Since the early days of the pandemic, owners of large buildings in New York and other big cities have been desperately hoping that the commercial real estate business would rebound as workers returned to offices.
Four years later, hybrid working has become common and the pressure on owners is intensifying. Some properties are being repossessed and sold at much lower prices compared to valuations less than a decade earlier, leaving investors with huge losses.
While the number of office buildings reaching critical states of disrepair remains small, the number has increased considerably this year. And investors, lawyers and bankers expect the pain to increase in the coming months because demand for office space remains weak and interest rates and other costs are higher than they have been in many years. The problems could be especially severe in older buildings, with lots of vacant space and large loan payments ahead.
The repercussions could extend far beyond the owners of these buildings and their lenders. A sustained decline in the value of commercial real estate could undermine the property tax revenue that cities like New York and San Francisco rely on to pay salaries and provide public services. Empty and nearly empty office buildings also hurt restaurants and other businesses that served the companies and workers who occupied those spaces.
“There are a lot more problems coming,” said Mark Silverman, partner and leader of the CMBS Special Servicer group at law firm Locke Lord, which represents lenders in disputes with commercial mortgage borrowers. “If we think the situation is bad now, it’s going to get a lot worse.”
Assessing the magnitude of the problem has been a challenge even for real estate professionals because of the different ways commercial buildings are financed and different rules about what must be publicly disclosed.
About $737 billion in office loans are spread among large and regional banks, insurance companies and other lenders, according to CoStar, a real estate research firm, and the Mortgage Bankers Association.
The default rate on office building loans that are part of commercial mortgage-backed securities was nearly 7 percent in May, up from 4 percent a year earlier, according to Trepp, a data and research firm. But only a small proportion of office loans, about $165 billion, are packaged in such securities.
Foreclosures, which can occur months or more than a year after the homeowner falls behind on payments, are also on the rise. Nearly 30 buildings in Dallas, New York, San Francisco and Washington whose loans are part of commercial mortgage-backed securities were in foreclosure in April, up from a dozen in early 2023, according to Trepp.
Some buildings across the country have recently sold for a fraction of their pre-pandemic prices.
In May, investors such as insurance companies and banks in the highest-rated triple-A mortgage-backed trade deal bond (generally considered about as safe as a government bond) lost $40 million, or about 25 percent of your investment. . Holders of lower-rated bonds from the same commercial mortgage deal lost all of the $150 million they had invested.
The building that served as collateral for those bonds, 1740 Broadway, was purchased by Blackstone in 2014 for $605 million. Blackstone had borrowed $300 million for the 26-story building near Columbus Circle. This spring, the building was purchased for less than $200 million.
“When we see delinquencies and foreclosures going up, that means we’re getting closer to the acceptance stage of the grieving process for office properties, and that’s healthy,” said Rich Hill, head of real estate strategy and research. roots of Cohen & Steers, an investment firm. firm. “But we’re not there yet.”
Hill said it could take until the end of this year or sometime in 2025 before the extent of the problems in the office market became clear.
Office leases tend to last up to 10 years to give landlords time to recoup their investment and broker fees. Long-term leases also guarantee investors that they will be paid interest on the hundreds of millions of dollars (sometimes even billions of dollars) they have lent to real estate developers.
As a result, it may be a long time before tenants’ decisions to downsize impact the market. Additionally, some mortgages granted at low interest rates have not yet had to be refinanced. But the longer interest rates stay high, the more trouble buildings that were profitable when interest rates were near zero will have.
Then there is the slow negotiation process between borrowers and lenders as they look for ways to reduce potential losses by renegotiating or extending loans.
“While there has been a lot of anticipation, it takes a while to come to fruition,” said Anthony Paolone, co-head of U.S. real estate equity research at JP Morgan.
Part of the delay is also due to the difficulty of valuing buildings after the pandemic. Until enough properties are sold, it has been difficult to know the true market value of the buildings.
“A lot of that stuff right now is just spreadsheet math because there’s no transaction activity to prove it,” Paolone said.
The sales that have taken place suggest a serious drop in commercial property values.
This spring, a 1980s office building at 1101 Vermont Avenue in Washington sold for $16 million, a sharp drop from its $72 million valuation in 2018. And near the Willis Tower in Chicago, an investor is made with a landmark building late last year at 300 West Adams Street for $4 million that sold for $51 million in 2012.
“We went so long without transactions that it created a lull,” said Alex Killick, managing director at CW Capital Asset Management, a special servicer that works with delinquent borrowers to recover money for holders of commercial mortgage securities. “Now we are seeing some. “There is finally some data to work with.”
Some data suggests that the problem is concentrated in a small proportion of buildings. While vacancy rates in U.S. office buildings hover around 22 percent, about 60 percent of that vacant space was in 10 percent of all office buildings nationwide, according to Jones Lang LaSalle, a commercial real estate services firm, suggesting the problems are concentrated rather than widespread.
Another encouraging sign, analysts said, was that the office building problems did not appear to endanger the banks. After the bankruptcies of Silicon Valley Bank and First Republic Bank last year, some investors feared for the health of other regional banks, which are big lenders to the commercial real estate industry. But few of the commercial mortgages held by banks have become delinquent, according to the Commercial Real Estate Financing Council.
Also largely unaffected by the situation are new trophy buildings in New York that can charge rents of up to $100 per square foot, double what older buildings can charge, according to the New York City Comptroller’s Office. NY.
The problem is most acute for building owners whose mortgages are coming due and who are losing many tenants. About a quarter of existing mortgages on office properties held by all lenders and investors, or more than $200 billion, will mature this year, according to the Mortgage Bankers Association and CoStar.
And while investors have been willing to lend new money to warehouse or hotel owners, few want to refinance office loans.
This could mean the end of a tactic often referred to as “stretch and fake,” which became popular in recent years. It’s called that because lenders agree to extend mortgages in the hope that, given more time, building owners can attract more tenants.
That approach arose in part from hopes among homeowners and lenders that the Federal Reserve, after raising interest rates over the past two years, would ease or cut them relatively quickly. In recent months, most economists and Wall Street traders have concluded that the Federal Reserve will not quickly reduce its benchmark rate or return it to the extremely low levels that existed before the pandemic.
“There has been systematic holding of our breath, and everyone expected that the rapid rate increase by the Federal Reserve would be reduced just as quickly, allowing people to breathe easier and rates would reset to lower levels “said Ethan Penner, the chief executive of Mosaic Real Estate Investors, a firm in Los Angeles. “But that hasn’t happened, and there’s only so long a lender can give a borrower patience and look the other way, especially once rental income starts to shrink.”
Another widely held hope in the real estate industry was that more companies would require their employees to return to the office more frequently, but that has not materialized either.
Law firms and the financial industry have slightly increased the office space they have rented from pre-pandemic levels, but many other industries have downsized. As a result, new leases signed are down about 25 percent from 2019, measured in square footage, according to Jones Lang LaSalle.
Over the course of a full week, about half of New York’s office workers on average go to offices, according to Kastle Systems, which tracks how many employees swipe their ID cards in commercial buildings. This is roughly in line with the national average.
The numbers exemplify the smaller role that offices now play in the lives of many American white-collar workers. That shift comes at a time when the U.S. economy is healthy, suggesting that problems in the office market may not pose a systemic risk to the financial system.
But landlords, their lenders and others involved in commercial real estate remain under pressure.
“I think we’re going to be living with a series of tough headlines for a while longer,” JP Morgan’s Paolone said. “These things just take a long time to develop.”