As CMBS Office Distress Takes Longer to Resolve, Focus Turns to the Pain Points

During the 1920 presidential election, which took place in the shadow of World War I, Warren G. Harding famously campaigned on “a return to normalcy.” Tortured grammar aside, Harding ended up prevailing in an Electoral College landslide by appealing to voters’ desires to leave behind a cataclysmic past and enter a future promising a restoration of the simple and familiar. 

Four years after COVID-19 ravaged the nation’s economy and altered work patterns forever, many professionals in both the office realm and commercial mortgage-backed securities (CMBS) arena are pining for the old days amid cratering values, record vacancies, and hundreds of billions of dollars of defaults on bonds backed by near-empty office properties. 

SEE ALSO: Commercial Real Estate CLOs Confront Rising Distress From Higher Interest Rates

Unfortunately, even in an election year, “normalcy” has never been so far away for these commercial real estate players. 

“I think it’s a long waiting game taking place by all parties at the moment — borrowers, special servicers, bondholders — as to the direction that value [for office] will go in the coming months or years,” said Chris Herron, managing director at Iron Hound, a workout specialist. “It’s extremely challenging to underwrite new office loans at the moment and equally challenging for all parties to admit that the value that was once much higher than the debt may not ever return.” 

Underwriting distressed office has never been more difficult. This is especially true of office attached to the nebulous world of CMBS financing, where loans are securitized into bonds that send debt payments to a trust made up of investors, and whose performance is overseen by faceless third parties such as a master servicer, a special servicer, and a controlling class representative once the original loan has been sliced, diced and sold off into the securities market. 

“At the end of the day, the special servicer might be spread too thin, and they have less at stake than if you had a single lender,” explained Jay Neveloff, chair of the real estate practice at Kramer Levin. “With a single lender, there’s a weekly team meeting, you’re talking about the loan at every status meeting, and it’s your money, it’s your evaluation within that institution. A special servicer has a whole portfolio of multiple loans to deal with.” 

Aside from the inherent complexity of the CMBS securities market, one reason why underwriting capital injections and resolving workouts within office CMBS has proved so damn maddening is because no one can tell whether the market has bottomed — leaving lenders and rescue equity alike with little choice but to take a wait-and-see approach. 

One year ago the office CMBS delinquency rate sat at 4.5 percent. By August, it had climbed 300 basis points to hit 8.09 percent, according to Trepp, a real estate data analytics firm. The Trepp special servicing rate for CMBS office properties now sits at 10.79 percent, up from 7.24 percent from one year ago. 

These are numbers not seen since the aftermath of the Global Financial Crisis in the late 2000s. 

“The volume of loans being transferred to special servicing is markedly up,” said Michael Cohen, managing partner at Brighton Capital Advisors, a CMBS workout specialist. “Every day, we see two to three highlighted office assets that get transferred into special servicing.” 

Cohen noted that the deals he’s personally handled range from a $15 million loan on an office in Raleigh, N.C., that is 100 percent occupied and is now getting an extension, to a $280 million note on two office buildings in Chicago that are 30 percent occupied. “We’re seeing things across the board, and, in general, we’re seeing that every loan is different, every servicer is different, and every controlling class holder is different,” he added. 

The uptick of CMBS loan defaults into special servicing is creating a backlog on workouts and resolutions across the asset class, according to Marcello Cricco-Lizza, a managing director and portfolio manager at Balbec, a CRE investment firm. In CMBS, Cricco-Lizza noted that sponsors and bondholders have calculated it’s best to extend a fixed-rate loan while it sits in special servicing and awaits a new equity partner to come in and assume the loan — trusting that the special servicer won’t go through the process of taking back the property and liquidating the loan at a loss. 

“In many cases, the only source of financing for that loan is to stay where it is and get extended,” said Cricco-Lizza. “So, yes, there’s a very big backlog of office loans that needs to get dealt with. And, while we’re seeing loan sales pick up this year, there won’t be quick resolutions for these assets.” 

But any extension granted amid a collective extend-and-pretend calculation on the part of lenders carries unforeseen costs. Many investors are buying discounted CMBS credit bonds, covering themselves from a value perspective amid the downturn, but putting themselves at risk for what happens to their investment after the sponsors exhaust four, five or even six years of extensions on fixed-rate loans -— a risk owing to the uncertainty surrounding future values and future leasing in the office sector. 

