Written by Brooks McDaniel, SVP of Building Repositioning, STO Building Group
“I get by with a little help from my friends.”—J. Lennon/P. McCartney
When times are tough, everyone needs a little help. And times have indeed been tough on owners of commercial real estate for the past few years. With COVID changing how and where people work, the demand for office space has declined, leaving most cities with an oversupply of commercial office buildings. This oversupply has led to two opposing effects:
The Consolidation Effect. This refers to the migration of office tenants to new or updated buildings in the best locations, upon the expiration of their pre-COVID leases. As these leases continue to expire, more and more tenants consolidate in the most desirable central business districts (CBDs), especially in the more recently built or renovated office buildings that include generous amenities and state-of-the-art systems. Within the consolidation zone, there will be increasing levels of competition between buildings to attract these new tenants.
The Attenuation Effect. This is the flip side of that coin—the outward flow of commercial office tenants from less desirable commercial zones as their pre-COVID leases expire and they relocate to the CBD. This effect will build on itself as vacancy rates continue to increase in these areas over time and the local economy is adversely affected. Within these zones, landlords will face an uphill battle to secure new office tenants, and many will consider converting their buildings from office to residential use.
To ensure this process of consolidation and attenuation reaches a new stasis with as little pain as possible, some assistance is required in the form of tax benefits and/or zoning benefits. These benefits have a short-term cost to municipal revenues, but a longer-term gain due to increased real estate value and the associated boost in property tax revenue. In NYC, there are two plans in place, which are a good start and a guiding light for other cities around the county.
1. COMMERCIAL OFFICE RENOVATION INCENTIVES
The Manhattan Commercial Revitalization (M-CORE) program is a tax incentive plan that is intended to encourage renovations of office buildings in order to attract new tenants and remain competitive with newer amenity-rich rivals. To qualify, the building must be located south of 59th Street in Manhattan, be built before 2000, and include an investment above a certain minimum threshold. In return, the building owners will be given up to 20 years of property tax abatement, as well as a tax exemption on the cost of construction materials, and a reduction of the mortgage recording tax. This is a generous package for those willing to make the investment, until the limit of 10Msf of office buildings have been renovated under the program. Act fast, supplies limited! While this program is open to any building in Manhattan south of 59th Street, it is a safe bet that almost all of it will be spent in the central business districts near Grand Central and Penn Stations, reinforcing the consolidation effect in NYC.
2. RESIDENTIAL CONVERSION INCENTIVES
There are beneficial changes to the official rules around residential conversions too, although they don’t include any tax benefits. The city’s zoning text already has a chapter devoted to converting commercial space to residential apartments, which lifts the cap on residential floor area from 12 to whatever floor area the building already has, and is more lenient with respect to rear yards, among other benefits. This is applicable to pre-1961 and pre-1977 office buildings depending on location, but not the dated and uncompetitive office buildings that were built after the cut-off dates. To remedy this, the city has proposed changing the cut-off to pre-1990 office buildings, which will extend these benefits to an additional 136Msf of existing commercial real estate. The Department of City Planning has also proposed rezoning several M-zones in Manhattan to allow residential conversions where they were previously prohibited. A streamlined entitlement process is also in the works.
These are incredibly valuable and useful incentives, but more could be done. The M-CORE limitation to 10Msf may prove to be shortsighted, given the hundreds of millions of existing office space in Manhattan alone. And the lack of a tax abatement or tax credit for residential conversions means that many of these projects may still need to be re-capitalized in order to pencil out. As a result, foreclosures and “hand-back the-keys” events will become more and more common to reduce the cost basis (for the current or a future owner) for buildings in the attenuation zones, and the banks will be left holding the bag. Some form of tax break would help many of these conversions to become reality.
Similar proposals are on the boards in several other cities, such as Boston, Chicago, and Washington DC. No matter where a building is located, it is probably subject to the recent forces of consolidation and attenuation. Strong incentives must be granted in each major municipality to support the sea
change that is occurring in the commercial office markets and allow building owners to confidently invest in their buildings for a new era ahead.