Triumphs and challenges: A spotlight on Calgary office conversions
What do we do about the office sector?
Over the last year, questions pertaining to the future of the office sector have dominated headlines, conference panels, and industry discussions to the point of near ad nauseum. In the wake of the pandemic, the CRE industry appeared braced for impact, not only from the high cost of capital during a phase of intense fiscal tightening but the seemingly inevitable impact of an overnight halt in office demand. The widespread shift to remote and hybrid work has left office spaces – once a darling of CRE portfolios – vacant or, at the very least, grossly underutilized compared to their pre-pandemic glory.
After all, the pandemic-inspired work-from-home movement was unprecedented; according to Statistics Canada, only 7% of workers in Canada said they “usually” worked from home in 2016. However, this jumped to 24.3% by May 2021, and remained there until early 2022. In recent months, many companies have moved away from a fully remote model to embrace a hybrid format that requires employees to come into the office a designated number of days each week or month. To this effect, our Q4 2023 Canadian office market update revealed that exclusively remote work arrangements fell from 24.3% in January 2022 to 12.6% in November 2023, while the proportion of workers with hybrid arrangements has tripled since January 2022, increasing from 3.6% to 11.7%.
In the world of CRE, having employees back in the office part-time is certainly better than the alternative. However, office vacancy rates are still soaring, and concerns regarding the impending lease renewals for office space that has remained under-utilized or vacant are omnipresent. At the same time, regions across Canada are grappling with a long-standing housing crisis that has been exacerbated by ongoing development challenges, including labour shortages, and increased construction costs in the construction realm.
As major cities like Toronto and Vancouver struggle to develop new housing to meet the demands of an ever-growing population, the question of office-to-residential (adaptive reuse) development emerges. If key Canadian markets have more office space than necessary but not nearly enough housing, couldn’t adaptive reuse become a viable solution to two problems at once?
There is, perhaps, no better case study to demonstrate the benefits and challenges associated with office-to-residential development than the Canadian region that explored this strategy before anyone else: Calgary.
Calgary’s tipping point – A catalyst for collaboration across stakeholders
If we look back to 2018 and 2019, the values of office space in downtown, Calgary had plummeted, which translated to a significant loss of revenue for the city. At this point, it was clear that the value of office space in Calgary was not coming back materially – something was fundamentally different – and this was ultimately the genesis for Calgary’s foray into office-to-residential conversions. With a shared goal of mitigating the revenue losses associated with a largely vacant office sector, all of the big businesses and industry stakeholders, including the government, major developers, key consultants, contractors, and architects, came together in the hopes of finding a solution. The question they faced was simple but undeniably lofty – what would it take to revitalize downtown Calgary, and what would it cost? What would it take for the industry to do this?
From a pro forma standpoint, office-to-residential conversions present as a tough sell at face value, as they can be complex projects that don’t ‘pencil out’ in the traditional sense. But when Calgary’s key players came together to consider this idea and develop a pro forma identifying the gaps and the associated costs, a $75 per square foot incentive program was proposed that would incentivize these developments, beginning August 16th, 2021.
The Downtown Calgary Development Incentive Program
Launched on August 16th, 2021, the initial phase of the Downtown Calgary Development Incentive Program (DIP) ran until December 2021 and focused on office-to-residential conversions, with a priority placed on Calgary’s downtown core. City representatives positioned the program as a much-needed step towards the creation of a more vibrant downtown community, as high office vacancy rates meant low downtown property values and, subsequently, property tax burdens outside of the downtown core.
Since its inception, DIP funding has been doled out across 13 developments (with 4 more pending approval), and the City of Calgary has since secured a housing accelerator fund, with a portion of this intended to help fund the next phase of the program. Initially, the program made $45 million in funding available (with rebates of up to $10 million per approved project), but an additional $108 million has been injected into the program since then.
This incentive has been undeniably paramount in Calgary’s leadership in the office-to-residential conversions and mirrors some of the investment initiatives created in US cities such as Nashville, Houston, Austin, and Denver. Thus far, the projects that have been approved under the DIP are expected to transform 2.3 million square feet of underutilized office space into homes.
The Cornerstone: From office to home
One of the first approved office-to-residential conversion projects to reach completion in Calgary is The Cornerstone, a development project described as “the perfect combination of sleek modern design, shared amenities, and close proximity to everything you want.” Prior to its residential makeover, The Cornerstone was a 10-story office building that sat vacant for nearly a decade in downtown Calgary, at 909 5 Avenue S.W. Today, it boasts 112 two and three-bedroom units, 40% of which will be affordable (20% below market rents). The second floor of the building will also be home to a co-working space for estheticians in Calgary.
The project was budgeted at $38 million, and as a part of the DIP, People First Developments will be reimbursed $7.8 million upon completion. Apartment features include 8+ foot ceilings, quartz counters, LED lighting, oversized windows, tenant-controlled heat and AC, in-suite laundry, and – a rarity for conversion projects – balconies. The Cornerstone is set to welcome its first residents next month.
Sierra Place: A Herculean effort
Prior to the inception of the Downtown Calgary DIP, an empty office tower at 706 Seventh Ave. S.W. was set to be transformed into affordable housing. Beyond being the first office-to-residential development in Calgary, this project was unique, as it was brought to life through a collaboration between Inn From the Cold and the HomeSpace Society. The building would offer six floors of affordable housing (82 units) for vulnerable populations, as well as four floors of shelter, transitional, and support services.
A number of funding vehicles were required to make this project a possibility, including significant contributions from HomeSpace and Inn from the Cold, CMHC, the Government of Alberta, and the City of Calgary. The Rapid Housing Initiative also played a key role, along with a significant philanthropic donation. Rapid was the operative word, however, as they only had 12 months to complete the project which, in the end, was an incredible feat.