“Overall, we’re in the early innings of office distress,” said Cricco-Lizza. “A lot of leasing is above market, [tenants] know their lease is above market, and, while they won’t default on their lease right now, they have more space than they need. But three years from now that lease comes to maturity … and, because of that backlog of tenants paying too much for space they don’t need, that drip will be painful on landlords for the next three to five years on all but the Class A product.”   

And no amount of government intervention can move this process along or provide better clarity. 

Even after the Federal Reserve cut interest rates by 50 basis points in mid-September, signaling the end to the swiftest interest rate hike in 40 years, the consensus among CRE experts was that an era of relatively easier money wouldn’t be enough to speed up agonizing resolutions that seem permanently frozen in place.

“Looser credit conditions don’t perfectly solve things like a complete change of utilization by office users,” said Iron Hound’s Herron. “So figuring out ways to get the necessary equity into assets when cash flow and value no longer support the building on its own is its own challenging exercise.” 

Structural problems 

Unlike the other asset classes, which were also hit by soaring interest rates, office has had its financial underwriting turned upside down by an increased cost of capital and falling tenancy. 

Today, four years after hybrid work became not just accepted but entrenched in the national ethos, U.S. office space carries an overall vacancy rate of 19.4 percent, with cities like Austin and San Francisco exceeding 27 percent, according to CommercialEdge, a data firm. 

Neveloff noted that the value of an office building is really a function of tenancy, with the equation essentially coming down to income versus expenses. Any lack of transparency around values is more about the unknowns surrounding present and future occupancy — which is contingent on several factors like a building’s location, tenant concessions and tenant improvement packages — than the trials and tribulations of debt. 

“It’s less dependent on what the lender does, and it’s totally dependent on cash flow from the property,” said Neveloff. “It’s really all about occupancy.” 

But the sharp decline in tenancy has turned CMBS office loans upside down, as they were underwritten at occupancy rates of 80 percent or higher. Without that assumed cash flow, and with such variance around what tenants will do upon the expiration of the five- and 10-year leases typical of the sector, everyone connected to the CMBS security is left anxiously waiting. 

“There’s uncertainty on the special servicer and borrower side in terms of value, and there’s uncertainty on tenant side on what their space needs are, and there’s uncertainty in the market and what’s the best fiduciary outcome for the trust,” explained David Putro, head of CRE analytics at Morningstar Credit Analytics. “No one knows when to pull the trigger and liquidate the loan. There are so many moving pieces right now, so it’s different from the recession in 2008 and 2009.” 

Another complication for the asset class is that expenses have increased dramatically in the last four years. Earlier this year, Trepp reported that repair and maintenance costs on office increased 12.3 percent on average from 2021 to 2022 in the 50 largest U.S. markets, and CBRE reported in late 2023 that allowances for Class A properties shot up by 13 percent annually in the third quarter of 2023. 

It’s not just maintenance and tenant allowances driving this. Insurance and electricity costs have also increased, giving lenders and special servicers reason to pause and reconsider a borrower’s ability to meet a loan’s debt yield, even after factoring in the the best possible assumptions on tenancy, according to Scott Levine, a partner in King & Spalding’s real estate practice.

“Operating expenses have gone up across the board for office buildings, and you have tenants who are leaving, which is still COVID-driven, but you have to re-tenant these buildings,” Levine said. “But, if operating expenses have gone up, are you really going to ask for higher rents in an office building where people are leaving?”  

This Chinese finger trap of flickering tenancy and rising debt costs has given even the most bullish investors pause on whether to put credit or equity into underwater capital stacks. 

Earlier this year, Chad Carpenter, founder of Reven Capital, launched Reven Office REIT, a $1 billion, publicly traded real estate investment trust solely devoted to deploying bespoke capital into distressed office properties. Carpenter told Commercial Observer that he’s reviewed $8 billion of investment opportunities and soft-quoted nearly $3 billion of loans from borrowers who are underwater with maturity defaults — and his conclusion is that “70 percent of all office buildings are dead.”

He noted that bid-ask spread is so wide from where the current values are, and where the loans originated, that defaults are swallowing up almost all of the equity in any office deal. He cited Trepp data that shows the average loan loss on CMBS office resolutions is a stunning 62 percent of the original loan value for loans worked out over the last 12 months. 

