Real-Estate Developers Rely on Conversions As Borrowing Costs Soar

  • Developers have long been converting offices and hotels into apartments.
  • They prefer the practice, called adaptive reuse, as borrowing and construction costs skyrocket.
  • An investor plans to convert Washington hotels into apartments for low-income people.

Increasingly, some real estate developers are aiming to convert offices and hotels into apartments because they say these projects are the only ones that make commercial sense right now.

Such conversions — known as “adaptive repurposing” — aren’t new, but investors say they’re becoming an increasingly attractive strategy, particularly for real estate sectors that are underutilized or distressed in the pandemic economy.

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Finding new and cheaper projects is a priority for many property developers as they are squeezed by seemingly inexorable increases in inflation, construction costs and interest rates. Banks are also tightening their wallets on riskier long-term projects that could be marginalized in a recession, said Emily Hubbard, a co-founder of Sage Investment Group, a real estate investment firm that undertakes multi-family home renovations and remodels.

What hasn’t changed, Hubbard added, is the need for housing across the country. “It’s on everyone’s lips,” she said.

Sage, which manages more than $50 million in real estate, is converting an Econo Lodge and Travelodge in Tacoma, Wash., from extended-stay hotels to low-income lodging, Hubbard told Insider. The company spent a total of $14.2 million to acquire the properties, which Hubbard described as “on the seedy side.”

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Hubbard said these opportunities are popping up more and more often.

Remodeling can help rejuvenate run-down properties

“There are many business owners who had to tap into their financial reserves during the pandemic and are now selling their assets,” Hubbard said. She added that with the motel purchases, we’re “also revitalizing something rather than building brand new, so it’s also good for the environment and the local community.”

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Sage oversaw some very different projects before the pandemic.

In 2019, the company acquired Sahara, a 173-unit student housing and short-term rental complex in Tucson, Arizona, for $8.5 million and spent an additional $2.7 million renovating the apartments, according to reports young professionals were marketed to Sage’s website. That year, it spent $4.5 million to buy and renovate Olympic Village Apartments in Tacoma, Washington, whose rents have been increased to “market price,” the site said.

The website says both projects resulted in internal returns of 40% or more. Hubbard expects the Travelodge conversion to generate a similar return when complete.

Sage Investment Group is converting this Port of Tacoma, Washington Travelodge into a low-income home

Sage Investment Group will convert this Travelodge in Port of Tacoma, Washington into a low-income home.

Emily Hubbard, Sage Investment Group

Conversions often satisfy the needs of both developers and their lenders, as many projects can be completed quickly and relatively inexpensively. For example, Hubbard said that Sage typically completes a conversion project in seven months, compared to three to five years for new builds.

Conversions were growing in popularity even before rising interest rates started hurting margins. Online rental marketplace RentCafe estimates developers completed more than 20,100 home conversions in 2021, nearly doubling the volume in 2020 and 2019 combined.

With remodeling, developers are also hoping to capitalize on increased demand for rental housing as buying a home becomes less affordable.

The CoreLogic Case-Schiller Index shows that the average U.S. home price rose more than 15% year-over-year in July, marking the 126th consecutive month of year-over-year increases. Meanwhile, financing those expensive homes has gotten more difficult – Freddie Mac said this month that the average 30-year mortgage rate topped 6% for the first time since 2008 and more than doubled from a year earlier.

Office buildings with persistently high vacancy rates are preferred targets for conversions

Obtaining these conversions could become easier in the coming years, especially as the offices remain vacant. Website CommercialEdge said in August that the average US office vacancy rate of 15.1% for the year hadn’t improved through August, despite states easing restrictions on shared workspaces and employers imploring employees to break their daily commutes to resume.

As a result, office space is falling in value – making conversion projects more viable if financing can be secured. A study by researchers from Columbia University and New York University published in June found that increasing work-from-home opportunities may have destroyed more than $500 billion in future office value.

Tom Ralston, a developer working with Dwelling Place, a nonprofit housing developer in Grand Rapids, Michigan, said office troubles present an opportunity given the strong rental market. The company recently closed an 80,000-square-foot office space in Wyoming, Michigan in August and plans to invest $32 million to convert the lot into multi-family homes.

“It’s not necessarily repeatable in every vacant office building, but one that’s a creative reuse of a really well-built structure,” Ralston told website MiBiz.

The same is true for hotels, which are still struggling to attract workers, Hubbard said. The Bureau of Labor Statistics said in September that the hospitality industry shed more than 1.2 million workers in February 2020.

Municipalities are pushing for conversions

Developers receive critical help from state and local governments, said Eddy O’Brien, a co-founder of Blaze Capital Partners, a developer that has completed four conversions this year, including converting a Homeward Suites hotel into The Spoke at McCullough Station , aa 124-unit apartment building in Charlotte, North Carolina.

For example, in July, Pittsburgh Mayor Ed Gainey introduced a $2.1 million incentive program for developers to convert vacant office buildings into apartments. The program includes zoning reforms designed to facilitate conversion projects and funding from the Federal American Rescue Plan, the Pittsburgh Post-Gazette reported.

But a nagging problem facing O’Brien and Hubbard is funding, which has become tighter since the Federal Reserve began raising interest rates to fight inflation. O’Brien said lenders make loans but may be looking for projects that can be completed in less time. He added that while conversions can meet this criterion, funding can still be difficult for developers without a track record of execution.

Glenn Ebersole, business development manager at JL Architects in West Chester, Pennsylvania, speculated that housing finance problems would continue into 2023 and that developers who don’t adapt would be “left in the dust.”

For the industry, this is “the new abnormal,” he told Insider.

“There’s no going back to the old ways,” Ebersole said.

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