A Flood of Defaults Swamps Big Names and Big Properties, Especially Offices
‘Once one big owner did it, it gave cover for other institutions to do the same.’
The first rumblings bubbled up in the depth of winter. Brookfield (BN), the largest office owner in Downtown Los Angeles, defaulted in mid-February on two major properties worth a combined $784 million.
Within days, the defaults started coming fast and furious by some of the most respected and most well-capitalized names in commercial real estate, including Blackstone and Columbia Property Trust.
The flood underscored the reality that, whatever the economic recovery from the pandemic, many commercial landlords are struggling to make their mortgage payments. In recent weeks, a number of prominent property owners have defaulted on loans, gone into special servicing, or otherwise shown signs of distress.
Tough times are especially pronounced in the office market, which is reeling from workers’ embrace — and employers’ acceptance — of work-from-home arrangements. Once viewed as a temporary measure forced by the pandemic, virtual work has outlived the era of social distancing and mask mandates.
That’s causing considerable trouble in the office sector — and the dam holding back default filings clearly has burst.
“Once one big owner did it, it gave cover for other institutions to do the same,” Josh Zegen, managing principal and co-founder of Madison Realty Capital, told Commercial Observer. “You saw a domino effect.”
The examples of large owners and prominent addresses in major markets abound.
Aside from Brookfield’s default in Downtown Los Angeles the other dominos include RXR, which is negotiating with lenders to convert two New York City office buildings to residential. In Washington, D.C., a $38.1 million commercial mortgage-backed securities (CMBS) loan on an office building that houses the U.S. Department of Treasury is headed to special servicing. And, in perhaps the most substantial sign of distress, Columbia Property Trust, which owns in San Francisco, New York and Washington, defaulted in February on $1.7 billion in debt backed by seven of its office buildings.
“We, like most office owners, are addressing the unique and unprecedented challenges currently facing our asset class and customer base,” Columbia Property Trust said in a statement to CO.
Challenges, indeed. As many workers skip the commute and set up at home or in coffee shops, demand from tenants has softened.
With white-collar employees continuing to work remotely, office users are rethinking their investments in space. In Manhattan, for instance, total office availability stood at 18.6 percent in the fourth quarter of 2022, a record high, according to Avison Young.
“Clearly the office sector is hurting post-pandemic,” Zegen said. “Leasing velocity is down. Rents are down. Is it a five-day week, a three-day week, a two-day week?”
Unfavorable occupancy trends are a double whammy for owners. Not only are their properties generating less income to service debt, but their property values also are taking a hit. That squeezes loan-to-value ratios and hampers owners’ ability to refinance.
Aside from the sluggish return to office, the spike in interest rates is probably the biggest contributing factor in this. Office owners were able to weather weak occupancy levels when interest rates were at historically low levels.
As recently as March 2022, the secured overnight finance rate (SOFR), a benchmark for many commercial mortgages, was a minuscule 0.05 percent. In February 2023, after the Fed’s latest rate hike, that figure had risen to 4.55 percent.
The one-two punch of higher vacancy rates and higher interest rates means owners of struggling buildings can’t simply swap loans.
“There was a period of time where you could refinance your way out of an issue, and that’s much more challenging with rates where they are,” said Grant Frankel, managing director at Eastdil Secured. “This is a re-evaluation of the asset class happening in real time, in the face of extraordinarily high carry costs.”
Loan volumes have shrunk as lenders take a harder look at office buildings’ rental revenues and vacancy trends.
“It’s tough to refinance office in the current environment,” said Darrell Wheeler, vice president and senior credit officer at Moody’s Investor Service. “It’s not an in-favor product for CMBS. It’s not an in-favor product for other types of lenders, either.”
Moody’s latest CMBS report shows delinquencies on all conduit loans increased to 4.22 percent in January 2023 from 4.17 percent in December 2022, driven by more than $500 million in office maturity defaults for the month. That included a default on the $103.4 million loan for 515 Madison Avenue.
For office owners — and especially for owners of older buildings in less-than-prime locations — the turmoil seems likely to continue for years. A recent report by Cushman & Wakefield projected that the U.S. will end the decade with 1.1 billion square feet of vacant office space. More than a quarter of the country’s total 5.56 billion square feet of office, about 1.4 billion, will be considered obsolete. Further, Cushman found that potential office users will need smaller 4.6 billion square feet of space by 2030 — thanks to the shift to hybrid work.
Publicly, office landlords predict a wide-scale return to office, and they promote the notion that meaningful collaboration and mentorship require facetime. Privately, they’re being forced to take a hard look at whether to hang on to struggling properties or let them go.
“Borrowers are making a determination of which assets they’re going to continue to invest in,” Frankel said.
Should the default dominos continue to fall, it seems likely that lenders will remain reluctant to finance office buildings. Buyers could find themselves on the hook for personal guarantees.
One investor’s challenge is another’s opportunity, of course. The reckoning means some healthy office buildings will be undervalued.
“Right now, virtually all office buildings that aren’t brand-new, Class A and transit-adjacent are being painted with the same brush,” said Will Silverman, managing director at Eastdil Secured. “Where the money is going to be made in this cycle is when the babies get thrown out with the bath water.”
