A pre-COVID conversion program in Downtown Crossing paid off for Cambridge-based 3MJ Realty in creating apartments in former office and department store space in the Ladder Blocks buildings along Temple Place. Photo by Steve Adams | Banker & Tradesman Staff

Turning out-of-favor office space into profitable rental housing has been a successful formula for Morris Naggar.

Since 2014, Naggar’s Cambridge-based 3MJ Realty has been converting the upper floors of low-rent office buildings in the Ladder Blocks section of Downtown Crossing into apartments, some renting for over $6,000 a month.

“We showed it to the commercial loan officers and the bank said, ‘What are you going to do here, guys? It’s not performing,’” said Naggar. “We asked them for more money so we could build out the residential.”

Naggar’s portfolio of dozens of apartment conversions points to a potential path forward for owners of class B office buildings in Boston that have been hit hardest by rising vacancies since the pandemic.

Prime Territory – with Caveats

With its lower rents, higher vacancies and smaller building footprints, the class B office market has been identified as prime territory for housing conversions. Class B office vacancies hit 23 percent in the Financial District and South Station submarkets this spring, according to a recent report by brokerage Hunneman. Across the larger downtown area, brokerage Colliers estimates the class B availability rate at 27 percent.

A study released last week by Cambridge-based National Bureau of Economic Research identified Boston as one of just six large U.S. metros where high apartment rents give developers a clear financial incentive to convert from lower-tier office space.

The study identified 73 buildings in Greater Boston totaling 4.2 million square feet that are suitable for office-to-residential conversions. It assumes future apartment rents of nearly $6 per square foot, and conversion costs of $311 per square foot.

The study didn’t take into account the additional financial incentives offered in Boston Mayor Michelle Wu’s recently-announced pilot program to encourage residential conversions in the downtown area. The program will offer a 75 percent reduction in property taxes for 29 years. Qualifying projects will be required to include 20 percent affordable units and comply with the new Massachusetts opt-in stretch energy code.

Matt Daniels, executive managing director at JLL in Boston, said property tax incentives aren’t sufficient to make or break a project.

“The taxes are the small piece of the puzzle,” Daniels said. “It’s a nice gesture, but the current market conditions are all about access to capital and the cost of that capital. When you do that math, it doesn’t justify the [conversion].”

Risk of the Unknown

Office-to-housing conversions come with additional financial risks associated with gut renovations of buildings that often date back to the 19th century.

3MJ Realty’s projects on Winter Street, Temple Place and Hamilton Place required breaking up the antique buildings’ lengthy floor plates to comply with residential building codes, including the need to carve out central shafts to provide light and ventilation for bedrooms.

One building, with entrances on Hamilton Place and Winter Street, was home to Conrad & Chandler’s department store in the 1960s before upper floors later were converted into office space. But office rents a decade ago ranged from just $10 to $20 per square foot, while the apartments consistently fetch $48 to $50 per foot on an annualized basis, Naggar said.

The properties’ three-bedroom units have generated the most demand, including students sharing them with roommates. Suffolk University’s expansion into Downtown Crossing, adding new student housing at 10 West St. in 2008 and 1 Court St. in 2021, has established downtown as a housing option for college renters, he said.

Real estate development was an outgrowth of Naggar’s apparel store family business, transitioning from a tenant to landlord of buildings in Central Square and Downtown Crossing. The latest example: 6 Temple Place, wedged between the Orpheum Theatre and a hotel development site on Hamilton Place, which Naggar visited last week to show Banker & Tradesman progress on his newest apartments.

Tipping Point Approaching?

Some research indicates that the argument for office conversions will become more persuasive in coming years, if lease expirations continue to drive up office vacancies and Boston’s high apartment rents continue their recent ascent.

A Deloitte study released in July predicts that apartment rents will rise 3 percent annually for the next five years, and by 2027, the increased income from housing will begin to offset costs of acquisition and conversions.

“If developers can leverage [public] incentives and assuming interest rates fall a bit, you might make a great decision that’s going to last for the next 10 years,” Deloitte Partner Kevin Richards said.

Steve Adams

Many office buildings owned by smaller developers without mortgage debt can continue to operate profitably for years to come, Deloitte predicts.

“If [occupancy] was 50 percent, they’d be fine,” Richards said. “They just need to pay taxes and run the untenanted outside portions of the building.”

Brokerage Avison Young is advising five local office landlords on analysis of housing conversions, said Patrick Schmidt, an Avison Young principal and practice leader of project management and development. At least three undisclosed projects are moving forward, with conversion costs estimated at $450 to $500 per square foot depending upon the level of residential finishes.

But some regions are offering more aggressive incentives than Boston, such as direct payments to developers. California is offering $400 million to landlords in a program running through 2024, while Calgary has budgeted $153 million for conversion and office demolition projects.

“What’s challenging is making the economics work,” said Matt Perry, corporate managing director for brokerage Savills in Boston. “You need office buildings that are vacant or close to vacant, and have floor plates that make sense. There’s a lot of intrigue and we’re in that phase where people are still doing their due diligence.”

Email: sadams@thewarrengroup.com

Developers Face Conversion Conundrums

by Steve Adams time to read: 4 min