Many questions about the future of the office market remain unanswered as the pandemic nears the two-year mark, but one trend has become increasingly clear: tenants are moving out of older buildings in favor of newer projects .
This accelerated change has left owners of some aging office buildings with many vacancies and insufficient cash flow to service their debt, putting billions of dollars in office-backed loans at risk.
The Chicago office building at 175 West Jackson Blvd., owned by Brookfield Asset Management.
The flight to higher quality assets had already taken off before 2020, but it has reached new heights during the pandemic, with tenants pushing for better air filtration, outdoor amenities and building sustainability ratings.
Additionally, some are now able to afford the premium space by reducing their rental footprint due to the remote work shift and as newer building owners offering record cash and rent incentives. to sweeten their offers.
Given the long-term nature of office leases, these moves have only occurred for a fraction of tenants that have expired over the past two years, and this trend will continue for several years to come. Experts say this won’t create a sudden wave, but a steady trickle of distressed office assets for years to come.
“Problems going forward will primarily come from markets that have significant amounts of dated properties that aren’t particularly desirable for big demand drivers these days,” said Manus Clancy, Trepp’s senior managing director. “You’ll see episodes in New York, Chicago and other places where big buildings that are securing loans with nine-figure balances are getting into trouble.”
In December, the CMBS delinquency rate for the office sector rose to 2.53% from 1.81% in November, according to Trepp. It represented the highest level since June 2020 in Trepp’s office default rate metric, which measures CMBS loans that are 30 days or more past due.
Courtesy of Trepp
A Trepp chart showing the slight increase in the office chargeback rate (orange) compared to the overall chargeback rate for all property types (blue).
The increase is mainly due to the fact that four large office buildings became 30 days past due on their loans last month, according to Trepp. The bankruptcy of Chinese investor HNA Group led its subsidiaries to become delinquent on loans secured by 245 Park Ave. in New York and 181 West Madison St. in Chicago.
Two other Chicago office assets defaulted last month for reasons more related to the underlying performance of the office market. Brookfield Asset Management has become delinquent on its $259 million loan for 175 West Jackson Blvd., which was 62% occupied in September, Crain’s Chicago Business reported. AmTrust Realty became delinquent on its $100 million loan for 135 South LaSalle St. after losing Bank of America as a tenant. Brookfield and AmTrust Realty declined to comment.
Experts predict more distress in the office market this year, and it has become a growing concern among financial market participants.
JLL Capital Markets Vice President Kyle Kaminski, a distressed debt specialist, said while attending the Commercial Real Estate Finance Council conference earlier this month he answered more questions about potential distress in the office market than in any other sector. Earlier in the pandemic, he said the conversation generally centered on the struggling retail and hospitality sectors.
“Hospitality had been the main driver of distressed loan sales and at the forefront of most lenders’ minds, but that has changed over the past year, and the general office has now replaced the hotels as new, ‘What are we doing here?’” Kaminski said. “There’s this view that the office has to have some level of distress, that’s going to cause pain points in most markets.”
Steve Jellinek, head of CMBS Research at DBRS Morningstar, said he’s started to worry more about the office market in recent months.
“The office is the area that keeps me up at night,” Jellinek said. “Although my instinct tells me that everything will be fine, that the occupancy rate will remain relatively stable, there is always this nagging question in my mind like: ‘What’s the next shoe to drop?'”
More than $7 billion in office-backed CMBS loans are expected to mature in the 12-month period beginning in October 2021, according to a Moody’s Analytics report released that month. The report identified 28 loans that it said were at potential risk of not being able to be refinanced, either because the building has upcoming lease expiries or because of low cash flow relative to the outstanding debt.
In an update to the October report provided to bisnow, Moody’s said nine of those potentially subprime loans have since been refinanced, allowing the owner to keep the asset.
Looking ahead 12 months from Jan. 1, Moody’s found $5.3 billion in maturing office-backed CMBS loans, down from October’s $7 billion figure in due to recent refinancing deals, according to data shared with bisnow. Moody’s has identified approximately 30 additional loans of $10 million or more that are due to mature in the fourth quarter of 2022 and pose potential refinancing risk, including properties in California, Texas, DC, New York and Michigan. .
Darrell Wheeler, CMBS researcher at Moody’s Analytics, said he was surprised to find that nine of the loans had been refinanced since his October report. He attributes it in part to the rise of a specific type of financing method.
Obligations of loans secured by commercial real estate – or CLOs – tend to finance transitional assets that do not have stabilized cash flows, and they are growing in popularity. CLO issuances last year totaled $45.4 billion, according to Moody’s Analytics, well above previous levels of $8.7 billion in 2020 and $20.5 billion in 2019.
Although financing mechanisms may be available for properties without stable cash flow, many properties still face the risk of default, especially older assets that do not meet the requirements of today’s tenants.
245 Park Avenue in New York
Wheeler said he views older buildings with significant lease expirations as a significant risk because many of the office leases signed in the past year were for newer buildings.
“It’s a real risk we’re seeing, and the major leases we’ve seen advertised always involve a LEED Platinum or Gold building,” Wheeler said. “There’s a demand for this type of space, and we’ve seen a change where you need to be concerned. Can your building be upgraded to this standard?”
In DC, for example, the trophy and Class A office sectors saw a combined positive net absorption of 334,000 square feet last quarter, while the Class B office sector – typically older buildings with less amenities – saw negative absorption of 233,000 square feet last quarter, according to CBRE.
The fate of older office buildings and their loans will likely depend on their owners’ financial means and their willingness to invest more money in their assets, said Melissa Che, senior director of Fitch Ratings.
“You’ll have stronger sponsors who may have assets that are going through a slack as occupancy goes down, but if they feel that’s a good asset, they’ll continue to cover the shortfalls,” he said. Che. “What is concerning is the weaker sponsors who may not be as well capitalized who are seeing some of these declines in performance and occupancy.”
In some cases where a property has strong underlying fundamentals, such as its location and nearby demand drivers, but a landlord has less money, Che said loan managers can provide flexibility to help borrowers to keep their assets.
“Some of the ones we see may be on the decline, but there is value in real estate, some servicers are willing to work with borrowers to save them more time, help them lighten their payments and give them time to stabilize,” Che said.
Owners of older buildings who don’t have deep pockets or flexible repairers can default on their loan and lose the asset, leading to potential foreclosure sales.
JLL’s Kaminski said he sees strong investor demand for distressed assets across all sectors. With distressed office assets, he said values could drop low enough to allow new owners to convert to another use, such as life sciences or multifamily. These conversions have become increasingly common over the past year as older office buildings become more obsolete.
“You’re going to see an increase in distress, people who aren’t able to keep paying their mortgages, so we’re definitely going to see an increase in defaults across the space,” Kaminski said. “What that means at the desktop level, I think we’re going to start to see a basic reset and you’re going to start to see a conversion to alternative uses.”
Kaminski said he expects the rise in distress in the office market to be gradual rather than immediate, a point on which all experts bisnow spoken for this story okay.
“I don’t think there will ever be this gigantic wave that just hit the shore and all of a sudden there’s all this distress,” Kaminski said. “I think it’s just going to be a rising tide throughout the year, and at some point in the future we’re going to look up and there’s going to be a significant amount of office space there, and you’ll know that you’re in the middle of it. It slowly crawls on top of you and continues to climb. Where it stops, I don’t know. That’s the million dollar question.