What to Do With Office Space in This COVID World

There is a lot of unused space in office buildings, city centers, and shopping malls. We also need a lot of space for multifamily housing, data centers, and warehouses. Is there opportunity here for investors?

In this podcast, Motley Fool analysts Deidre Woollard and Matt Argersinger discuss:

• The complexities in transforming an office building into apartments.
• Commercial real estate trends catching their attention.
• Ideas for investors who like dividends.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on June 18, 2022. 

Matt Argersinger: The idea that you can take an office space maybe in the suburbs, that isn't going to be really appealing in this post-pandemic world, but can I turn part of it into maybe a warehouse space, a data center, industrial light manufacturing space, maybe to do some prototyping, to do some R&D, and then build an office component that's attached to it, I think that's really appealing.

Chris Hill: I'm Chris Hill and that's Matt Argersinger, head of the Motley Fool's Real Estate investing services. We're taking a closer look at space and how it's transforming. Shopping malls, skyscrapers and suburban office parks were rocked by COVID. Maybe they can help fill the need for data centers, multi-family housing and warehouses. Today, Deidre Woollard and Matt Argersinger discuss commercial real estate trends to watch. Why it's not that easy to transform an office building into an apartment building, and a few ideas for investors who like dividends.

Deidre Woollard: There are so many question marks about the future of central business district and about suburbs. I want to talk to you because you recently went through a journey as an investor. You were part of a large plant office conversion in Atlanta, in a central business district, and it didn't quite go as planned. Let's talk about it.

Matt Argersinger: Deidre, I'm going to take you back to the summer of 2019, and I know in COVID years that seems like ancient history. [laughs] All the way back to the summer of 2019, I'm in Atlanta with Greg Martz, who at the time was the head of operations for our Millionacres service, and we were looking at a beautiful mid-century office building in Atlanta. A developer was going to come in and redevelop that building into a newer Class A boutique business office space. The plans were great. They had already ordered the tall windows that were to replace all these old windows and redo the whole facade of that building and all the internal parts of the building, and it looks fantastic.

At the time Atlanta was really seeing a lot of growth in population, employment, and office space was getting absorbed pretty quickly, and there was a real need for the versatile boutique office space in that part of Atlanta. That was 2019. Everything's great. We invested in that project via our Mogul service. Of course, when COVID hits in early 2020, those plans get forward a little bit. Knowledge of construction, prices go up, the demand side for office really gets hurt, in the sense that already by that time, 100 Edgewood, which was the name of the building, was already going to be pre-leasing. Seeing all this demand, that demand completely evaporated by the summer of 2020, and here we were with an office building that was being converted, but probably wasn't going to have any tenants. It just became this really fragile situation for our investors.

We're really worried about what the outcome was going to be. We're looking at big losses. Fortunately, the developers at the time, were able to strike a deal all the way not going to January 2022, with a company that was going to come in, acquire the building and turn it into apartments, which are right now in downtown Atlanta, those are much more demand. The building also sits adjacent to Georgia State University, which is really expanded its campus. There is a need for either apartments or student housing, a residential space less than an office space. Luckily, the developer that we invested alongside was able to sell the building to that new developer. We took a loss on the building, but it was a minimal loss. Our losses would have been much more if they probably try to sell it as an office building or at least gone through the development and met really poor demand. That was an example where I feel really fortunate that we got out of a situation because there was a residential developer coming in that was going to redevelop the building into something that was more in demand.

Deidre Woollard: Yeah. The reason I wanted to talk to you about that story was that this office-to-residential conversion thing I think is really fascinating and maybe worth the beginning although it's really hard to know. One of the things that are interesting to me is I moved to Alexandria in 2019, it's when Motley Fool was founded, and through the Mogul Service, we had a couple of different projects in that area. One of them was near my house and office, a condo conversion project. I'd love to go to construction sites. I went over there with my phone, taking pictures a couple of different times and watched. You think an office building conversion to residential, maybe it's just you add more bathrooms and kitchens. Nope. This was just that things are being torn out, the whole facade is off, and there are things being added. Why is residential conversion not quite like a just quick-slips solution?

