The Office Glut Comes Home

When Covid shut down Michigan’s economy in March 2020, 400 DTE employees fled from the high-rise at 414 S. Main. They never returned. Several retail businesses also exited the building, leaving nearly 117,000 square feet vacant.

Last year, the Mansour Companies of Birmingham, working with the Kalabat Development Group of Bloomfield Hills, paid DTE $21 million for the nine-story building and its 120 parking spaces. They told the city that they plan to convert all seven floors of office space into 120 luxury apartments that would be marketed to “higher-demographic professionals.”

It was the first of what may become a flood of projects aimed at converting empty downtown commercial space for residential use. And that trend could have a tsunami effect on Ann Arbor’s rental market, lifestyle, nightlife, business and residential life, and even the city’s appearance.

At the start of the pandemic shutdown, Curtis Commercial LLC owner Jim Curtis predicted “a seismic shift” in Ann Arbor’s commercial real estate sector. So did Ed Shaffran of the Shaffran Companies, who began turning some small commercial spaces into residences years ago.

Though the federal government declared the pandemic officially at an end last month, many businesses are still struggling with how to operate in a new business climate. Some are expecting their employees to return to pre-pandemic “normal” office life. Others have structured a hybrid home/office work week. Still others are shuttering and selling their office space while employees work at home full-time. As a result, a record number of commercial buildings in Ann Arbor are either vacant or underutilized.

“This is the time to reconsider the old way of doing business,” says Shaffran. “Before Covid, 92 percent of all rentals downtown were office or retail. After Covid, I think we’ll be lucky to get to 80 percent.”

Prior to 2020, Ann Arbor was “a very expensive community,” Curtis points out. “Outside the city limits, rental rates are considerably less, but the presence of the U-M and the hospital encouraged landlords to raise rents—and continue raising them.”

“That probably will change—dramatically,” Shaffran says. “We’ve experienced major changes in density and lifestyles here—and we’re about to see a lot more.”

—

For thirty years, Swisher Commercial has released an annual report analyzing Ann Arbor’s commercial real estate market. Last year, even as most Americans returned to “normal” life, the vacancy rate rose to 14.8 percent—with landlords bracing for more losses when leases expire. “When the government ordered people home for a short period of time, some people learned that they prefer working from home,” writes Swisher president and CEO Bart Wise. “And that makes a big difference downtown …

“Some businesses still operate better with workers in the office; some have evolved flexibility, combining work from home with part-time on-site work; and other businesses have significantly decreased their use of office space or even dropped their leases altogether … and the sorting-out is not over.”

Destination businesses like mortgage companies, healthcare facilities, lawyers, and medical offices still need offices where they can meet their clients, Wise writes. But “[s]howings of office space and leasing activity are still well below pre-pandemic norms.”

In a telephone interview, Wise adds, “I cannot tell you how this situation will turn out, but I’m suggesting that we will continue to see a hybrid work model.”

That has landlords, real estate agents, and businesses wondering: Is this a crisis or an opportunity?

—

Before the pandemic, Wise had been predicting a local building boom: New businesses were constantly coming to town and shopping for space, while the demand for new healthcare facilities soared. Instead, the rise of remote work and dramatic increases in construction costs mean that “we’re not likely to see as many new buildings,” he says. “That works in favor of existing landlords.”

However, property owners who need to renovate office spaces to lure new tenants or transform office spaces into residences are struggling with time, talent, and budgets. Labor shortages, supply chain problems, and the economy combine to increase the cost of renovations significantly. Those higher costs impose added burdens on landlords who lost tenants during Covid.

“As always, innovative businesses continue to be created and expand in Ann Arbor,” says Wonwoo Lee, chief real estate officer for Oxford Companies. “They’ll continue to absorb its office and flex space.” However, he adds, “In the meantime … it may mean a new rent structure for many commercial landlords. A recalibration is happening and will continue to happen.”

“If rental rates were reasonable before the pandemic, and those buildings were well maintained, there’s very little likelihood of losing tenants,” Curtis says. “But if the rates were high and the properties were not well kept or not located in a prime location, then landlords will be forced to respond if they want to stay in business.”

Shaffran agrees. “I think we’ll see the transformation of Ann Arbor in the near future.”

Like Curtis, Shaffran has spent his entire professional life in the world of local commercial real estate. Fifty years ago, both witnessed Briarwood mall’s negative impact on downtown shopping and social life. They witnessed the city’s restaurant revival and condominium craze, and watched big-box stores and then Amazon further threaten locally owned downtown businesses. And they’ve seen Ann Arbor rebound from every crisis.

Through a half century, Shaffran has tracked—and responded to—trends in commercial real estate. “In the old days, managers wanted formal offices with doors and outer windows. In the 1980s, everyone wanted their own individual offices, so we built cubicles and furnished partitions. In the 1990s, everyone wanted open space, no more cubicles.

“Then Covid changed the requirements yet again. Now significant numbers of workers are insisting they want to work at least part-time at home. Still, I believe there will always be a need for office space—but what percentage of the real estate market is an unknown factor. Everything comes down to economics.”

Economics and available space, he adds. “Ann Arbor’s downtown is basically freeze-dried. The city’s boundaries dictate what will happen in the future. These days, development is all about access to sewer and water, and we have tight geographical parameters. We have very, very little open space left.”

