Europe’s leading cities are booming. Even as the continent’s overall population is levelling off, urban dynamos such as Amsterdam, London, the Nordic capitals, and the biggest German cities are undergoing rapid population growth. Over the next 20 years, these ‘winning’ cities are projected to grow by 15-30% – similar to the country-level rates in some emerging markets. These cities are often hubs for finance, business services and technology, and they also boast excellent universities, good infrastructure and an attractive quality of life. Accordingly, they attract high levels of internal and international migration, and their youthful demographics in turn engender faster population growth.
So far, however, the supply of housing has failed to keep pace. Development of residential property has been subdued across Europe, with the annual rate of residential development less than 0.5% of existing stock. And some of the existing stock is becoming obsolete.
Residential development is constrained by factors such as ‘green belts’ around cities and the preservation of historic areas. And many residents are unwilling to tolerate high levels of development that could hold back house-price growth. Meanwhile, as household sizes are becoming smaller, a higher number of housing units is needed for a given number of people. Smaller families and more people living on their own mean that more space is required per head than in the past.
As land prices, construction costs and sustainability standards rise, a lack of bank funding is also inhibiting new development. Many smaller housebuilders were wiped out during the global financial crisis. And, as they struggle with high and rising debt, national governments simply can’t afford to build high levels of social housing.
At the other extreme, the office sector faces few of these constraints. In a single year, as much as 5-10% of existing stock can typically be developed. And space requirements within the office sector are moving in the opposite direction to residential housing. Open-plan offices, electronic archiving, flexible working and hot-desking have all reduced the space required per person.
Converting office space to residential use is potentially very profitable, even though the costs of conversion are substantial.
A consequence of these contrasting patterns is that capital values have grown much more quickly for residential property than for offices. This is remarkably consistent across Europe. And it means that converting office space to residential use is potentially very profitable, even though the costs of conversion are substantial. Additional returns can come from adding additional floors or extending the property.
Finding suitable properties for conversion can be relatively easy. That’s because many property owners lack the mandate, the motivation or the money to carry out the conversions themselves. Many ‘core’ property funds are prevented from holding riskier assets, including buildings that require substantial capital expenditure before they will provide income. Owners of offices are often more comfortable with their current use than with uncertain prospects of future gains. And many simply lack the financial resources and skills to carry out conversions. Valuers, meanwhile, are generally unwilling or unable to price on the upside from residential conversion.
Many local authorities are now implementing policies that make it easier to obtain planning permission for residential conversions. In the UK, for example, a permitted development right has been in place since 2013. This allows developers to create residential units from offices without having to submit a planning application. And the German parliament is now discussing a proposal to create a new zoning type. This will enable low-density offices and industrials to be converted into high-density residential blocks.
Conversion opportunities are not confined to offices, either. Although oversupply is most pronounced in offices, several types of industrial land can also be rendered much more valuable through conversion to residential use. These include warehouses, factories, rail yards, industrial estates and wharves.
There are three main types of conversion strategy. Rezoning involves changing the planning (zoning) status of a property asset to residential. Once the plans are agreed, the property can then be sold on at a considerable profit, before the development work is actually done. Conversion entails converting existing buildings once planning is in place. This strategy focuses on markets where office capital values are low. Besides homes, offices can also be profitably converted into hotels, student dormitories or housing for the elderly. Redevelopment requires the demolition of the existing property so that new residential properties can be built in its place. In many cases, this makes the most economic sense. Centrally located former offices, industrial sites, hospitals and waterfront harbour areas are prime sites for residential redevelopment.
So what are the risks? The main ones are overpaying for sites or development and a fall in market prices. But these can be minimised by building-in a substantial margin, choosing high-quality residential locations and selecting buildings that could be upgraded and re-let as offices should the conversion strategy fail. The opportunity to add extra floors or otherwise extend the property also reduces risk, as does pursuing a rezoning strategy.
There’s no doubt that residential conversion is an inherently risky process. So it’s not a strategy that will suit defensive investors. But given the demographics of Europe’s ‘winning cities’, residential conversion is likely to offer compelling attractions for many years to come.