News & Insights

Recent California legislation is attempting to accelerate and facilitate, statewide, the national trend of converting commercial real estate into residential use.

Whether in Chicago, New York or elsewhere in the country, housing shortages (affordable and market) have soared due to increasing demand — including from institutional investors. That surging demand has driven the cost of housing beyond the financial means of many individuals.

While the inventory of available housing has been shrinking, evolutions in modern lifestyles have aligned to create challenges in the commercial real estate industry, resulting in decreasing demand for many office and retail projects. Remote work-from-home business models have increased the amount of online shopping, exacerbating the impact on shopping centers, while also reducing the demand for office space. As these issues continue to persist, the conversion of failed or underutilized office and retail properties into residential projects has gained momentum. Nationwide, cities are working to transform vacant and underutilized commercial space into much needed housing.

In California, in an effort to accelerate such conversions, Governor Gavin Newsom recently signed two new laws designed to facilitate such commercial to residential conversions — limiting the ability of local jurisdictions to interfere with the conversion process and streamlining portions of the development approval process. While in the long term, this potentially could increase the availability of housing and rejuvenate underutilized commercial properties, not everyone is in favor of the new laws — which can be perceived as a usurpation of the traditional authority of local governments.

AB 2011 (the Affordable Housing and High Road Jobs Act of 2022) and SB 6 (which includes the Middle-Class Housing Act of 2022) both become operative on July 1, 2023. Both laws specifically address the conversion of commercial property currently zoned for office, retail or parking uses. AB 2011 also conditionally grants affordable housing projects “by right” approvals, which would spare a project from some of the most rigorous requirements for local governmental approvals. SB 6 not only contemplates market-rate housing, but also creates benefits for the inclusion of affordable housing within the market-rate housing without a mandate for it.

Both laws provide for the payment of prevailing wages, but under AB 2011 prevailing wages are only required for developments of 50 or more housing units. Proponents of the new laws claim that thousands of well-paying jobs will be created. Both laws have provisions that are conditionally modified if other legislation is passed on or before Jan. 1, 2023. Also, both pieces of legislation have some provisions that are repealed automatically on different dates in the future.

With all of this in mind, developers and property owners should educate themselves to understand the nuances of these two new laws, which are the latest in a series of efforts to increase affordable housing in California. To benefit from either law, a developer must satisfy specific and detailed criteria regarding the composition of a project site, its location, the surrounding uses, density, etc.

Below are just a few aspects of the new legislation:

State vs. Local Governance. A basic issue is the scope of authority of the state legislature/governor to preempt local regulations. In recent years, the state legislature has preempted local regulations in other contexts, e.g. allowing half-way houses in residential neighborhoods despite local opposition. While some local jurisdictions previously attempted to thwart such state-wide intrusion into local governance, whether they will attempt to sidestep SB 6 and AB 2011 is an open question. SB 6 declares that affordable housing is a statewide concern — not a “municipal affair” as referenced in Section 5 of Article XI of the California Constitution — and therefore it applies to all cities, including charter cities.

Mixed-use vs. 100% Affordable Housing. SB 6 provides benefits so long as 50% of the square footage of the new construction associated with a project is designated for residential use; provided that none of that square footage is designated for hotel, motel, bed and breakfast inn or transient lodging — except for residential hotels. SB 6 further provides for a streamlined approval process if at least two-thirds of the development’s square footage is designated for residential use. Therefore, benefitting from SB 6 does not require a complete conversion to residential use.

Other Elements of Redevelopment. While the purposes of the laws primarily address eliminating or streamlining some local approvals, in many instances other existing requirements continue to remain in place and have not been expressly eliminated, including state mandated requirements.
Private Party Agreements. Shopping centers, in particular, are governed by private party agreements, e.g. CC&Rs, ECRs, REAs, etc., and any changes to those agreements would require the consent and approval of third parties that may have no interest in, or specific requirements regarding, changes to the shopping center. On a more limited basis, the same is true of office buildings. Projects also are likely to be encumbered by existing financing, the terms of which may limit the developer’s options, and the reduced value of the underperforming property may make it difficult to obtain new financing for the desired residential component of the site and to pay off existing financing. The new laws do not appear to directly improve the developer’s position with respect to those existing private party relationships. However, SB 6 does require relocation assistance from the developer to eligible commercial tenants at the end of their lease.

Conclusion

This legislation has created an opportunity to redevelop underutilized office buildings, shopping centers and parking areas in a way that may help to alleviate the housing crisis. Ideally, the legislation will help breathe new life into some of the commercial uses of the original projects, creating a symbiotic relationship between the new residential housing element and any retained commercial element. Where commercial projects have suffered wholesale failure, the new laws may facilitate the creation of sub-communities of affordable and market-rate residential housing. Regardless of which law is utilized, developers will continue to be constrained by traditional considerations of financing, profit and market demand. The commercial real estate industry already has been moving in this direction, and now California potentially has made one aspect of the redevelopment process a bit easier.

Steven Otto is a partner at CGS3. The article was published in The Daily Transcript and the Daily Journal (subscription required).