Owners of empty Southern California offices pivoting to apartments, warehouses

In the heart of Santa Ana, a newly renovated office complex has a date with the wrecking ball.

There’s nothing wrong with the complex, which features two glass-sided office buildings, renovated underground parking, remodeled lobbies and a new event lawn, conference center and fitness facility.

Since the pandemic, however, the owner, Kearny Real Estate Co., has been able to fill only about half the space at the “Elevate@Harbor” complex on Harbor Boulevard. So, Kearny decided to tear the buildings down, fill in the underground garage with dirt and erect a new warehouse on the 8-acre site.

“It just came to a point where (this property) made more sense as industrial than an office complex,” said Dan Broder, Kearny’s assistant vice president.

Three years after the COVID-19 pandemic began, remote work continues to wreak havoc on the office market, pushing vacancy rates to their highest level in years and causing building values to plummet.

“RTO” (or return to office) is flagging, with just half of Los Angeles’ office workers showing up at their desks, by one measure.

Hence, building owners are searching for solutions to cascading cash flows and rising operating costs.

Some are selling for a loss. Others — like LA-based Kearny Real Estate — are converting office buildings into warehouses, apartments, medical buildings, data centers and hotels.

One report shows Los Angeles County developers produced 798 housing units in former office buildings last year, more than any other city in the nation.

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“Tenants have made changes to how they’re occupying space, and therefore, they are right-sizing or are generally downsizing how much space they use,” said Kevin Bender, JLL’s executive managing director in Los Angeles. “That, coupled with tenants that are deciding to vacate altogether, … (is) driving the increase in vacancy across most product types.”

For many, declining rental income is coming just as property owners are facing the twin perils of expiring loans and higher interest rates.

Two downtown Los Angeles skyscrapers are in default and dozens of Southern California office buildings are on watch lists for troubled debt.

“They’re experiencing vacancy increases, and the rental rate is not going up,” Bender said of downtown buildings. “Their buildings are worth less than their loans.”

Vacancies at 29-year high

U.S. Census figures show L.A. and Orange counties have lost about 250,000 commuters since the pandemic began as more employees continue to work from home. 

As of June 28, just 49% of Los Angeles’ pre-pandemic workforce showed up at their offices, according to Kastle System’s “Back To Work Barometer,” which tracks app, keycard and fob usage to measure office occupancy rates.

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As a result, office vacancy rates hit a 29-year high in L.A. County this year, and a 10-year high in Orange County, according to the brokerage CBRE.

“Companies are really struggling to get their employees back to the office,” said Amber Schiada, a Southern California-based researcher for the brokerage JLL, at a recent real estate conference in Las Vegas.

Meanwhile, Inland Empire offices were barely touched, with vacancies up just slightly in the second quarter. That’s because Riverside and San Bernardino counties have steady office demand from health care and government and fewer downsizing tenants, CBRE field research manager Bradford Ortlund said in an email.

Not all office buildings are in financial distress.

CBRE found that 10% of the nation’s “hardest-hit buildings” accounted for 80% of the increase in big-building vacancies from 2020 through 2022. At least 52 LA County buildings and 20 Orange County were among those hardest-hit offices.

Buildings constructed before 1990 in the greater L.A. area accounted for 80% of the office space vacated in the past four years, CBRE’s analysis showed.

“A lot of negative demand is typically concentrated in older product that hasn’t been renovated,” said David Barnett, a CBRE thought leader for Southern California.

Meanwhile, investor appetites for office have been waning, causing building values to fall by 40% or more.

“There’s a number of these scenarios where these assets have traded at roughly half of what those numbers were four or five years ago,” said Anthony DeLorenzo, a CBRE vice chair specializing in Southern California’s office market.

Downtown downturn

In March, KBS Realty Advisors sold the 40-story Union Bank Plaza in downtown L.A. for $104 million. According to Bisnow, a commercial real estate website, that was half what the Newport Beach-based investment fund paid for the building in 2010. The tower was 38% vacant at the time.

“Demand for office space in downtown Los Angeles significantly declined as a result of the COVID-19 pandemic, with employees continuing to work from home,” KBS said in a November Securities and Exchange Commission filing. “In addition, with rising interest rates, prospective buyers were challenged to obtain favorable financing, … (impacting) the purchase price.”

