With rising demand for industrial product and a lack of undeveloped land, converting vacant office space into additional industrial product has become a more popular option among developers. However, recent research from Prologis shows that in the long term, conversion projects are unlikely to meet the growing demand for logistics facilities across the country.
“Based on our analysis, we believe that the trend of converting office properties into logistics facilities will be minimal,” Melinda McLaughlin, global head of research for Prologis, said. “Simply put, most office buildings can’t physically accommodate logistics uses and would need to be demolished. This type of conversion is expensive, and the location must achieve superior rents to make economic sense, relative to a typical greenfield project.”
According to the report, titled ‘Sizing Up Office-to-Logistics Conversions,’ work-from-home trends have created high office vacancies across the United States. In the fourth quarter of 2021, the national office vacancy rate rose to 16.6 percent, 4.4 percentage points higher than in the fourth quarter of 2019. On the other hand, the logistics vacancy rate declined 1.4 percentage points during the same period to an all-time low of 3.4 percent.
While these differing vacancy rates may suggest a strong potential for office-to-logistics conversions, Prologis estimates that conversions would likely only make a dent in the current industrial supply. According to the report, the office-to-conversion trend is likely to amount to between 40 and 80 million square feet over the next decade, or about one percent of the current logistics supply.
Many factors are behind this low conversion rate, including economic hurdles, zoning requirements and location of current office supply. According to Prologis, the increased risk associated with a longer entitlement and permitting processes make conversion projects less feasible for many developers. Additionally, because office spaces cannot physically accommodate logistics uses, many would need to be demolished and redeveloped, further lengthening the development process. Office properties with multiple tenants also potential challenges due to high de-tenanting costs.
Logistics-specific requirements further limit which office sites can be redeveloped. While many office developers focus on prioritizing access to a skilled workforce when developing office product, logistics properties typically are planned at sites that prioritize transportation and infrastructure. According to Prologis, only about 27,000 office buildings – roughly 2.2 billion square feet of total office space – meet the needs of logistics tenants.
“It’s tempting to focus on the opportunity in converting office or retail properties into logistics facilities, especially in high-demand markets where industrial land is scarce. However, the path to conversion is very complex and challenging, with long development timelines,” McLaughlin said. “First, the site must be able to accommodate high clearance heights, truck bays, ample parking, and other upgrades required for logistics. Developers must also contend with re-tenanting limitations and rezoning risks including possible community opposition.”
While there are many concerns associated with office conversions, the report also notes that office campuses with a single tenant may be a more suitable choice for developers looking for an office-to-industrial conversion project due to an easier de-tentanting process.
Additionally, conversion projects in large markets may be a good option for developers as they are more likely to make up for redevelopment costs through higher rental rates. This has been seen primarily in large coastal markets, like Los Angeles, the Inland Empire, San Francisco and Washington D.C. Prologis also notes that even though Class B and C office rents generally exceed logistics rental rates in these locations, lower cap rates and tenant improvement costs typically make office-to-logistics conversions a more attractive option.
Despite potential conversion opportunities in these regions, Prologis suggests that the office-to-logistics conversion trend across the United States is not likely to meet the current demand for industrial product. Successful redevelopments are likely to be focused in markets with high land costs and heavy competition. New developments are also likely to take time as developers undergo long entitlement processes.
‘Each redevelopment project is unique so it’s difficult to estimate the average financial cost differential; however, the increased risk associated with a longer entitlement, permitting and redevelopment timeline adds to the returns required to make these projects feasible.” McLaughlin said.