Here’s why Philly’s empty offices likely won’t become apartments anytime soon

It’s over three years since COVID-19 swept the country, and much of the world seems normal again. Diners have returned to restaurants, stadiums and nightclubs are packed, and unemployment is lower than it was in 2019.

Housing prices, however, are stubbornly high, while hybrid work is shrinking the demand for office space. A second quarter report from real estate services company JLL shows a 17.3% vacancy rate in Philadelphia and 20.6% in the suburbs.

So when can we expect to start seeing obsolete office buildings being transformed into much needed apartments?

Don’t hold your breath. A massive wave of conversions isn’t likely in the near-to-medium term, local experts say.

“It’s very, very difficult to convert office to residential,” said Jim Pearlstein, president of Pearl Properties, at a June Center City District meeting.

“I have a lot of nightmare stories,” said Pearlstein, who has plenty of pre-COVID office-conversion experience. “That’s not taking into consideration construction costs, which are so high right now. … The depth of the market [for residential conversion] isn’t the answer that we all think it can be.”

That’s not to say there won’t be any action. There are one or two obvious candidates for conversion in the coming year, such as the Morgan & Lewis building at 1701 Market. MM Partners recently decided to turn the 121,500-square-foot Jewish Federation office building at 2100 Arch St. into apartments, too.

But most local experts agree with Pearlstein and don’t expect the city’s existing office sector to be transformed into new neighborhoods any time soon. The barriers to conversion are high, including building layout and cost, and there is little Philadelphia officials can do to speed the process.

The possibilities of turning empty office districts into new residential neighborhoods have been contemplated since 2020, as have many of the hurdles.

These include:

Overall cost. Converting an office building into apartments isn’t necessarily radically cheaper than building a new multifamily structure. At a Center City District event in April, cohead of JLL’s Philadelphia office division, Ryan Ade, estimated that converting an old building could cost 75% of building a new one.

A Brookings Institute report on myths about office-to-housing conversions highlighted an analysis of San Francisco that found such projects could cost between $472,000 to $633,000 per unit and “given current economic conditions and development costs, most conversions of underperforming office buildings to housing are not financially feasible.”

Acquisition cost. The cost to acquire office buildings is high, too, although that may change as under-occupied buildings struggle financially. But for now, the costs of acquisition add a further barrier to those who dream of conversion.

“I’m optimistic that over time, the sellers and banks of some of these buildings will become a little more realistic as to what the building is worth,” said Leo Addimando, managing partner of Alterra Property Group in Philadelphia.

Long leases. Office leases are quite lengthy. Ten years, if not longer, was the pre-pandemic norm, and most buildings bristle with leases that sport a hodgepodge of ending dates. That means it’s rare to find a building completely empty.

Instead, many of the struggling Philadelphia-area buildings are shambling along with 50% or less occupancy.

The wrong floor plan (among other things). Many post-World War II office buildings have lots of dark interior spaces, with no access to sunlight, that would be inhospitable for housing.

Plumbing is set up to accommodate large shared bathrooms, not toilets dispersed throughout. Even the windows in these structures are a problem: In the era of climate control, they were not built to be opened.

“Some of the office buildings are very deep buildings,” said Allan Domb, a major Center City property owner and former mayoral candidate, who called for more conversions on the campaign trail.

“The only way to make them viable for residential is to core the center to create a light well or courtyard in the building. And that’s very, very expensive,” Domb said.

Fewer buildings to convert. Cities like Boston or New York, where the pre-COVID urban office sector was robust, have plenty of older office buildings amenable to residential conversions. But in Philadelphia, where the office sector has long been stronger in the suburbs, most of the easiest-to-convert buildings in Center City were turned into housing before 2020.

Those problems have been obvious for years, but since 2022, as the office recovery sputtered, new challenges have arisen.

Construction costs and interest rates. Since March 2022, the Federal Reserve has increased interest rates at the fastest pace in 40 years and has signaled more to come.