Matt Argersinger: I think there's some confusion or misinformation in the market that people just look at all these vast office buildings in places like New York City or Washington DC where you live, and it's like, well, why can't we just convert all these underused office buildings to apartments or condos. Seems easy solution, while it's actually very difficult to do. I'd say most office buildings, just aren't structured correctly to have that conversion. We just actually invested in an office building in Alexandria, actually, not too far from where you live, that is in the process of being converted into apartments. But if you look at this particular office building, you've got doubled loaded corridors, which means you have a narrow central corridor, and on each side you've got a lot of ample space windows.

From a bonus perspective, really convertible to apartments use. You also have larger floor plates, and wide column spacing, ideal for fitting in dozens of apartments, per floor. It also has good utilities. When you're converting offices to apartments, the biggest thing is water, because as you said, you're adding dozens of bathrooms, and kitchens that are going to be more in use, using a lot more water. Fortunately, this building has sufficient utility capacity to really upsize and handle the additional water load. It also comes with ample parking. This particular building is in the suburbs, usually one, in that case, when it's not a walkable area, you want a 1.5 to one or two. Essentially, 1.5 parking spaces per apartment, this building has that by quite a margin. We had to check a ton of boxes to make this a workable investment for our investors.

But think about that for your average office building, your skyscraper, or maybe a really large office building in New York City that has huge floor plates where it's, you're not going to have a lot of access to windows, you're going have to really build out the internals, it becomes very expensive and very difficult. This is not a panacea to the office conundrum that we have. I still think we have so much office space in this country. It's too costly and too capital intensive and labour-intensive to convert it to residential.

Deidre Woollard: I have a follow-up question on that. I was just thinking about this, which is, there's not really a public market investing play for these types of conversions. The two projects we just talked about, they're private projects. There's not really someone who's doing this as a single thing?

Matt Argersinger: Well, yeah. There's no direct play that I can think of in the public markets. You've got office REITs and in some cases, multifamily REITs who are doing these redevelopments, but it's a relatively small percentage of their portfolio and incrementally, it's going to add very little to their net operating income over time. There's not really a direct play. The two deals we've discussed so far were private deals. Equity was raised. On the crowdfunding platform, we invested in that way, but these were single-asset deals by smaller developers, not exactly your public mega-market cap companies.

Deidre Woollard: Let's talk about one that is public, which was a REIT until it recently changed out of the REIT structure. Again, in Alexandria, we had this massive mall redevelopment taking place. The Landmark Mall, it's been an eyesore for a few years. It's now being rebranded as West-End. It's going to be anchored by a hospital, there's going to be apartments retail. It's this massive project between Howard Hughes, another publicly traded company, Seritage Growth Properties, and Foulger-Pratt. This one is interesting because you just mentioned parking, like there's no issues with parking when you're converting a mall, which is a great thing. [laughs] We're seeing this really taking a mall and turning it into a community walking paths, apartments, retail, maybe office or industry, but it takes so much capital. With Seritage, they've really been struggling to keep going and especially during the pandemic. We've been following that one a little bit, what do you think?

Matt Argersinger: Why I like this particular deal makes a lot of sense to me, because you mentioned Howard Hughes, Seritage, and Foulger-Pratt by the way, which is private, but they're one of the largest developers in Washington DC really specializing in apartments. This kind of development makes sense to me because you got a huge amount of space, you're developing what's a mixed-use property and if you think about what's needed in a place like Alexandria which we're talking a lot about during the show, but massive suburb right outside of DC, more apartments, more medical office space for sure, retail of a different kind, more of a walkable place with amenities, experiential properties.