Downtowns all over the country have yet to recover from pandemic lockdowns that turned central business districts into ghost towns, and LA’s city center is no exception.

Downtown L.A. had a 25% vacancy rate during the second quarter, higher than the downtowns in New York City, Chicago, Philadelphia and San Diego, CBRE figures show. In the “east downtown” submarket, which includes the Fashion and Arts districts, 46% of the office space was vacant.

Reduced demand and declining cash flows created financial distress for property owners, especially those with loans coming due.

In February, Brookfield DTLA Fund Office Trust Investor, an investment trust that owns several downtown L.A. office buildings, announced in SEC filings that its subsidiaries had defaulted on two high-rises: the Gas Company Tower and 777 Tower, both 52 stories tall.

“We’ve seen this perfect storm of client-office demand (going down) and debt coming due,” CBRE’s Barnett said. “Almost half of that (commercial) debt, is due this year and next year.”

Trepp, which maintains a mortgage database for commercial properties, reportedly put 81 Los Angeles office properties on a watch list for troubled debt, according to CBRE.

Properties typically get put on a watch list if they show early signs of potential distress, such as losing a big tenant, said Jesse Gundersheim, a CoStar senior market analyst.

In Orange County, 24 office properties with commercial loans sold to investors are on a troubled debt watch list, Gundersheim said.

Future of office

Under the hybrid remote work model, many offices are busy on Tuesdays, Wednesdays and Thursdays, but almost empty Mondays and Fridays, analysts said.

So, what to do with the extra space?

Some of it is being converted to housing, industrial space, mixed-use and retail, according to a recent JLL report.

In 2021-22, residential was the most common use, accounting for 52% of U.S. office conversions, the report said. Industrial accounted for 16%, followed by 14% for mixed-use, 2% for retail and 1% for hotels.

Most office conversions occur in “Class B” or “Class C” buildings more than 30 years old, wrote the study’s author, Jacob Rowden, JLL office research manager.

“Los Angeles most resembles the U.S. as a whole, where conversions have historically been mostly residential or hospitality,” Rowden said in an email. “Orange County is a more industrial-centric market and a rapidly-growing logistics hub.”

L.A. County generated more housing units from office conversions than any other U.S. city, according to a July 10 RentCafe analysis of Yardi office conversion data.

The 798 new homes generated by 2022 office conversions were three times the annual average for the previous two decades. Office conversions spurred development of 1,474 new homes since the pandemic began, the analysis showed.

Newmark reported at least four sales recently to potential office-conversion developers.

They include the 12-story Topaz Tower in San Pedro sold in April to Culver City-based Urban Stearns, which plans to convert the half-empty building with ocean views into residential. The previous owner got city approvals to develop 228 apartments, but an Urban Stearns spokesperson said the firm is assessing whether to stick with that plan or add more units.

The one thing the company is certain about is the need for new housing.

“You can work from your home, but you can’t live in your office,” the spokesperson said.

Despite the momentum, analysts note that office-to-residential conversions can be challenging. Office buildings typically were designed with larger floors, making it difficult to provide windows and sunlight to every unit. The ceiling heights, mechanical and electrical systems, physical plants and plumbing are different in office buildings than in residential buildings.

“There’s still a lot of expense that goes into converting buildings to the residential side,” JLL’s Bender said.

An ideal floor size is less than 20,000 square feet and less than a fourth of the nation’s hardest-hit office buildings are that small, according to CBRE.

Ultimately, analysts say, some office towers either will go back to lenders or will sell at a substantial loss so new owners can afford to lower the rent.

As for Kearny Real Estate’s two office buildings in Santa Ana, demolition looks like the best bet, despite the cost.

Assistant Vice President Broder estimated it will cost about $35 million to tear down the offices, grind up the concrete garage and build a 163,000-square-foot, state-of-the-art logistics center. That’s on top of the $45 million already invested in buying and renovating the property.

“It’s amazing, isn’t it,” Bender said of the Santa Ana demolition. “The pricing for industrial and office has never justified doing that. (But) in today’s market, with the lack of industrial supply and the lack of demand on the office side, you can now justify that sort of conversion.”