Office Properties With Healthy Fundamentals Are Hitting Special Servicing

But reviewing the status of various New York office and office-to-residential projects in recent years shows that 180 Water Street was not the outlier it might seem.

The Cunard Building at 25 Broadway was sent to special servicing in April 2024 after defaulting on the maturity of a $250 million CMBS loan despite 92 percent occupancy throughout 2022 and 2023. Metro Loft’s 20 Broad Street, also an office-to-residential conversion project, was sent to special servicing last August ahead of a September maturity date despite a 98 percent occupancy rate there too as of the fall of 2023. And 1407 Broadway’s $350 million CMBS loan was sent to special servicing in September 2023. As of June 2024, the building was 81 percent occupied.

The notion that loans behind office buildings and office-to-residential conversion projects are being sent to special servicing may not seem that surprising given the past few years of economic uncertainty. That is, until you learn that in more cases than expected, the buildings in question seem as strong and healthy as possible on paper, with low vacancies and reliable rent collections.

“This is not a normal market occurrence,” said David Wegman, a director in the commercial real estate division for data analytics company Trepp. “If a property is performing in terms of occupancy and rent collection, then normally this is not an issue.”

To get a general idea of how prevalent this is, Wegman isolated office properties nationwide backed by securitized debt and at 85 percent occupancy, and came up with around 2,000 properties. He then found that around 100 of those, or about 5 percent of the loans, were in some stage of distress.

There are several reasons for this, but a key one is the drop in valuations that has plagued the office sector since the pandemic’s earliest days.

“In the office market, valuations have come down regardless of the building,” said James P. Godman, a partner in the real estate practice at law firm Kramer Levin. “So you’ve got kind of a guilt by association. One method appraisers use to value buildings is the sales comparison approach. So, if your neighbor and the building down the street have valuations that declined, then you’re going to take a hit as well.”

Wegman notes that this has been a major issue for projects attempting to refinance.

“On those hundred properties in some stage of delinquency, half are because the loan has matured and they’re dealing with refinance issues,” said Wegman.

He uses the hypothetical example of a building worth $100 million that received a $65 million loan at origination, assuming 65 percent loan-to-value.

“A lot of loans are interest-only, so they don’t amortize down,” said Wegman. “When that loan matures, you have to refinance that $65 million. But if the value dropped from $100 million down to, say, $80 million, the lenders will still lend the 65 percent, but now it’s on a lower dollar amount. So, in that scenario, they’ll loan $52 million instead of the $65 million.”

And this is before taking into account that the loan-to-value itself may have contracted.

“Let’s say five years ago, a lender was willing to give you a loan at a 70 percent loan-to-value,” said Godman. “If your building was worth $100 million, they were willing to give you a $70 million loan. Now they may be at 60 percent. So now you’ve got a $10 million gap. That’s what’s happening in the refinancing environment.”

Wegman also cites higher interest rates as a significant factor contributing to this issue.

“When I looked at the hundred or so loans, [they had around] a 4.7 percent interest rate, looking at fixed-rate loans,” said Wegman. “Now, when you go to refinance, that interest rate is 7 percent. In order to qualify for the loan, your NOI has to be a multiple above that. So, even though the property’s performing, you may not get the debt service coverage ratio needed to satisfy the lender.”

Nathan Berman, Metro Loft’s founder and CEO, said that rising interest rates were the clear culprit in the cases of 180 Water Street and 20 Broad Street.

“When you borrowed money five years ago at 3 percent and now need to pay 6.25 or 6.5 percent in interest to refinance, what do you think is happening to that building?” Berman asked. “And it has nothing to do with the performance of the building itself. These buildings can’t sustain mortgages that have doubled, or more than doubled, interest payments. If you are highly leveraged and you double interest rates, you’ll be in trouble.”

Berman added that while the current situation was foreseeable as interest rates rose over the past few years, possible solutions were scant. Owners were basically at the mercy of economic conditions.