This Landmark redevelopment, I think is emblematic of a lot of these kinds of property redevelopments across the country that I think there's a real need for. I think we're building out these mega mixed-use projects around the country that can mix together residential, office to a certain extent, hospitality, retail, and amenities all in one place and it a walkable or easily accessible type of area. I think there's a huge demand for that. Seritage Growth Properties, they've been in this transition redevelopment phase for a while now. I can't speak to whether or not they're going to be successful because they've got a lot of real estate on their books to convert this way. But these projects, the Landmark projects that you've described make a ton of sense to me. I think that's going to be one that's really successful.

Deidre Woollard: It's really those class B malls, the malls that maybe weren't doing so great. We're losing tenants even before the pandemic and I think that's really something to pay attention to because before Landmark started its conversion process, it was being used a bit as a fulfillment center. It's this piecemeal solution, but we saw that a lot during the pandemic. Amazon was buying up malls, but also working with malls to takeover spaces. But here's the thing, we're starting to hear a little bit about Amazon delaying the opening of fulfillment centers, subleasing space, and scaling back, is this whole turning unused space into fulfillment centers a trend that might be waiting a little bit?

Matt Argersinger: I don't think so. I know the Amazon comments definitely sense a little bit of a chill to the market. You can see the valuations. The market we know has been extremely volatile this year. It sounds surprise to see stock prices down really across-the-board, real estate has not been spared, but when I look at the industrial REITs, they have whether it's Prologis, whether it's STAG Industrial, Duke Realty before, it's now being acquired by Prologis, but all of these valuations just got hit really hard, really since that Amazon comment in late April. I think it's a little overplayed. I think the e-commerce expansion, it's much broader, much bigger story to me.

CoStar recently came out with a report and they were looking at just the leases signed across the country there was in May, for example, there was 80 million square feet of industrial leases signed. That's up 16 percent from the same month in 2021 and this number blew my mind, 85 percent higher than May 2019 and that was almost a year before the pandemic. That to me tells me there's still a lot of momentum within the space. I think the country still needs a lot of warehouse fulfillment space and a lot of parts of the market. You have Prologis, I mentioned they finalize the deal to acquire Duke Realty, that's a $26 billion all stock deal that was just done this past week. Blackstone acquired PS Business Parks, another big one for about eight billion dollars a few months back. These are some of the smartest industrial real estate operators in the world and these transactions might even signal a short-term top, but I also think they reflect a long-term belief in the asset class. I just think there's so much more to play out, more runway here for industrial real estate?

Deidre Woollard: One of the things I always think about it up, like never bet against Blackstone. They know far more than I do. I watched that company to really understand things. But I think there's something else interesting that Prologis is doing. They've bought a couple of office parks recently and I'm starting to wonder about a new type of industrial real estate that we're starting to see more tech-enabled, a little bit less just a box and a little bit more amenities for the workers, but partly because they'll be running more robotics and things like that. Is that where we might be going with this?

Matt Argersinger: I think that's an exciting area development. I think what you're describing, you may be used to be called flex office, but that's a term that's been around for a long time. But the idea that you can take an office space may be in the suburbs, that isn't going to be really appealing in this post-pandemic world, but can I turn part of it into maybe a warehouse space, a datacenter, a light industrial, light manufacturing space. Maybe to do some prototyping or to do some R&D and then build an office component that's attached to it. I think that's really appealing. I think there's a huge demand we know on the R&D side, on the lab space side medical office.

That development or build-out of existing office space is much more in demand than your traditional office space built with offices and cubicles. I think we all agree that that might be a thing of the past in a lot of cases that the traditional office, but there is and so we talked about the transformation of old resale space. Old office could be the new office if it's converted in a way that's more flexible as you said, that maybe it's more collaborative spaces let's the building to offer more things, more amenities, but also more flexibility in terms of what kind of work that can be done there. I think that's a real trend.