Pain in the assets
It’s not just office owners who are feeling the squeeze. A $270.3 million CMBS loan on Blackstone’s Manhattan multifamily portfolio recently was sent to special servicing. (Blackstone has not been immune to the office default wave, though, and might have arguably sparked it when the investment giant walked away from 1740 Broadway a year ago.)
The pain is especially acute in the retail sector, which was struggling long before the pandemic. Moody’s reported that the largest newly delinquent conduit loan in January 2023 was a $257.7 million mortgage on Gurnee Mills, a Simon Property Group mall in Illinois. Simon, one of the nation’s largest mall owners and operators, also missed a payment on a $295 million loan on The Shops at Mission Viejo, a regional mall in Southern California.
And even owners who are trying to find refinancing solutions face a valuation problem: Their properties are valued completely differently than they were a year or two earlier. In Manhattan, Jeff Sutton’s Wharton Properties continues to work on a resolution for the defaulted loan on his retail building at 1551-1555 Broadway, nearly five months after the loan went into foreclosure. (Sutton declined to comment.)
A recent Trepp alert highlighted the CMBS loan as the property’s value also dipped. The $180 million loan on the high-profile Midtown Manhattan asset — home to American Eagle’s flagship Times Square store — first hit special servicing on Nov. 15, 2021, before it officially defaulted on Sept. 30, 2022, according to CRED iQ.
Shortly after Deutsche Bank filed a foreclosure action on behalf of CMBS bondholders, 1551-1555 Broadway’s valuation shrank from $442 million in early 2022 to $378 million in December.
A source with knowledge of the situation said Sutton is now working with the loan’s special servicer, LNR Partners, on possible paths forward for the property as the industry faces refinancing challenges from rising interest rates.
The Feb. 15 Trepp alert noted Sutton owes nearly $182 million to Deutsche Bank on the property, which includes the original loan amount plus accrued interest and fees. Citigroup originated the $180 million deal in 2011. The value of the property was $360 million at the time of the 2011 origination, according to CRED iQ.
CRED iQ data states that Wharton Properties “is making efforts to secure financing and/or sale sufficient to pay off both the senior loan ($180 million) and [mezzanine] ($103.85 million).”
Demand might be slack for retail and office space, but the U.S. real estate market faces a chronic housing shortage. That reality has spurred a nationwide push to repurpose struggling retail and office into apartments and condominiums.
Scott Rechler, chairman and CEO of RXR, is negotiating with his lenders to redevelop two undisclosed buildings in New York City from office to mixed-use residential. If he can’t come to terms, Rechler told CO, he’ll give the buildings back to the lenders.
“We need [the banks] to cooperate to enable us to do that in a way that makes sense,” Rechler said earlier this year. “Some buildings aren’t going to come back to be competitive as office buildings, so you need to think of what the alternative is.”
Of course, reconfiguring office space into residential housing is a complicated process. A developer needs approval from lenders and from local authorities, and then has to finance the project over what could be an especially rocky economic period.
What’s more, office buildings present physical challenges. Plumbing is an obvious one — while an office tower might have one set of shared bathrooms near the elevators, apartments need a bathroom and shower in every unit.
“In many instances buildings don’t necessarily fit the template of what’s best for a housing conversion,” Zegen said.
Despite the hurdles, developers nationwide have converted hundreds of office and retail properties over the past decade. Adaptive reuse projects have a major cost advantage over new construction, which helps developers achieve affordability.
Per-unit construction costs for adaptive reuse projects can be about 30 percent lower than the cost of replacing a demolished building with new construction, according to a 2022 study by NAIOP, the commercial real estate group formerly known as the National Association of Industrial and Office Properties. NAIOP found that 222 office buildings had been converted to residential from office nationally since 2010.
In all, 885 buildings were converted from commercial or institutional uses to residences. Those conversions were distributed among 278 cities, but fully half of the converted office buildings were in 24 cities. The most active locations were Chicago (46), Philadelphia (34) and Los Angeles (31). St. Louis, Cleveland, Milwaukee, Baltimore, Washington, D.C., and Kansas City, Mo., had more than 20 multifamily projects each, NAIOP reported.
Office buildings were the most common building type targeted for reuse, with 222 projects. (Former factories came in second at 196, followed by 127 hotels.)
With workers continuing to work from home and housing inventories still tight, the trend of repurposing office buildings into multifamily projects is “likely to accelerate,” wrote Emil Malizia, a professor of city and regional planning at the University of North Carolina at Chapel Hill and author of the NAIOP study.
“The conversion of existing space has become more attractive primarily because less time is needed to bring the renovated property to market,” Malizia wrote.
However struggling offices are repositioned, it’s clear that a large swath of the industry’s inventory requires a major makeover. In the meantime, owners will continue to confront a level of financial uncertainty few could have anticipated a few years ago.
“There’s a handful of buildings in each city that are attracting tenancy, and then there’s everybody else,” Zegen said. “There’s a lot of antiquated building stock in the U.S. that needs upgrades, that needs money.”
Andrew Coen contributed to this article.