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Are Residential Conversions the Answer to a Stagnant Office Market?

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About $820 billion in CRE loans are coming due in 2024 according to MSCI—about 20% of that linked to office properties. As noted in last month’s coverage of commercial real estate trends in Greater Phoenix, concerns about defaults are rising, but we are not yet seeing them in any significant number. (Indeed, in highly amenitized properties in the Camelback Corridor, we are seeing price improvement—a stark contrast, for example, to the weakness in the Central Avenue corridor.) While loans are coming due, lenders seem to be frozen, reminiscent of the “extend and pretend” days of the Great Recession that hit around 2010-2012 for CRE.

The office market in Greater Phoenix continues in a holding pattern, with everyone from property owners to investors waiting for the next shoe to drop. There is an understandable undercurrent of concern related to commercial office space and discussions about what can be done to reuse or repurpose these buildings, including converting offices to multifamily housing. This is not a local issue or conversation—it’s happening across the nation.

Making a Push for Office-to-Residential Conversions

Nationally, the number of office-to-residential conversions is up more than 350%, according to data from RentCafe. While that seems like a huge increase, it represents a tiny fraction of the overall multifamily market: just 55,300 units across the country. Phoenix ranked at #10 in the country as far as conversions, with 1,377 units projected in 2024. The highest-visibility project is Kierland Sky, which will add 420 units to the market.

Still, it is a trend in the early going—one that governments are supporting at a variety of levels. For example:

The Challenges of Converting Commercial to Residential Adaptive re-use has been a familiar strategy for years within the retail sector and even hotels. Converting commercial buildings to residential ones, however, comes with an array of challenges, including changes to structures, ventilation, plumbing and floor plans—not to mention the unknowns of rezoning. Add to those the recent issues at the One Camelback property, including the bankruptcy of the subcontractor and construction delays. Moreover, any developer who wants to ride the adaptive reuse trend in Phoenix will be facing serious competition, with a record supply of multifamily product going live in the coming months.

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Phoenix, Arizona Supply-Driven Housing Market Still Short on Supply

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Overview of the Arizona Home Supply in Phoenix

The Greater Phoenix residential market continues its snail’s pace. We remain short on supply, and occasional downward blips in interest rates have not moved demand—as noted last month, the Phoenix housing market is stuck in a loop. The anticipated interest rate reductions projected by the Federal Reserve may help, although mortgage companies have already built some of that expectation into their current interest rates. In addition, there is some speculation that we will be see only two rate cuts rather than three during the remainder of 2024.

With additional rate decreases, it should become easier for current homeowners to make a lateral move or a move up, which has been unappealing in the past year or so. With lower interest rates, more buyers may enter the market as well—although that could also affect prices. 

It is a supply-driven market, and until we see more homes on the market, we will experience more of the same. The lack of inventory gives buyers too few choices—unless they want to step up and pay the price. We are starting to see some pockets where buyers have more negotiability, such as Avondale, El Mirage, and portions of the East Valley, especially areas like Queen Creek where there are new builds. In the overall market, demand is strongest in the $1 million plus bracket, and even more above $2 million, because the buyers don’t necessarily need to borrow to purchase. Arcadia, Paradise Valley, and portions of Scottsdale and North Central remain in high demand and low supply. 

What’s the Impact of the NAR Settlement? Too Soon to Tell

We have been getting quite a few questions about the impact of the recent National Association of Realtors (NAR) settlement that has been all over the headlines. The short answer is that the settlement just came out, and no one really knows. In addition to the NAR, the various real estate associations are going to provide different types of guidance for agents, sellers, and buyers. 

As initially filed, the lawsuit was going to require that buyers have and pay their own broker. The fact of the matter is that sellers are going to be willing to pay a buyer’s broker to have the exposure on the AZ Multiple Listing Service and to make sure that their property gets shown. In addition, if a buyer needs to pay a commission, it may price them out of the market, particularly in entry-level and move-up housing. 

For the time being, we anticipate a lot more discussions about commissions and how they are allocated, and there is likely to be more negotiability. As you can imagine, this is a hot topic. Stay tuned for more details as the situation evolves, and follow the R.O.I. Properties Facebook page for the latest news on the Phoenix housing market.

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Housing Market in Phoenix, AZ Stuck in a Loop

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An Overview of the Housing Market in Phoenix, AZ

Groundhog Day kicks off the month of February, but like the Bill Murray movie, we continue to be stuck in a loop without much real day-to-day change in the market. In the first few weeks of the year, interest rates bumped above 7% once again, before falling again since the beginning of March. Inventory has held relatively steady—at historically low levels, about 34% below normal—while average sales prices hit all-time highs in January. Contract activity, which typically rises sharply from January through March, stagnated after rates increased and has been underperforming in comparison to 2023. Technically, we’re in a slight seller’s market, but buyers are seeing more negotiability and opportunity in some areas.