Deidre Woollard: Absolutely. Our podcast producer had asked us about datacenters and transforming malls and anchor stores into datacenters. I did a little dig in on that. It's interesting because it's in the current situation probably not just because there's so much energy and water issues designed for datacenters. They don't quite fit into smaller spaces like that but as datacenters evolve as they need less space, as we see more edge computing coming on mind. I think there might be a potential thing there, I think it's still five years down the road maybe, but what do you think? Is that a place we could go as well?

Matt Argersinger: I think so in certain cases, but I agree with your first comments, which was the datacenters right now it's a little bit of scale game and I think the most efficient way to do it and by the way, I live in Loudoun County, here in Virginia which is-

Deidre Woollard: The home of datacenters.

Matt Argersinger: I was going to say. Just the development is just incredible, but you have these large companies buying up hundreds of acres of what used to be farmland and turning that into datacenter space and they could do it really efficiently like you said the utilities, they can add solar panels, water is accessible. Cooling these massive spaces. With utility costs that you can keep down is key. I think that's where, say, 80-90 percent of development is still going to take place. You'll see occasional small-scale datacenter around in certain markets, but the game is still, I think a big space, big open area needs.

Deidre Woollard: Yeah, I would agree with that. Well, let's talk about interest rates. I feel like everyone is [laughs] talking about interest rates these days. But there is some analysis I saw recently from MSD Real Estate assets showing that commercial real estate property sales down by 16 percent in April year-over-year. What do you think we're going to see in the commercial real estate side? Is that going to slow down maybe some of these conversions?

Matt Argersinger: I think yeah. I mean, I think we're certainly seeing the impact of rate rises right now. You're going to see that slowdown. It will probably be a short-term thing. I mean, you have developers, real estate operators that they're already facing serious construction cost, inflation, labor shortages. Well, now they're facing higher interest rates and we have to remember on the development side, most of these developments and conversions are often financed with short-term floating mezzanine bridge construction debt. That's the debt that's in place during the initial build phase because refinance later hopefully to longer-term fixed rates. But in the short-term, there is a lot of floating debt out there and so higher interest rates can have an impact on developments cash flows or a bank's desire to fund something of that scale early on in the project. We have to remember, I think if you step back, 2021 was such a big year for transactions in the commercial real estate space. According to Real Capital Analytics, [laughs] $809 billion worth of transactions. That was more than double the figure in 2020 and well ahead of the previous record, which was 600 billion in 2019. Even if we weren't facing the additional headwind of interest rates, I think we expect at least some slowdown already this year because just 2021 was such a booming year.

Deidre Woollard: No doubt. If we're looking at potential danger signs here, interest rates, potential concern, supply costs, price of steel, lumber or things like that, the potential for rents to go down, which it doesn't seem to be the case right now in terms of multi-family rentals all across the country are seeing double-digit increases over last year. Is there anything else that people should be looking for as a potential sign that we might be facing trouble.

Matt Argersinger: I think you ticked off all of the major concerns on the supply side. My worry now is if we do enter a slowdown or even an economic recession, you're going to see a slowdown on the demand side. Right now I think developers are trying to get any project they can and get through because they know the demand is there, whether it's residential or even hospitality or some of the things we talked about, dataset centers, warehouses. They see the demand there, they're just having issues on the supply side.

Now, if we enter a slowdown, that demand side is going to get hit and so, therefore, that could have a double-whammy effect on the ability to get a lot of these projects done, put a lot of them in danger. That's something I think we need to watch. If interest rates get ratchet up too high, too fast, could that slowdown the economy too quickly to the point where now we're in a situation where employment is going up? Businesses are seeing a huge slowdown in orders and all of a sudden, all these projects that were penciled a few months ago, even at higher interest rates don't make sense anymore. That's what I'm watching. I think the supply issues are things that should be transitory, I hate use that word. [laughs] I think probably six months from now, we can look back and say, a lot of that stuff probably leveled out. The demand side is I think right now the big question.

Deidre Woollard: We've talked about this for a while now, and it just seems it's murky to me. There's so much that isn't clear. As an investor though, what are you seeing that might be interesting? What stocks have caught your attention?

