential market in DC has remained strong. Young people especially want to live, work and play downtown. The sticking point is the cost of the conversion to get there—and it ain’t cheap.  The best candidates for conversion are Class B and C office spaces that are on a corner and have good windows on all sides of the building. Downtown DC has a lot of mid-block office buildings that have maximized their horizontal footprint to make up for the fact that they cannot build high (because of the Height Limit). Buildings are built literally right up against each other, wall-to-wall, with almost no natural light peaking in or with a horrible view of a dumpster-filled alley.  Buildings with what’s called “post-tension” construction are also not ideal. Unfortunately, many office buildings from the 1980s and 1990s used this method, where there is a cabling that holds the floor plates together. If, during conversion, a cable is accidentally cut, the whole structure could collapse. This isn’t to say conversion is impossible, but certainly more complicated and costly.  The costs for conversion are moving in an unfavorable direction. Construction costs are up 20 percent compared to 2020. On the financing side, interest rates have doubled and are likely to go up more in the coming months. Investors are intrigued by conversions but are concerned about what’s hidden inside old buildings that could drive up construction costs more than anticipated.  At the same time, the city is talking about slapping on inclusionary zoning requirements downtown, which would be prohibitively expensive and kill conversion projects in their tracks without massive government subsidies. You need top-dollar private rents to subsidize affordable housing, and it’s not clear downtown rentals can charge that high a rental price.  Allowing more density could help, particularly on narrower one-way streets like L street. Those could be a story or two higher. Loosening the Height Limit by several stories would be great. Then each conversion could squeeze in more money-making rentals.  The best course of action the city could take is tax abatements. The city is staring at years of losses in commercial real estate tax revenue anyway. Why not give conversions more space and time to pencil out before tacking on a layer or tax costs. Or other building requirements like green roofs or stormwater retention could be pushed back a few years for new conversions. Within ten years, the city could make the money back, and then some. Look at how NoMa, the Wharf and Navy Yard have delivered in tax revenue after an initial large public infusion of subsidy. While conversions are under construction, retailers should get an abatement themselves as they try to transition their businesses away from office-worker patrons.  The DC government is an essential partner to make conversions happen. Developers can’t do it on a large scale without their help. The first step is convincing our local elected officials of the urgency of the downtown office vacancy crisis. More employers may decide Reston or Bethesda has everything they need, closer to where their workers live, without the commute and at a cheaper price point.  A rude awakening will come soon enough this coming in March when commercial tax assessments are sent out. It could get ugly and painful—for property owners and elected officials who are accustomed to steadily increasing tax revenue to fund social programs.  No one should bet against the District in the long term, Pestronk insists. But in the short term, the solution is clear, and it involves more mixed-use and 24-hour vibrancy in the city’s commercial core. The city government needs to work with property owners and developers to pave a cost-minimizing road to get there.