Global Courant
Faced with an ongoing housing crisis, Los Angeles is doubling down on converting unused commercial buildings into homes. Last month, as part of the DTLA 2040 Community Plan, the City Council approved a long-awaited update to the City adaptive reuse regulation adopted in 1999, making the production of more than 12,000 units of new housing. The update makes more commercial properties eligible for incentives such as streamlined permits and flexible regulations.
Now may seem like the perfect time for office-to-apartment conversions: the persistence of remote working has led to record vacancy rates in LA But the dramatic rise in interest rates over the past year has made refinancing office building loans very difficult defaults and distressed sales. “Default values for durations”—loans that are due and cannot be refinanced—have soared. Almost 90% of office loans expire this year are likely to experience difficulties in refinancing.
In downtown LA, skyscrapers are sold for half of what they did ten years ago. Given that high commercial real estate prices have typically hurt the financial viability of adaptive reuse projects, a steep fall in office building prices could in theory be beneficial. But high interest rates also make conversions more expensive to finance. ULA’s measure — the so-called “gentlemen’s tax” that took effect in April — is another disincentive for both the sale and remodeling of office properties, also applying a 4%-5.5% tax to commercial real estate transactions and multi-family homes.
From a local government perspective, there is a significant risk of leaving the fate of these properties to chance. Sharp declines in sales prices mean sharp declines in local tax revenues. To mitigate this risk, LA should consider fiscal policies to more convincingly tip the scale toward adaptive reuse. One approach worth considering is a temporary property tax reduction program for office-to-residential conversions.
A multi-year tax credit for eligible projects would reduce the initial costs of adaptive reuse projects. A simple example of a 10-year abatement program could reduce a qualifying property’s tax bill by 100% for the first year after approval, then by 90% in the second year, 80% in the third year, and so on until the property returns to the full rateable value of the converted home. In addition to encouraging new purchases, an effective abatement program could also encourage current owners to convert their buildings and avoid the financial disincentive of the ULA’s property transfer measure.
In New York City, a tax cut program between 1990 and 2020 helped produce nearly 13,000 housing units in Lower Manhattan, representing more than 40% of the area’s total housing growth during this period. A similar program can be scaled up Washington, DC.
Tax cuts to encourage housing construction have been criticized by opponents as redundant giveaways to developers. But this critique does not take into account the cost of doing nothing.
Consider an unconverted office building with a current tax value of $50 million, but which would become a distressed sale in 2024 for half that value. Suppose that sale results in a 50% drop in property tax revenue over the next 10 years. Now suppose the building is instead converted into 200 residential units while benefiting from a tax reduction program, meaning that 50% of tax revenue is lost over the same 10 years. This conversion to residential could be conservatively expected to preserve the full 2023 valuation of the property. After ten years, the lost tax amount is equal to the drop in tax revenue from a distressed sale – but Los Angeles ends up with 200 more housing units instead of an underutilized office building.
In addition to helping to meet Los Angeles’ ambitious housing production goals, adaptive reuse conversions can provide a more stable source of property tax revenue because the housing sector is much better insulated from factors such as remote working and other economic shocks that affect the office sector. And they can also help keep office prices up by reducing supply. Both forces could put the finances of cities and counties less at risk in the future.
In Greater Los Angeles, 20% of loans for office buildings due in 2025 and need to be refinanced. Creating a tax cut program or similar incentive in time to avoid massive declines in property tax revenues would be a big boost for policymakers. But other huge fiscal programs like California’s Project Home key — which raised $600 million in the first year of the COVID pandemic to convert homes for people experiencing homelessness — have been quickly formulated and expanded in times of crisis.
The clock is ticking to address LA’s potential “doom loop” for office real estate. Decisive action could increase housing production and lead to robust property tax revenues that could benefit Angelenos for decades to come.
Jason Ward is an economist, deputy director of the Edge Los Angeles Housing and Homelessness Center and a professor at Pardee Edge To graduate.
