Converting Existing Office Space to Office Condos

[ By Jim Riggs ]

Total project cost for Camelback Lakes Office Suites in Phoenix, Arizona, was close to $180 per building square foot, or nearly 30 percent higher than a ground-up building. But demand is high in this prestigious location.

The popularity of office condominiums is making inroads into existing for-lease buildings. Condo conversions -- the industry term for converting an existing for-lease building into office condominium space -- are popular in Arizona and Nevada. The reasons are consistent with the oldest real estate axiom: "Location. Location. Location." While infill sites are becoming scarce, interest remains strong in office space in the more densely populated areas of a community where office customers already live and work. As a result, office condominium developers need to look to existing office space for development opportunities.

To date, most of the office condominiums that Scottsdale, Arizona-based Shea Commercial has developed have been in new, ground-up developments in campus-like projects comprising multiple one-story buildings with adjacent surface parking. This successful office condominium development model includes separate tenant entrances, premium identification and visibility through signage and convenient parking.

This model works extremely well when sizable lots in good locations are available for development, but this is no longer the case in many areas. Two condo conversion projects --Horizon Ridge in fast-growing Henderson, Nevada, and Camelback Lakes Office Suites in Phoenix, Arizona's prestigious Camelback Corridor -- do not fit the classic office condo mold, and present different opportunities and challenges through the conversion process.

Assembling the Pieces of the Puzzle

Prices for units at Horizon Ridge in Henderson, Nevada, were set at a rate that compared favorably to area lease rates. The 55,250-square-foot project sold out quickly.

On the surface, the conversion process seems fairly straightforward. Buy an existing building, create a condominium plat and sell condo units. Sounds simple, right? As is the case with all development, however, it is never as easy as it first appears. Basically, the condo conversion process is a puzzle that must be solved. The puzzle pieces include:

• a purchase analysis to determine the cost of the land, building as well as improvements and upgrades needed to create appealing office condos;
• the premium required to purchase an operational building with tenants, which is typically more expensive than buying land and constructing a new building;
• tenant negotiations;
• building inspections;
• building and systems improvements; and
• establishing a condo unit sales price that reflects the market.

The acquisition process is more time consuming and cumbersome than a simple raw land transaction and the purchase price is critical to ensuring a successful deal. Unlike a ground-up development, in which the developer creates the major portion of the value in building a project, the construction in a condo conversion is already complete. The sales price is established through a market capitalization rate based on the revenue stream from tenant rents. In highly desirable upscale areas, such as the Camelback Corridor, rents are higher and lead to buildings that will command a premium price. If there are existing tenants with leases and lease options, those agreements must be addressed immediately.

As with any existing building, complete and thorough inspections of the building, building structure and mechanical systems are needed. Any existing building that was either built or operated as a for-lease building will require some improvements. Shea has found that converting a building designed "for lease" to a "for sale" product with the curb appeal and functional amenities that our buyers demand, requires planning, coordination and diligence.

The final piece of the conversion puzzle is a function of all of the previous cost items with an understanding of the target market. Once the costs are completely established -- and they will be high - the condominium sales price must support the buy vs. lease analysis created by Shea.

Conversion Projects

The Economics of Conversion How do the economics of conversion compare to ground-up development? The major positives on conversions are that they are available for sale sooner and the space is in an established office environment. On the negative side: the cost of a conversion property is higher and the margin between cost and sales price is lower. At Camelback Lakes, the purchase price of the land and building, together with the existing tenant leases, was about $152.35 per building square foot. This amount is about 10 percent higher than our typical land purchase and building construction cost. Ground-up cost for a typical project of this nature (two-story development), dependent on land cost, would be between $135 and $145 per building square foot. Cost for building and system upgrades -- totaling approximately $2 million -- plus soft costs (design consultants, etc.) of around $200,000, bring the total cost of the project close to $180 per building square foot, or a 29 percent increase in cost from a typical ground-up deal. That said, the sales prices are not significantly higher in a conversion deal versus a ground-up deal. At Horizon Ridge, the purchase price for the land and building (no tenants) was about $177 per building square foot, or 26 percent higher than a ground-up deal. The reason was this was a new building; however, it was designed and constructed as a for-lease building and improvements and modifications were necessary. Improvements cost about $190,000 and the soft costs were about $60,000, bringing the total to $182 per building square foot.

Shea at Horizon Ridge in Henderson, Nevada, southeast of the Las Vegas Strip, presented a unique opportunity to provide office ownership in a developing area of established office buildings and new residences. The Horizon Ridge conversion provided 55,250 square feet of condominium space in two identical two-story buildings. The surrounding area features many new developments, including high-end residential, Del Webb's Anthem project, St. Rose Dominican Hospital, for-lease office projects and retail projects offering a variety of goods and services.

When Shea acquired the property, construction on Horizon Ridge had been recently completed and no tenants or leases existed. During the technical project analysis phase, the company discovered that even though the buildings and all of the building systems were new, improvements or modifications were necessary to appeal to potential office condo purchasers. These improvements included changes to the HVAC systems, restroom upgrades and lobby presentation.

Prices for the units were set at a sales rate that compared very favorably to area lease rates and the project sold out quickly. Buyers now enjoy high-end office space in a very upscale area with the benefits of ownership, including tax advantages, equity building, appreciation of property values and predictability of monthly expenses. Camelback Lakes is the conversion of a successful, long-standing for-lease building just east of 24th Street in Phoenix. Built in 1981, Camelback Lakes Office Suites is a three-story building with 87,000 square feet of office space. The Camelback Corridor is a premier address in Phoenix and home to Fortune 500 Companies, the Ritz-Carlton Hotel, the Arizona Biltmore Hotel, Saks Fifth Avenue and a number of trendy restaurants and night spots.

Converting a 25-year-old for-lease building poses numerous challenges. The building improvements necessary to bring Camelback Lakes up to ownership standards are significant in scope and cost. The useful life of the HVAC system had expired, requiring a completely new system for the building. The restroom fixtures and finishes were outdated and needed repair. The lobby and common hallway finishes necessitated demolition and a complete makeover. Moreover, six tenants at Camelback Lakes intend to remain under their current agreements and will stay open during the construction phase, making careful coordination paramount.

That said, the opportunity to own office space on Camelback Road is rare and greatly outweighs the cost of refurbishment. Buyer interest in Camelback Lakes is very strong because of its excellent location.

The conversion of for-lease office buildings to office condominium space is a new trend that is here to stay. As raw land prices, building materials and construction costs continue to rise, the availability of buyers who want an address in an established, desirable business area will lure developers to convert.