What makes conversion projects so challenging?
It should come as no surprise that the current interest rate environment has presented a difficult landscape for office-to-residential conversions. Massive cost escalations have required these projects to go back to the drawing board and determine how to make the development work in this new financial reality. However, beyond the constraints of the current market, there are a number of challenges associated with conversion projects that must be accounted for when determining the feasibility of these developments.
One of the biggest potential costs is the replacement of a building’s exterior cladding. If the exterior cladding needs to be replaced, it’s effectively the same cost as erecting a brand-new building. Mechanical systems are also fundamentally different in an office environment compared to a residential environment, so there may be a need to re-run mechanical/electrical systems in these buildings, which can be costly.
When comparing older offices to newer offices, it’s important to consider that smaller, more ‘cube-like’ floorplans are typically more advantageous to a successful conversion, as well as older buildings, due to lower floor plates and ceiling heights. Standalone buildings are also typically better candidates for an office-to-residential conversion.
Although older buildings are structurally better positioned for office-to-residential conversions, there is a caveat: abatement. The older the building, the greater the need for updates, such as glazing (window replacement) and elevator system upgrades. Moreover, changes to building codes must also be considered.
From an ESG perspective, updating older office buildings does pose a benefit, as buildings built in the 1970s or 1980s are typically incredibly energy inefficient. By simply getting a building up to code during the conversion process, developers are drastically improving the efficiency of that building, and creating far less waste than would be associated with a tear-down and new build.
There are, of course, some quirks associated with office-to-residential conversions. First and foremost, the windows in most office buildings don’t open and, more often than not, there are no balconies. The latter, specifically, is where some conversion projects have gotten into trouble from a budget perspective, as retrofitting a building to include balconies can be an exceedingly expensive – if not impossible – endeavour. A popular workaround is the creation of rooftop patios in place of individual balconies or, in some cases, developers will take square footage away. In other words, they might move the exterior in to effectively ‘carve out’ balcony space. Parking can also present a challenge for these projects, as the parking ratio requirements for an office building differ considerably from the requirements for residential, and digging out levels for underground parking can be another significant cost. However, these projects are typically situated in urban centers, where a one-to-one parking ratio is no longer required due to proximity to transit and the inherently walkable nature of dense metros.
Ultimately, the viability of a conversion project comes down to whether or not it makes economic sense to do it. If you have to redo everything, it likely doesn’t make sense.
Cost comparisons: Conversion projects vs. new builds
Although each office-to-residential conversion is unique, by and large, most of these projects amount to 75 to 80% of the cost of a new build. If, by some miracle, you come across an under-utilized office building that requires very few of the aforementioned upgrades, you’re probably saving another $30,000 per unit. It’s important to note, however, that converted buildings rarely feature as much amenity space as a new residential build, and most of these projects get approximately 80% of the achievable rent for the area in which they’re constructed. So, although developers will save on construction fees, the revenue potential for the building will be lower than that of a new residential building.
That being said, a portion of these builds is typically dedicated to affordable housing – so a level of affordability must be baked into these projects. Moreover, not-for-profit affordable housing players typically have access to additional funding that market developers don’t, making conversion projects an understandably attractive option.
Perhaps the most significant advantage to note is the reduction in development timelines associated with conversion projects. In Calgary, there are teams of people dedicated to fast-tracking these approvals; typically, the approval timeline is one to two months, and the full design and construction timeline is one to two and a half years long. When compared to a new residential build, this is a very streamlined timeline, and time saved is money saved.
Are other types of conversion projects viable?
This might be unique to Calgary’s larger downtown revitalization goals, but if a conversion project doesn’t pencil out for housing, it may still pencil out for a post-secondary development or a hotel property. Moreover, the Calgary DIP is still willing to incentivize these projects, to the tune of $50 per square foot (compared to $75 per square foot for residential conversions). There are also groups now getting ready for the next phase of the program, who are considering the viability of office-to-student-housing conversions.
If the worst-case scenario occurs, and none of these options pencil out, the city of Calgary will contribute up to $15 per square foot to help demolish the space.
What are the keys to success?
The success of an office-to-residential conversion hinges almost entirely on the availability of government support and streamlined approval timelines. Any region considering the viability of these projects must ensure they have a council and administration that is motivated to work with the local development community and view them as partners. Calgary, in particular, has also benefitted from a ‘broad catchment area’, within which any approved conversion projects don’t require a development permit. The only exception to this policy is in the case of a heritage building, or a building that backs onto a rail line; in these scenarios, a development permit is required.
However, it’s also imperative to have a team of people who understand the building incredibly well and can advocate for what will work, and what won’t work; stakeholders on these projects must do their due diligence from day one. To this effect, the expertise of engineering teams, designers, and consultants who have experience with conversion projects can be a huge asset, as they can offer tried and true ideas and solutions that may save a project time, money, and headaches.
Should conversion projects be explored in other regions?
Downtown metros are economic hubs and gathering spaces for cities, and when once-prime real estate sits empty, communities should feel motivated to revitalize those spaces, and municipalities should feel motivated to invest in that revitalization. After all, when people leave the downtown core, or no longer have a reason to come into that area, there is a significant trickle-down effect on other sectors, such as retail. With this in mind, office-to-residential conversions provide an opportunity to enrich city centers, increase tax revenue, and bring more people back into the fold with much-needed housing – especially when a housing affordability crisis has unfolded across Canada at large.
Ultimately, all levels of government and an entire industry must come together for conversion projects to come to life. But when this happens, municipalities realize a unique opportunity to move the needle themselves and, as a result, more regions are moving to embrace conversions as part of their CRE strategy moving forward.