“The banks are seeing there’s no hope with values. We’re seeing a lot of sales comps are out now on big deals, and what’s really interesting is it’s not just empty buildings. We see [distress] often with buildings that are 60 to 80 percent leased that have a lot of [rent] roll in them,” said Carpenter. “So these buildings, even though they’re cash-flowing, they can’t refinance because there’s too much of a gap between what we or anyone else will give them to pay off the lender.

“The point is it’s not just empty buildings — it’s everybody,” he added.  

Even though several experts agreed that many balance sheet lenders are exhausted with the extend-and-pretend strategy, and are increasingly choosing to monetize an office asset (even at a loss), the complexities of CMBS have made it difficult for lenders and borrowers alike to exit deals, delaying the pain even further. 

“It’s more challenging in CMBS to find that additional cash, especially when some of these office buildings are in default,” Neveloff said. “So, in my mind, CMBS does provide a challenge.” 

The CMBS conundrum 

It can’t be emphasized enough just how different CMBS financing is from traditional balance sheet lending. In CMBS whole loans and participation loans, co-lenders battle it out with each other across byzantine lending syndicates — when multiple funding sources have originated a loan — leaving all lenders in a pickle on how to resolve major decisions once defaults arise.

Furthermore, a default mucks things up for both borrowers and investors because all debt payments flow into the CMBS held by investors, and, because cash flows and loan terms are each fixed, any individual loan is theoretically supposed to be unmodified. But once defaults occur, an unrelenting waterfall of complications and lawyering wash over all the parties, from borrowers and the different CMBS servicers, to the several levels of bondholders across the CMBS investment tranches. 

Christine O’Connell, a partner in King & Spalding’s real estate and funds practice, said that her firm is seeing “a good number of [distressed] office deals” in big markets like New York and D.C. that have been securitized into large CMBS loans. The mezzanine debt and preferred equity behind these enormous financings has added “innumerable complications” and made traditional CMBS even harder to unwind, she said. 

“The capital stack is much more complicated than it was previously,” O’Connell said. “It’s not as simple as during the GFC, when a bank had a loan on an office building and they foreclosed and knew how to underwrite it and there was a path out. This is a lot messier, for lack of a better term.” 

Levine, O’Connell’s fellow attorney at King & Spalding, added that CMBS machinations are “100 percent dragging out the office distress,” not just because the capital stacks are more complex than they used to be, but also because master servers, special servicers and controlling class holders are looking for different outcomes than the secured bondholders. That in turn limits what investors can do under CMBS pooling and services agreements (PSAs). 

The workout process is also uniquely long and costly for CMBS. 

Darrell Wheeler, head of CMBS research at Moody’s Ratings, noted in a recent report reviewing three decades of CMBS data that if loan defaults are resolved within six months, the loan loss severity is about 20 percent of the total loan. But, if it takes longer than six months, that loss severity reaches 43 percent. Two years of workouts cause loan losses to reach 53 percent, and anything above five years takes out an average of 77 percent of the total loan. 

“Once you’re past six months, you’re looking at resolutions that have a lot higher cumulative loss severity,” said Wheeler. “So time is money in CMBS.”

Perhaps most frustrating: The sheer volume of office CMBS defaults has left many special servicers under water, leaving a workout dependent on previous or existing relationships.

“You need to package everything right for a special servicer, you need to have a proposal and know what they’re looking for, and maybe you get moved up in the stack a little bit, but they’re still months behind on this stuff,” said Levine. “And if there’s mezzanine debt and other players involved, that’s a whole other mess going on because the class holders are worried about getting wiped out before a modification happens.” 

However, not everyone blames CMBS or special servicers for abetting the drawn-out process of underwater office workouts. Reven Capital’s Carpenter believes that CMBS is actually helping bring clarity to the shadowy value game. 

“In terms of workouts, what we’re seeing is CMBS is leading the way for resolving distress,” said Carpenter. “Even with special servicers taking a long process to resolve an impairment, they’re actually doing it. They’re the first guys to put borrowers in default and resolve the loan.” 

Carpenter instead trains his ire on commercial banks. He argues they are the prime culprits for the lack of value clarity and the long workout process, driven as banks are to protect vulnerable balance sheets and nervous depositor capital. The New York Times reported earlier this year that commercial banks hold about $1.4 trillion of the $2.6 trillion in CRE loans set to mature over the next five years, based on data from Trepp. 

