Are we at peak skyscraper?
When I think of New York City, skyscrapers immediately come to mind. There are only a few cities I’d associate with skyscrapers: New York of course, Dubai, Hong Kong, and potentially Taipei. No European cities come to mind. My brain just doesn’t associate Europe with skyscrapers. This is a fairly accurate view - Hong Kong has more skyscrapers (554) than Europe combined (c400).
The top three European cities for skyscrapers are Istanbul, Moscow and London, with 54, 49, and 37 respectively. We’d expect these numbers to stagnate, especially in the middle of a global real estate slowdown. The construction of one of Germany’s tallest buildings, Hamburg’s Elbtower, was even halted after the developer stopped paying. Despite this, European skyscrapers are on the rise. For example, London’s Square Mile (its historic financial district) has 11 skyscrapers planned or in construction. This is a significant increase, considering the city currently only has 37.
However these cities handle skyscrapers differently. Istanbul’s skyscrapers are multifunctional, used for offices, housing, and even hospitals. Whereas in London, similar to Paris and Frankfurt, they’re typically corporate offices. But is there sufficient demand for new offices? Do we need all these skyscrapers?
Is there enough demand?
Hybrid working and the change in office space usage are two of Covid-19’s lingering societal changes. Investor confidence in offices is at a low. If we look at the spread between real estate bonds and gilts (UK treasury backed bonds), we see that since office bonds have had a higher spread in yields since 2022.
This drop in investor confidence is understandable: office vacancy rates have been hitting highs since Covid. The UK, for example, is estimated to have 110 million square feet of vacant office space. This is equivalent to 180 Gherkin skyscrapers of space.
This is made worse when high profile companies are breaking or not renewing their leases. The most notable example is Meta breaking their lease on a central London office for a £149m fee. They paid 7 years of rent upfront to avoid needing this space. HSBC is doing the same, leaving their global headquarters in London’s Canary Wharf, and downsizing considerably.
This behaviour is happening globally. Bloomberg Intelligence claim a quarter of companies plan to downsize their offices. So if the writing is on the wall, why are all these new skyscrapers in the pipeline?
The answer is quite simple: companies want really good office space. We’re seeing this in company behaviour - HSBC and Meta will still have a main office, but this will be nicer, smaller, and made more flexible. This shifting behaviour is increasing demand for prime tier one offices, while decreasing it for secondary offices. Knight Frank, a global real estate consultancy, expect the spread between prime and secondary rental yields to widen. There are also ESG tailwinds: offices are an easy decarbonisation win for large companies. It also appeals to their employees. This drive for ESG compliant office space is also broadening this spread between desirable and no-longer desirable offices, fuelled by the shortage in good sustainable offices.
Potentially all these new skyscrapers will be let very quickly, as part of this rush for prime office space. But I don’t think the net demand for commercial real estate is increasing. I suspect the net demand will decrease, and will flock towards nicer offices. This still leaves huge amounts of vacant offices, especially those in less central areas, or those which can’t complete with sustainable, modern, fun, tier one real estate.
Putting the excess to good use
So we have this market stratification, with a wanted top layer and an abundant unwanted second layer. What can we do with the secondary tier?
The first option is to try and improve it. Not every business wants or needs a large HQ in prime global real estate. There are a huge number of remote first organisations who value practicality over presence, as well as many more smaller organisations who can’t afford/ don’t want those offices. Making this secondary tier real estate better than the competition is the best way to market it. This can also boost yields for the owner.
Another option would be to demolish it. This is a real business model. Find distressed real estate assets, buy them, demolish them, and then sell the land. This model only works for two reasons:
- Commercial real estate assets are being sold at a loss.
- The housing shortage has put a premium on land values.
The difference between the land value and the price to buy the distressed building is often large enough to offset the demolition costs, or to even make a profit despite demolition. Groupe Mach, a Montreal based developer, has spent over $750m on these transactions alone. However I’m not a fan of this approach, primarily due to the embodied carbon impact that ensues. The final option is to convert it.
Deathbed conversion
Broadly, we can separate real estate into the following asset types: residential, retail, industrial, commercial, and alternative. If we wanted to make use of this excess commercial, we’d have to turn it into one of the others.
Industrial can be ruled out very quickly. Industrial buildings are more complex, have challenging heating and power needs, often need specialist machinery, and aren’t typically allowed in city centres. Retail is just as easy to rule out. Retail has been doing well recently, but the demand for retail space is far smaller than the excess commercial space we have. This wouldn’t solve the problem.
We’re left with residential and alternative. Alternative conversions could include life sciences, logistics and data centres. There’s a strong demand for each of these. Again, these building types require specific features making them hard to convert.
The final option is residential conversion, which is increasingly gaining support. For example Madrid’s local authorities have decided to fix their housing shortage by allocating €200 million to purchase and convert commercial properties into housing.
It’s still a challenge. Zoning and planning rules are the first issue. Changing a space from business to residential requires approval from local authorities. The process varies with geography, but is typically time-consuming.
In the UK, the process is more streamlined under the “Permitted Development” process. This allows the conversion of a Class E property (commercial, business, or service) to Class C3 (residential), without planning permission. This only applies when no external work is needed. However, this isn’t the case for most commercial buildings, which also brings us onto the next challenge.