The market isn’t going to change overnight. The majority of would-be sellers remain locked in, without the ability to move up or down due to interest rates. On the demand side, potential buyers are dealing with interest rate levels and the appreciated pricing we’ve experienced over the past four years. 

The Federal Reserve has stayed disciplined about tamping down inflation. Although the most recent inflation data came in “hotter than expected,” some market analysts believe the central bank could start cutting rates by the end of June—even if buyers would like to see it happen sooner.

Here’s a quick roundup of what’s happening in the Phoenix housing market:

Arizona Housing Market Supply Graphs

Active Listings Up, But Still Historically Low

  • New listings for January exceeded last year by 16%. That was the highest January since 2020 in Greater Phoenix, but the fourth lowest in 24 years for Greater Phoenix. 
  • Supply rose 10% in the first 6 weeks of the year, but the figures vary widely by home type and price range. Condo/townhome and mobile home listings were up 17% and 15%, respectively, while single-family homes were up just 8%. Listings above $1M were up 21%, while mid-priced listings between $300K-$600K were up just 5%. 

Demand Running Below Normal, But Better than December 

  • At 22% below normal, listings under contract and closed sales were still an improvement over December 2023, which was 31% below normal. 
  • 44% of February closings involved seller-paid closing costs, including mortgage rate buydowns. FHA financing is on the rise in the $300K-$600K bracket, with about a third of buyers using it compared to 9% two years ago.
  • The market over $1M, which is less influenced by mortgage rates, is having a strong spring season. Listings in escrow are as high as they were in the record year of 2022, despite more than three times the inventory (2,500 homes) being available. 

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Watching the CRE Trends in Greater Phoenix

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As we head into the end of the first quarter, three CRE trends bear watching in the Phoenix market—offering examples of the ever-changing landscape to which landlords and investors need to adapt.

CRE Trend #1: Default Concerns Rising

Concerns about potential defaults on the multifamily side have been lingering for months, and we are finally seeing notices of trustee sales. While the One Camelback development in the fall was the highest-profile situation so far, we are closer to the beginning of this CRE trend than the end. Vacancies are up and average asking rents contracted 3.7% YOY through November en route to the second-weakest performance among Yardi Matrix’s top 30 metros. The Greater Phoenix CRE market has a significant quantity of undelivered multifamily inventory under construction that’s on peoples’ minds—including lenders. About 33,000 units are in planning and/or under construction.

CRE Trend #2: Affordable Multifamily

While the in-the-pipeline development has been dominated by class A properties in recent years, we are starting to see more affordable product emerge. Public-private partnerships, sometimes known as P3, foster development via nonprofit organizations funded with bonds, public funds or government monies through the state or city. P3 initiatives are prominent in the West Valley and we are seeing a proliferation of affordable builders and nonprofits that are focused on Low Income Housing Tax Credit (LIHTC) projects. The overall trend dovetails with Gov. Katie Hobbs’ focus on affordable housing, and the $49 million commitment to affordable housing developers announced in January by the Arizona Department of Housing (ADH). 

One recent example is how Dominium structured financing for the construction of two developments in Glendale totaling 605 units. In addition to $86.1 million in Freddie Mac 4% LIHTC tax-exempt loans, the developer received a mix of P3 funding: equity bridge loans from Merchants Bank and construction loans from Barclays Capital, bonds from the Arizona Industrial Development Authority with U.S. Bank as trustee, and construction loans from the ADH, Maricopa County Human Services Department, and City of Glendale.

CRE Trend #3: Ground Leases

Finally, we are seeing more deals structured as ground leases. As our community matures, there are fewer available key parcels located at major cross streets or with desirable frontage. With a ground lease, the owner of a property might lease the undeveloped commercial land to a third-party investor, while retaining the fee interest. Then, the investor may work with a build-to-suit developer to build a Chick-fil-A, Walgreens, or Raising Cane’s. 

Note that the trend isn’t limited to retail: In recent weeks, we have also seen ground leases used for the Arizona Athletic Grounds sports complex in Mesa and for a medical office property on the Banner Thunderbird Medical Center campus in Glendale. 

While many corporate owners used to require full fee ownership of the real property, many are now compromising and settling on long-term land lease interests, to secure the location. Historically, there had been very little investor appetite for that type of transaction, since you’re only getting a slice of interest in the property rather than the whole thing. But as well-located land becomes harder to come by, it requires creativity. Similarly, it takes a mindset change on the part of a landowner: Rather than selling a property outright, a ground lease offers the potential for a long-term annuity income stream.