“What the banks have done is nothing because they have different rules. The CMBS rules are documented in what they have to follow in pursuant to the trust,” Carpenter explained. “The banks, on the other hand, they’re just hiding, they’re extending and pretending, because they don’t want to disclose any potential impairments or realize any potential losses [on balance sheet loans].”

Carpenter believes once a few commercial banks begin to announce large office loan losses, the dominoes will start to fall atop balance sheets across the sector.   

“If you take all these regional banks who are overexposed to office, and you say, on average, it’s a 50 percent [loan loss on office] when the dust settles, [you have to ask] are these guys insolvent because they’re so highly levered?” he said. “The regional banks are not levered 1-to-1. They’re levered 4-to-1, 8-to-1, or 10-to-1, so it’s pretty scary.”  

Some solutions 

Apocalyptic notions aside, there are innovative steps being taken to speed up the workout process and rightsize CMBS capital stacks amid generational office distress.

Philip Rosen, head of Weil, Gotshal & Manges’ real estate practice, said that he’s been working with special servicers to create A and B note structures on CMBS debt, whereby the loan is divided into two pieces as a resolution tactic — an A piece that is kept current and given a realistic number to make right, and a B piece which is more of a hope certificate.

“Being creative is something that’s part of my job and part of the job of every expert in restructurings,” said Rosen. “So one of the reasons you do extend and pretend is you need time for the market to adjust and then you come up with creative solutions.”  

Brighton Capital Advisors’ Cohen and his partner Richard Fischel are working on a large CMBS office transaction in which the borrower is willing to come into the negotiation with cash to improve the building’s lobby, improve its ground-floor retail, and retrofit the interior to make it more attractive to tenants. The only way to achieve this plan, though, is if the lender resizes the loan into an A-B note structure. 

The modification works like this: Borrowers size an A note to whatever they think the building’s new value is, then any new equity gets interest payments returned first. When the asset is finally sold, any money above the A note’s value in the preferred return gets paid back to the B note.  

“The A-B note structures are what people are talking about now,” said Cohen. 

But not all lenders are created equal. Levine noted that some lenders are willing to cut deals and recoup 30 percent of the original loan amount, based on the fact they’ve been collecting interest payments for years prior to walking away at the maturity default. Other lenders, like debt funds, have equity arms that own properties, so they’re more willing to take back assets following foreclosure than a balance sheet lender would be. 

“It’s not as much of a heavy lift, as they have people who know how to own and run properties,” said Levine. “Other places, like the banks, aren’t in the business of owning properties, so they’ll be more reluctant to do those things.” 

And, even though many solutions have encouraged sponsors to find local private equity partners who know an asset’s submarket and can make educated decisions after injecting capital, oftentimes the capital used to rightsize an office loan can come from credit and equity funds established by an underwater borrower. 

In just the past year, office landlords like RXR and SL Green, and CRE investment firms like Ares Management, Heinz and Rialto Capital, have all announced their new or existing debt funds will begin investing capital into distressed office product.

“All these guys who are holding office distress themselves are also the most educated in the space and are the ones who can say, ‘No one understands the issues and how this asset class operates better than us, so let us use fresh capital to redeploy these assets to get fresh returns,’ ” explained Dylan Kane, managing director at Colliers (CIGI) Capital Markets. 

Much of the mezzanine debt and preferred equity that these office rescue funds deploy comes from private equity, high-net-worth individuals, family offices and large institutional investors, according to Neveloff.  

Even so, all the money in the world isn’t enough to move the needle if a borrower and lender can’t agree on value. At the end of the day, like almost all business ventures, it’s what happens across the table between two opposing sides that resolves any problem. 

Iron Hound’s Herron emphasized that borrowers who are willing to extend a loan at par value, and can find fresh capital to place behind their debt, will find an easier experience in a CMBS office workout than a borrower who cannot invest new equity without a significant concession from the lender.  

“This is not to say that special servicers aren’t going to negotiate all aspects of an extension, but it is a different conversation from the beginning for the deals where this is feasible,” Herron said. “Unfortunately, at this moment in time, there are a significant number of deals that fall into the latter category and will see delays in resolution as the market either does or doesn’t recover.”  

Brian Pascus can be reached at bpascus@commercialobserver.com