Commercial buildings are built differently. The needs of a residential building are fundamentally different to that of a commercial building. One example is the fixed windows in skyscrapers, which don’t open. This means they can’t be used for residential as is. And replacing every window on a skyscraper would be prohibitively expensive. Another issue is the “floor depth”, defined as the distance from the windows to the midpoint of its floor plate. Office buildings are often very deep, designed to let natural light reach the centre. However this prohibits turning them all into flats. We could create an outer rim of flats, but those on the inside would have no natural light.
The entire building also needs assessing. In older buildings, hazardous materials like asbestos or lead-based paint can complicate the conversion process. Accessibility and parking are also important, and could require modifications to building entrances, common areas, and parking zones to meet residential needs. Additionally, the conversion impacts mechanical, electrical and plumbing systems. For example, each flat would require its own supply of water, ventilation and electricity. These steps are not trivial.
In addition to being complex, these changes are expensive. Some conversions can cost between €100 to €500 per square foot. This can exceed the €320 per square foot cost basis for developing an average office building. However this isn’t the only cost to consider. There is a huge opportunity cost to conversion. Commercial real estate is higher yielding than residential.
Some reports even suggest a 50% drop in office prices is needed to make this conversion financially viable for a property owner. For building owners to justify a conversion without a corresponding price drop, they have to charge very high rents. In essence, the office buildings are just being turned into more expensive apartments, leaving the housing crisis unsolved.
Reasons to be cheerful
It’s not all doom and gloom. There are some great examples of office conversions. Looking at New York City for inspiration, developer Vanbarton Group worked with architect CetraRuddy to convert 180 Water Street in the Financial District. They carved out a 30x40 foot central atrium to bring in light and air. They also added new floors to the top of the building to make up for the lost square footage, bringing a total of 574 new market-rate rental units online.
Across the Atlantic, another example is London’s Parker Tower, which required a new facade and other adjustments to fully convert into residential.
So we know these conversions are doable, but they’re not simple. They’re also expensive. How can we scale this up to a stage where these existing, unloved buildings are being used to address the housing crisis?
The PT1 verdict
There are two distinct trends here. The first is the change in demand for commercial office space. There’s increased demand for high quality, central, sustainable space. There’s a shortage of this prime real estate, sparking a boom in planning applications and construction starts. The decreased interest in secondary office space is leading to these high vacancy rates and unused space.
In parallel, there’s a fundamental housing crisis. Germany lacks 700,000 apartments. The UK is missing 1,500,000 homes. For decades neither country has been building enough homes. And this is a problem in other countries as well. So can we kill two birds with one stone, and convert this extra vacant space into residential? And, how do we expect cities to change with this concentration in prime real estate?
Starting with the second point, we expect different city profiles to respond differently. For larger cities, this densification is happening in existing popular areas. Using London as an example, companies like HSBC are leaving the newer business district of Canary Wharf to come into the established areas of the West End and the City. This could be problematic for these newer areas. The Canary Wharf Group, who manage Canary Wharf, have already announced plans to build more residential and life sciences properties in the area. Is this diversification away from commercial a response to falling demand?
We think it will be simpler in those smaller cities with only one primary business district. Here, we expect an increase in density. Munich has maintained one of the lowest vacancy rates in Europe, particularly in its city centre and for high-quality office spaces.
An open question is what an increased density actually means. Before Covid-19, we had high occupancy rates, but with companies across different offices. Now, we’re seeing companies converging on the same area, but with lower occupancy rates. It seems like the density of companies per square mile has increased, but not the density of workers per square mile.
Moving back to office conversions, our dream scenario involves converting excess commercial space into residential. Preferably, this would be affordable too. We’ve already spoken about how hard it is. But there’s a lot of room for innovation:
1. Better Data and BIM - The building assessments and planning can be streamlined. Better data and BIM (building information modelling) will simplify the initial assessment. A digital twin, with a comprehensive bill of materials for each building would be great. Knowing from the start if and where we have asbestos would help.
2. Automated Conversion Plans - The next step is to use this data to build smart automated conversion plans. For example, the complex structural and MEP (mechanical, engineering, and plumbing) changes needed to turn offices into flats. Using procedural AI to optimise HVAC and MEP planning can lead to cost and carbon savings.
3. Digital Stakeholder Management - Another bottleneck is the planning and engagement with different public and private bodies. New York City has taken action to simplify this, but other cities are yet to do so. Instead of waiting on cities to change, existing software can adapt to digitise this process.
4. Smart Construction - Making planning, design and consultation easier is important. But ultimately the real challenge is in doing the actual work. We can serialise and modularise many of the components. There’s another aspect to this too: increasing the value of waste. Circularity platforms can help put that waste to good use.
5. Government & Municipal Changes - Governments (federal, national, and local) should incentivise this work. Planning regulations should change to make office to residential conversions easier. There could also be tax incentives on these properties: providing they are made affordable. Turning offices into luxury apartments doesn’t benefit anyone.
Ultimately, this is an economics game. If innovation can bring the conversion price per square foot down, these converted properties could be sold at affordable rates and still make a profit for the developers. So no, we’ve not reached peak skyscraper. But if we don’t fix all this empty space, we might soon be there.