Matt Argersinger: Well, there are few that stand out to me and I'm looking at briefs and I think the outlook has certainly changed in the last few months. We have high inflation, the higher interest rates, stock prices have been hit hard. Real estate usually holds up better, but that's not been the case this year and that's caused some REITs that I follow to really fall to their lowest valuation in years in terms of things like stock-price to funds from operations, dividend yield. A few that's really interesting to me. One is Alexandria Real Estate Equities, tickers ARE, I've probably talked about this one in the past, but it's a leading life sciences office REIT, incredible track record, incredible management team. I think it's just been thrown out with all the other biotechnology because biotechnology is a big component of their rent role.

This has been clobbered down around 40 percent from its recent high and trading for about 16 times funds from operations this year, which wow, you just never see that valuation for Alexandria Real Estate Equities. Another one is Mid-America Apartment Communities. It's the second largest owner operator of apartments in the country. Predominantly positioned in the Sunbelt markets and really seeing no let up in demand, no let up in occupancy rates or in rental rates. I just think they're joining sanding at the stock prices again. Down 25, 30 percent roughly from its high, that seems like an opportunity. On the hospitality side, I was looking at VICI Properties, which essentially owns Las Vegas, Deidre [laughs] as you probably know since they acquired MGM Properties a few months ago. I think the hospitality space is really interesting. The dividend yield on VICI almost five percent. I think there's real bounce-back in hospitality, especially in large events and conferences later this year and into 2023. That looks really interesting to me as well. What about you, Deidre?

Deidre Woollard: Yeah. I like VICI and is one of those ones like keep liking more and more. I interviewed their CEO, Ed Pitoniak last year, and I just heard the commitment to the company. Since then I've been following it. They got that MGM Growth Properties transaction done. Las Vegas is back all the tourism numbers and even the convention numbers are coming back. But the interesting thing is what's next for them. The Flamingo is on sale on The Strip now for a reported billion-dollars.

There was talk about that on the call. Of course, they would say nothing about it. I don't know if they're going to get that one. But what they did announce recently is the first project in their deal with Cabot, which is an owner and developer of golf communities and resorts. On that earnings call, they talked not just about gaming but moving into experiential and that's really interesting to me right now. The other one in that space, the giant in that space is EPR Properties, which is ticker EPR. I know you have covered that one before. They just announced another deal too for a couple of Canadian properties, a resort and a waterpark. I have a little bit of concern about a fall in discretionary spending because of inflation and people watching their wallets. But I also feel like there's that pandemic buildup and I just like EPR because the diversification inside their properties in terms of having resorts, movie theaters, which not so great, but they're dealing with that, ski properties. It's really an interesting one to me right now.

Matt Argersinger: I think a seven percent dividend yield or almost on that one right [laughs] now at the price as we're taping the show. I agree, lots of good values out there. I think coming into this, the good news is for investors that REITs have some of the best balance sheets that they've had in their history and so I'm glad a lot of these companies are playing offense. They're actually going out and acquiring properties, as you mentioned and I think that's going to pay off a few years from now. You just have to live with this roller-coaster ride I think for the next several months. But coming out of it, I think a lot of these will look really good.

Deidre Woollard: I think the lesson that I've taken from this conversation and thinking about real estate in general is that real estate it will shift. It will shift to be what is valuable at the moment. It may be an office today, it may be an apartment building tomorrow. Real estate is fascinating to me because everybody needs somewhere to be and the buildings and the land will shift to be what we need it to be for now and then it will shift again for the thing that we need next.

Matt Argersinger: Absolutely. Space will find its demand and smart operators, smart owners, landlords will find the right way to position that property.

Deidre Woollard: Absolutely. Well, Matt, thanks as always for chatting real estate with me. Tones of fun. Thank you.

Matt Argersinger: Always a pleasure, Deidre. Thank you.

Chris Hill: As always, people on the program may have interest in the stocks they talk about and the Motley Fool may have formal recommendations for or against them, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.