Want to Learn More about the Potential of Ground Leases? Ground leases require a mix of creative planning and thinking along with legal knowledge to create a structure that maximizes the value of your real estate assets. Contact the R.O.I. Properties team to learn more about this increasingly popular trend: [email protected] or 602-319-1326.

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Shifting into Neutral with a Real Estate Special Commissioner

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Our firm recently became involved with a divorce case that had already been going on for 6 months, with a disputed property preventing the husband and wife from moving forward. After being appointed as a Maricopa County Real Estate Special Commissioner, we were able to value, rehab, manage and sell the property within 45 days. The case could have stayed in the courts for years without a neutral third party.

A Real Estate Special Commissioner or other neutral third party can be highly effective in a wide array of cases, including divorce, receivership, probate, and bankruptcy. As in the above example, the common element is the use of a court order or court-supervised proceeding in order to sell a property or arrive at an alternative settlement.

Real Estate Special Commissioners and Other Court-Ordered Appointments

When disposing of assets, the court appointee needs to be responsive to the court’s expectations and requirements as well as the parties’ goals. For determining a valuation, commercial real estate assets require a broker opinion of value (BOV) or an appraisal; residential properties will typically use a broker price opinion (BPO) or appraisal. The property type and metrics are incorporated into a marketing strategy, with the goal of securing high-probability buyers (e.g., investors, owner-occupants or specialized buyers) and the best possible pricing terms.

Buyer selection, contract negotiations and documentation are designed to limit the liability of the parties involved in the underlying litigation. Disputed property sales are typically on an as is/where is basis, without representation and warranties, and they may be subject to court approval/oversight, depending upon the forum.

Different case types incorporate different types of experts, and a real estate broker may play a role in each:

  • Divorce: In divorce cases, a Real Estate Special Commissioner is typically a licensed real estate broker appointed by the court to initiate and complete the sale of real property. A standard order requires the party in possession to contact the Special Real Estate Commissioner within 10 days, and then the valuation, marketing and disposition process is initiated. Access, showing times, reporting intervals, short sales/foreclosures and other provisions can be addressed by special orders. Although the court retains jurisdiction, the Real Estate Special Commissioner generally has authority to proceed with a sale in divorce cases, without court approval.
  • Receivership: Receivership specialists are generally appointed in cases of monetary or other default in loan documents and/or a dispute among principals, although we are also seeing an uptick in their use for divorce cases with business operations and in “business divorce” cases. After intake and assessment of the assets and liabilities of the receivership estate, the receivership specialist develops a stabilization, turnaround and/or disposition strategy, along with formal reporting. Ideally, real estate assets should be sold while a receivership action is pending, in order to create the most pre-market awareness and negotiation leverage–and to limit the lender’s liability.
  • Bankruptcy: In most bankruptcy cases with real estate assets, the bankruptcy trustee or the debtor-in-possession (DIP) will hire a real estate broker to market and sell the real estate assets to pay the secured creditors in full and make a distribution to unsecured creditors.
  • Probate and Fiduciary Matters: Conservators, guardians, personal representatives or trustees with fiduciary responsibilities serve in a role of trust, and manage the affairs of the individual solely for his/her benefit. The role of a real estate broker can include steps such as valuation, marketing and sales of applicable real estate assets, and may be expanded to asset intake, inventorying, maintenance, management and repairs in some cases.

Higher/better bidders may be present in probate and bankruptcy matters; when that is the situation, they are encouraged to bid at the court hearing where the trustee or fiduciary is seeking court approval of the sale. As a final step, any court-appointed agent and/or trustee must be prepared for the inquiry of the judge regarding the valuation, marketing, management and contract negotiation process.

Settlement vs. Sale

Court-appointed resolutions may also include options beyond selling the disputed property. A receivership specialist, for example, can level the playing field when one party controls the finances or business interests in divorce or business divorce. To accomplish that, a Receiver can perform asset intake and put systems in place to build an accounting system. Other tasks may include tracking financial activity in operating businesses and/or real estate-centric businesses such as hotels, mini-storage businesses, apartments, shopping centers, gas stations or any other real property-centric business. With all parties having access to the same information, it’s far easier to get spouses or business partners to agree to engage in settlement negotiations regarding the allocation of assets and liabilities.

Beth Jo Zeitzer is the President and Designated Broker of R.O.I. Properties. R.O.I. Properties is a full service real estate brokerage and consulting firm focused on the enhancement of real estate assets.  R.O.I. serves sellers, buyers, investors, attorneys, trustees, lenders, asset managers, turnaround professionals, and fiduciaries in the acquisition, lease and disposition of commercial and residential real estate.  Services include Brokerage, Special Commissioner/Special Master Appointments, Management, Valuation and Expert Witness consulting and testimony, for retail, office, industrial, apartments, hotels, land, mini-storage and single-family assets.

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