Shaffran’s real estate holdings never catered to large corporations, he says. “We know it’s much easier to rent 100-, 200-, 500-square-foot properties rather than large ones.” And he believes the current market offers exciting new options.

Decades ago, he began renovating the city’s former “small red-light district” on S. Fourth Ave., converting second- and third-story spaces into loft apartments when their infrastructure permitted. He did the same with properties on Main St. “Property owners don’t want vacancies, and local workers are interested in cutting commutes,” he says. “Conversions made sense back then and even more sense now.”

Jim Curtis grew up downtown, living above his parents’ chicken restaurant. “People talk fondly about the old days, but in Ann Arbor, the new days are much better,” he chuckles. “When I was young, every business shut down at five o’clock … Now Ann Arbor has shops and restaurants open in the evening, and people are browsing, shopping, and dining then. There’s a vibrant social, retail, business atmosphere downtown.”

But, he acknowledges, transforming office space into residences requires time, money, imagination, and patience. His company converted a large third-floor office space into a loft apartment, “and we spent years working with the city to obtain a residential permit. The process is costly—though not as costly as new construction—but the demand is there.”

“We’ll see that happen in some situations, when infrastructure, zoning, and economic feasibility are in alignment,” Lee says. “It’s not a simple process.”

And, not every empty office space is conducive to conversion. “You need significant elements—light, ventilation, safe ingress and egress, and infrastructure—to get city approval,” Curtis points out. “Upper-floor properties in the middle of a block, where windows are only in front and back, can’t be converted. And when conversion is possible, landlords will need to recoup the renovation costs, which might mean high rents.”

Still, Curtis expects conversions to continue—and predicts a domino effect that will impact retail, rents, aesthetics, and lifestyles.

The few retail tenants Curtis lost during Covid were people who decided to retire, he says, and he points out that downtown stores didn’t suffer as much as the malls did when customers switched from in-person to online shopping. “The city has unique boutique services and products,” he says. “The size of our retail shops and loyal customers allowed them to come back strong.” He believes that if the downtown residential market rises, shoe stores, clothing stores, pharmacies, eyeglass stores, and boutique grocery stores will follow—and that sounds like the cityscapes of a century ago, before suburbs, malls, and big-box stores.

Curtis also sees another silver lining in the current commercial real estate market: “the incentive of more reasonable rental packages, which will increase retailers’ ability to provide improved products and services.” And that, he says, will benefit “the long-term future and health of the district.”

Lee admits that commercial rents may drop in the near future, but adds a caveat: “To be clear, however, commercial leases are often for multiple years, and property owners can’t just raise or lower rent in the middle of a lease term. And other factors, like increased construction costs and the slowdown in developing buildings because of those costs, can impact rental rates in the opposite direction.

“At Oxford, we have had circumstances in which we’ve been able to be more flexible, and others where nothing has changed.”

Curtis’s company also owns a number of small student rental properties. Perhaps surprisingly, he regards the new high-rise luxury student buildings as a plus. “No longer can landlords with properties far from campus charge exorbitant rates for poorly maintained properties,” he says. “Those high-rises have forced marginal landlords to do one of two things: get out of the business or improve their properties and restructure their rents.”

Going forward, Shaffran says bluntly, the city has only two options: “We either build up, or we stop growth.”

In landlocked European cities, he says, “You see old buildings with new buildings built on top of them. This way you can maintain the historic character and charm of old Ann Arbor but make room for growth.” One example he cites is the transformation of the former 1920s-era Montgomery Ward, which was topped with four new floors of apartments.

Shaffran is hopeful that the city will be favorable to plans for building up, around, or on top of historic structures. The other options, he says, are either demolishing and building new, or freezing the city at this moment in time.

Building upon or around existing structures can be the answer “in some cases,” Curtis says. “It’s a Catch-22: New construction is harder and more expensive, but as the value of city properties rises, so will the pressure to look at historical buildings, to expand their potential.

“We have an excellent, tough but fair, historic district commission whose purpose is to preserve the charm and unique qualities of our city. We all see the value in that, but with the university and hospital both placing demands on our real estate, developers will look at every possibility for growth.”

On the other hand, Shaffran says, perhaps the university might be realizing it doesn’t need all its current off-campus rental space, now that some employees are working off-site. “We may see schools, industrial buildings, and even parking garages—no, I take that back, not parking garages!—turn into new uses in the coming years.”

Covid started a domino effect that toppled traditional work and lifestyle expectations, Shaffran says, and it may do more. He predicts that Ann Arbor will see many businesses adopt shorter work weeks. “That’s not too far away. Thanks to Covid, we’ve become a much more flexible society.”

As far as the future of commercial real estate goes, Wise writes, “I’m not using the word ‘panic,’ but landlords are adjusting, certainly. There is definitely an outflow of businesses, but also a continual inflow.”

“We can see the trends as a threat, or an opportunity,” Shaffran adds. “If I were younger—I’m sixty-nine now—I’d buy the Sears building at Briarwood and convert it into residential space. And I’d do the same with empty commercial properties along Washtenaw.

“Change is in the air—and with change comes opportunity.”