“There’s really not very much you can do [in that situation] short of paying off the loan,” said Berman. “That solution is always available to you. But nobody expected rates to be where they are today. When you double the rate, that’s something that very few buildings can sustain.”

Also, in the midst of workouts and restructuring, some of these buildings have already been through one distress period, and the accrued interest from this is a factor the industry has yet to confront, said Adam Friedman, chair of the distressed real estate group and the bankruptcy and financial restructuring practice at law firm Olshan Frome Wolosky.

“For the last five years, even in buildings that are performing well, we’ve been doing loan extensions, forbearances, and even modifications where there are large fees to get that extension or forbearance,” said Friedman. “But the default rate interest continues to accrue during these extension or forbearance periods. A lot of these forbearance or extension agreements just kick the can — extend and pretend — and never solve the accruing default rate interest.”

Friedman notes that these rates can climb into the mid- or high teens, allowing the interest to accrue quickly and dangerously.

“Even when buildings are doing much better, they’ve been saddled with years and years of unpaid interest, and that really starts to tack on in a very significant way,” said Friedman. “Over four years, you can significantly over-leverage the property with the unpaid default rate.”

Given all this, some office owners find when they start the refinancing process that standards have become arduous, making it more challenging to qualify for financing on the same level as before.

“A lot of loans are hitting their 10-year maturities. Ten years ago, the office market and the lending market looked really different,” said Sarah Helwig, a vice president at Morningstar Credit. “In order to finance a loan, they want to see good metrics, and the conditions are more stringent and may change for the refinancing. [The borrowers] may not meet the new lending standards.”

And, outside of financing issues, office owners, especially for buildings below the Class A categorization, have already been dealing with a deficit in tenant demand. So a building could be close to fully occupied, but if a major tenant or two have lease expirations looming in a year or so, the anticipated challenge of finding a suitable replacement can also send a property closer to distress.

“Some appraisers take the net income approach,” said Godman. “Your rent roll might be good today, but what appraisers and lenders will take into account is what happens when your existing leases expire. Will you be able to rent at the same rents? Most likely not. The rents are probably going to be significantly lower, and that’s if you can even find a tenant for that space in this office environment.”

Godman also points out that rising expenses in general are another factor making refinancing all the more challenging.

“On the expense side, you’re taking a hit because expenses have gone up across the board,” said Godman. “Along with rising interest rates, now your projected net income is, by definition, going to be significantly lower. That’s another metric for determining the valuation of your building, so right away lenders looking to refinance your building are looking at a lower valuation, and therefore will be willing to provide less loan proceeds than lenders were whenever you originally financed your building.”

In cases like these, additional investment on the owners’ part for upgrades — to bring buildings closer to Class A to satisfy the current flight to quality — can potentially help persuade a lender that an owner can continue using the building at its best value. If a loan is sent to special servicing, the servicer has the option of deciding to purchase the property itself if it believes it can run the property better than the current owner.

Michael Cohen, founder and managing partner at Brighton Capital Advisors, worked with a building where the owner had to invest equity equal to 10 to 15 percent of the loan amount for tenant improvements to prove the owner could run the building at its best-use case. This investment earned the owner a two-year extension on its loan.

“They’ll have the ability to use that money for the property, and it bridges them to the next part of the market,” said Cohen, who emphasizes the importance for owners of proving to lenders they can not only run a building, but also evolve its status in the marketplace through upgrades to appeal to modern office tenants.

“You have to go in there with a plan,” said Cohen. “If there’s equity in the building remaining and the servicer thinks it can lease up the building themselves and you don’t want to put any money into it, they’re going to take the property back from you.”

Metro Loft’s Berman, who ultimately brought in an equity partner for 180 Water Street and sold 20 Broad Street to the building’s mezzanine lender, said that the hard reality for building owners in these situations leaves them with several less-than-ideal options. Still, there’s usually the possibility that a smart strategy can keep a building in a portfolio.

“You have two options,” said Berman. “If you are over-leveraged, bring the leverage down, meaning pay off part of the loan. And, unless you’re prepared to bring in fresh equity, giving the keys back is very often the answer.”