The number of US office space owners defaulting on their loans is on the rise, fresh evidence that more entrepreneurs believe hybrid and remote work habits will permanently impact the office market.
Investment giant Brookfield Asset Management recently defaulted on a more than $750 million loan it took out on two 52-story towers in Los Angeles, according to reports filed in February. The real estate company RXR is in talks with lenders to refinance debt on the 61 Broadway building in Manhattan, a 34-story tower in the Financial District, according to people familiar with the matter. According to them, transferring the tower to the lender is one of the options currently being considered.
Another sign of distress was the partnership of Related Cos and BentallGreenOak, which is trying to refinance a $150 million debt on a project where warehouses are being converted into offices, in Long Island City, New Jersey. The project has not progressed as expected, people familiar with the matter say.
Five to ten office towers per month join the list of properties at risk of insolvency due to low occupancy rates, expiring leases, or debt that needs to be refinanced at a higher interest rate, according to Manus Clancy, a senior manager at the information company Trepp.
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A record of vacant spaces in many cities
Concerns regarding the stability of the office industry accumulated during the pandemic. The slow pace of returning to office work has led to record office vacancies in many cities. The increase in interest rates in the past year increased the cost of the purchase and debt recycling of properties, and decreased the values of the properties.
Until now, most property owners have been able to stick with their existing mortgages because contracts are typically ten years or longer, and many lenders have agreed to extend expired mortgages.
The delinquency rate among commercial property-backed loans remains low, but it may increase. This rate rose in the month already by a quarter of a percent to 1.83%, the largest increase since December 2021, according to Trepp.
Loans backed by offices in Philadelphia, Denver and Charlotte (North Carolina) have either been transferred to special lenders in recent weeks, or were part of a bond issue whose rating was downgraded by the rating company.
“The commercial real estate markets are currently in a recession,” says Owen Thomas, director of Boston Properties, one of Israel’s largest real estate companies for office space, in a conversation with investors at the beginning of the month.
The hopes that the workers will return to the offices are disappointed
The growing number of distressed office buildings reflects the recognition by owners and lenders that the return to office they had hoped for is not about to materialize. The number of employees who returned to the offices has stopped at about half the number it was before the pandemic. This reflects the popularity of telecommuting and hybrid working. The layoffs in the high-tech industry add to the concerns of property owners.
Property owners take some solace in the fact that high-end buildings in good locations are still in demand. Some predict that the economic slowdown will lead managers to insist that workers return to the office, but almost no one thinks that office use will return to the level it was before the pandemic.
A report by Cushman & Wakefield predicts that the US will end the current decade with a record of about 10 million square meters of vacant space, compared to about 6 million square meters in 2019.
“The economy built all this office space for a workforce that was supposed to be in the office most of the time,” says Kevin Thorpe, chief economist at Cushman. “Most businesses simply don’t need as much space as they used to.”
For most property owners, the loss of the buildings to the lenders due to an inability to meet the loan repayments, may be painful but not devastating. For most investors, the office buildings are a separate financial entity. If they default, lenders can foreclose on the building but have no access to the company’s other assets.
The banks’ concern: will not stop at profitable real estate
But the pain from the foreclosures may cause waves among the entire financial system. About $1.2 trillion of debt was backed by office buildings as of the end of the third quarter last year, according to Trepp.
The banks are afraid of more problematic debts. Wells Fargo announced in January that total debt backed by office buildings that it does not expect to get back with all interest rose to $186 million in the fourth quarter, up 8% from the third quarter.
Lenders are wary of making new loans backed by office buildings unless they are fully leased for long periods to strong tenants. “You’re taking a career risk if you give a loan to an office,” says Trepp’s Clancy.
Office building loan refinancings often involve deals where owners agree to refinance in exchange for loan reductions or other new terms. Or the owner is trying to convince the credit providers to agree to a new business plan, for example trying to convert some of the offices into apartments.
But at a certain point, when the buildings are literally worth less than their mortgage, the owners will return the keys to the lenders. “If you think the debt is too high for a new deal plan, there’s no reason to put money in,” says Rechler.
It will be years before the pressure on the office market passes. Lenders have several financial deterrents against foreclosures. The meaning of such a foreclosure is to write off the value of the loan, and in many cases this requires the borrower to pay tax on the transfer of the property to his possession.
In one case from March of last year, a loan taken out to purchase a building at 1740 Broadway in Manhattan was transferred to another lender because of a large lease that had expired. The status of the building, which is 26 stories high and is owned by Blackstone, has not yet changed, according to sources familiar with the matter. “Such a transfer takes time,” says Rechler, who has already gone through two previous difficult periods. “You have to cross the chasm to the other side,” he says.