Although the costs of construction materials have largely stopped rising, they have stabilized at much higher levels than pre-pandemic. Across a variety of material types, construction costs are an average of 19% higher than they were in 2020, according to the data tracking firm Gordian.

“It’s a mix of the cost of acquisition, the cost of construction, availability of financing, and the rates charged for it,” said Alterra Property Group’s Addimando, whose company performed office-to-housing conversions pre-pandemic and has been exploring the possibilities in today’s market.

“All of those things come together to make it rather difficult at this moment to do an economically sensible office-to-residential conversion,” Addimando said.

New apartment buildings. The last big hurdle is specific to Philadelphia. Unlike its surrounding counties, the city has been aggressively building housing — and specifically apartments. Northern Liberties alone has permitted almost 6,000 units in the last five years, leading some bankers to express concern that landlords may have to offer rent concessions.

How many more apartments can Philadelphia’s market absorb in the short term? That’s a question under debate that could specifically haunt ambitious projects like office-to-residential conversions of post-World War II buildings that have to compete with more standard offerings.

“There’s a lot of ground-up apartments being built in Philadelphia right now,” said Ashley DeLuca, who coleads a new team at the law firm Ballard Spahr focused on distressed office buildings.

“So it’s a question of whether you can compete with a ground-up construction project with really fancy amenities that you may not have the ability to do, given the floor plate that you’re working with,” DeLuca said.

Zoning is a major hurdle facing conversions in other cities like New York. But much of Center City’s office sector is covered by the most flexible zoning in the Philadelphia’s code and already allows residential development.

No trips to the zoning board or legislation from City Council would be necessary to convert most office buildings in Center City or University City.

The city’s 10-year property-tax abatement was created in 1997 to facilitate the transformation of underused office buildings in Center City into residential apartments. It lasts longer and comes with fewer restrictions than comparable incentives in other cities.

Although the abatement became a hot-button political issue when it was applied to all construction and City Council eventually halved the benefit for new projects in 2019, it remains intact for conversions.

“We still have in place, I think, the most potent and reliable abatement,” said Paul Levy, head of the Center City District, a business advocacy group.

“Many people seem to be confused,” Levy said. “There’s been so much focus on the reduction in the 10-year tax abatement for new construction, but there was no change to the 10-year tax abatement for the renovation of vacant office or industrial to residential use.”

In cities like New York and Boston, where empty office buildings are a bigger economic threat than they are in Center City’s weaker market, policymakers are looking at conversion incentives that mirror what Philadelphia already has in place.

Industry advocates say that incentives for conversion are not high on their list of asks for Philadelphia’s future mayoral administration.

“Short of throwing money at the problem, or providing some sort of subsidized financing product, I’m not really sure what the city can do,” said Addimando.

There are changes that could be made in Harrisburg.

The historic tax credit program could be increased from its limit of $3 million a year, a sliver of what states like Texas and Ohio offer. Or Philadelphia could be allowed to target longer tax abatements to particular geographic areas, if state lawmakers devised a way to relax the state’s uniformity clause. But that is seen as unlikely.

The city itself could experiment further with tax-increment financing, wherein future tax revenues for a project, or in a geographic area, are earmarked to fund redevelopment (such as a conversion project).

But real estate industry experts say that poor cities like Philadelphia mostly doesn’t have the resources to fund such ambitious development projects for private entities.

Only the federal government does.

“The federal government is going to have to step in and offer some really attractive financing programs for people to convert these buildings [like] loan programs at subsidized interest rates,” said Glenn Blumenfeld, principal with the tenant brokerage firm Tactix Real Estate Advisors in Philadelphia.

“The government could offer a program with 3% interest rates, a 50-year loan amortization, and guarantee the loans and the developer would have to provide below market-rate housing,” said Blumenfeld. “You just can’t have these urban cores with all these rusting, hulking, office buildings decaying over the years.”

Editor’s note: This article has been updated to clarify the address of the old Morgan Lewis headquarters. It is located at 1701 Market St.