Commercial Real Estate Outlook: Zombie Offices, the Push for Conversions and a Return to ROI

Commercial Real Estate Outlook: Zombie Offices, the Push for Conversions and a Return to ROI

AE Logo

Recession or not, we have resources to help your business master this moment of high interest rates, labor shortages, sticky inflation, and slower growth. We've put together our Agility & Excellence Resource Center to bring you strategies and solutions with a finger on the pulse of what's ahead.

The following provides key takeaways from CBIZ Marks Paneth’s Oct. 26 Real Estate Market Update Mixer, hosted by Managing Directors Michael Siino and Neil Sonenberg. The event featured a discussion with New York City real estate veterans Michael Cohen (President, Colliers International) and Jeffrey Gural (Chairman and Principal, GFP Real Estate), and was moderated by CBIZ Marks Paneth Managing Director Darya Shneyder.  

When asked about the current headwinds facing the commercial real estate market – high interest rates, declining cash flows, hybrid work schedules, $1.5 trillion in looming loan maturities – the panelists at CBIZ’s latest Real Estate Market Update Mixer confirmed it’s not going to be easy.

Jeffrey Gural, Chairman and Principal at GFP Real Estate, pointed out that the market is going to test the resilience and adaptability of industry professionals.

As evidenced by the growing number of zombie office buildings dotting the Manhattan skyline, not everyone in the industry is going to survive the tumult. Real estate owners who play the long game will have a leg up. Renewing your focus on return on investment (ROI), completing conversions, taking advantage of thriving Class B assets, and being known as a quality landlord can help. 

What’s next for commercial real estate in New York City and beyond? Read on to find out.

A new world for CRE

“If my father were alive today, he would be absolutely flabbergasted that 23rd Street and 6th Avenue is worth more than 57th Street,” said Michael Cohen, President, Tri-State Region, at Colliers International.  His father, Jerome M. Cohen, was a legendary real estate professional and former president of Williams Real Estate.

The evolution in Manhattan hotspots is just one example of the market’s transformation. More crucial, especially given today’s high interest rates, is that the method and criteria for investing in CRE have changed materially in the past 20 years.

“When Jeff and I were coming up in the business, real estate was a cash-flowing asset,” Cohen said. “You bought it, you fixed it, you repositioned it—and you achieved a rate of return that allowed you to finance out your investment.”

But over the past decade or so, appreciation, not cash flow, became the objective: to get in and get out. That worked when interest rates were low and capitalization rates compressed. Hence the flood of private capital and the shift in focus from ROI to internal rate of return (IRR). Yet in the past 10 years, a hyper-competitive environment meant that these players’ margins were all razor thin.

Now, as interest rates climb and occupancy rates plunge, those who overleveraged are in trouble.

“If rents didn’t climb at the rate your Argus predicted, or if your exit cap rate was higher than predicted, or if your cost of debt was more than expected, you’re doomed,” Cohen said. “That describes the predicament of just about every building that was acquired in this town over the last 10 years.”

Conversions offer a way out—but are easier said than done

Signing new leases with existing or new tenants in itself will not be sufficient to reduce the unprecedented inventory of available space to acceptable levels. This can best be accomplished by significant conversions of available commercial buildings to other uses.

But conversions are difficult work. First you must go through the “painstaking” process of emptying out the building. Then you need to roll the property into a new capital stack to provide the necessary financing—and your financing has to be low enough to revalue the building as raw material, Cohen said.

That construction and labor costs are currently high only exacerbate these challenges. Fortunately, effective tax planning can generate significant savings. For instance, if equipment and other construction material cannot be repurposed, there are tax benefits available when demolishing previously constructed spaces. What’s more, in certain circumstances a complete write off can be made of all previously capitalized equipment and improvements that are no longer being utilized.

Dealing with local regulations on land use and zoning, however, presents further obstacles.

“I called the head of [New York] city planning, who’s a friend of mine, and told him I’m trying to get this property rezoned,” said Gural. “He said what are you talking about? You can convert this building to residential. I asked him to check with his staff. Five minutes later he called back and said you’re right, it’s not legal for you to convert without a zoning change.”

Gural would know: he’s currently converting the famed Flatiron building into roughly 40 condos.

To make conversions possible at scale, he said that the government will have to help ease those hurdles: for example, by offering a tax package that incentivizes owners to convert commercial properties for residential use. Meanwhile, New York City’s “M-Core” program provides an alternative option for aging commercial buildings in the city, offering incentives to help owners decrease vacancy and attract world-class tenants.

The flight to quality landlords

As panel moderator Darya Shneyder noted, remote work has changed the CRE landscape—and while many organizations may be rethinking their footprints as a result, it’s a myth that work-from-home is automatically giving employers the option to significantly reduce their space.

Gural and Cohen acknowledge the current struggle. But they don’t see remote work as a bigger threat than high interest rates. As Cohen said, “You can't downsize your footprint for your Friday level of occupancy” if you have the full workforce coming in midweek.

And after all, efforts by commercial leaseholders to be more efficient with their space has been happening for decades, as individual offices gave way to cubicles and open-plan seating. Nodding to a potential recession, Gural put it this way: “The minute people are worried about keeping their job, they’re going to come back to the office.”

Though Class A assets provide more amenities to lure workers back in, Class B properties are thriving in part because there’s more scope for growth. “Class A tenants are basically companies that make billions of dollars in profits,” Gural said, and there are fewer of them. “The vast majority of businesses in New York are small businesses.”

There’s also a flight to quality landlords—the ones who brokers can confidently recommend when their clients can’t decide which space to take and who offer creative (and useful) amenities. Gural meets personally with prospective tenants, no matter their size, and brings flexibility to his leasing arrangements. For example, he recently struck a deal with a nursery school lessee offering lower rent in exchange for a 25% discount on childcare services for other tenants in the building; Gural will subsidize another 25% of the costs himself.

Gural’s company also owns the Meadowlands and holds a popular contest in all his buildings where tenants can win tickets in a suite to see a Jets or Giants game, or concerts from the likes of Taylor Swift, Beyonce and Bruce Springsteen.

Positive indicators ahead  

Though the commercial real estate market is experiencing turbulence right now, it’s not all bad news.

Asked about silver linings during this time, Gural suggested that perhaps there won’t be a recession: “I can’t remember a recession where people were talking about how there’s going to be a recession for two years. Every recession was you pick up a paper and something crazy happens and the next thing you know, you’re in a recession.”

Cohen, meanwhile, hopes for the return of ROI in real estate investment decisions.

“There will come a time in the cycle when real estate will be available at a fraction of their inflated values and when cash flow will matter again,” he said. “For a period of time, conservative underwriting will allow you to carefully buy.”

Connect With Us

For more information, please connect with a member of our team.

Copyright © 2023, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly traded and privately held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).

Commercial Real Estate Outlook: Zombie Offices, the Push for Conversions and a Return to ROI following provides key takeaways from CBIZ Marks Paneth’s Oct. 26 Real Estate Market Update Mixer, hosted by Managing Directors Michael Siino and Neil Sonenberg. 2023-11-10T18:00:00-05:00

The following provides key takeaways from CBIZ Marks Paneth’s Oct. 26 Real Estate Market Update Mixer, hosted by Managing Directors Michael Siino and Neil Sonenberg. 

Planning & Tax MinimizationReal EstateFederal TaxYes