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Office Defaults, Foreclosures Expected To Escalate In Dallas

Owners and developers of office product in Dallas are battening down the hatches ahead of what they predict will be an especially turbulent back half of 2023.

Funding for office projects — both new and existing — has been limited for many months now, and recent failures in the banking sector are expected to further constrain liquidity. Owners staring down the end of their loan terms will likely be hard-pressed to find new debt, which many expect will lead to an increase in defaults and foreclosures.

Gensler's Justin Bashaw, Bank of Texas' Mandy Austin, Newmark's Susan Arledge, Morrison & Head's Ryan Chismark, Granite Properties' Will Hendrickson and VCC Construction's Derek Alley

“I think we will see additional distress on the horizon in office,” Will Hendrickson, senior managing director of Granite Properties, said at a March 23 Bisnow event held at the Marriott Dallas Uptown. “I shy away from using terms like 'wave of distress' or 'tsunami of distress,' but we’ll have pockets of distress.”

Dallas’ strong employment growth, robust talent pipeline and laissez-faire business environment has kept its office market fairly insulated to date, but the effects of remote work, the tightening of monetary policy and fears of an impending recession are beginning to take a toll.

The market has a record amount of sublease space, top-line rent growth has stagnated, and cap rates are inflating. All of that translates to lower values that challenge refinancing, which could lead to an uptick in dispositions during the latter half of the year, said Ryan Chismark, partner at property tax consulting firm Morrison & Head.

“The silver lining on all of that is there are opportunities out there for somebody who has been holding on to an asset for a while,” he said. “They may feel more comfortable with the return, and I think sellers in the next three to six months are going to be more willing to meet the market.”

Some owners may have no choice but to relinquish control of their buildings, said Adam Jackson, chief investment officer at Stream Realty Partners. This has already played out at some Dallas properties, including The Towers at Park Central, PIMCO’s 846K SF, Class-B office complex at the High Five Interchange.

“The cost of debt is going to force the hand of a lot of these older office projects and cause them to be physically restructured,” Jackson said. “We anticipate a pretty strong amount of foreclosures over the coming years, similar to what happened in the ’80s.”

Some owners of distressed office stock are considering conversions to multifamily. In the downtown area, five office-to-resi projects are expected to knock 6.5% off the CBD’s vacancy rate, according to a study by JLL.

For certain buildings, conversions can breathe new life into an underutilized space, but for others, especially those in suburban markets, the math doesn’t work, Hendrickson said.

Kensington Vanguard National Title's Zach Sams, NINE dot ARTS' Jackie Fraser, VanTrust Real Estate's Bill Baumgardner, Stream Realty Partners' Adam Jackson, Innovan Neighborhoods' Maggie Parker and Omniplan's Jeff Slajer

“We’ve looked at [conversions] on a couple of projects, and what we’ve found is we needed urban rents to make the projects work and to convert them to multifamily,” he said. “We couldn’t pencil it out.”

A proprietary tool developed by Gensler measured the viability of resi conversions for hundreds of office buildings and found that only 30% make good candidates. The other 70% are either too new or too distressed to make a conversion pencil.

“Bad office buildings make for great residential properties; good office buildings are the challenge,” Gensler Design Director and Studio Director Justin Bashaw said. “We work with some developers right now who have invested a lot into amenitizing their office assets, and some of those are still sitting empty.

“We’ve tried very hard for years to shove the city into one building and give it all the amenities it needs,” he said. “We really need to start thinking about putting the building in the city.” 

About half of Texas’ office stock was built in the 1970s and 1980s, product that Jackson said falls short of meeting the demands of today’s workforce. In many cases, he said, the wisest option is to demolish the building and start from scratch.

“We see investors too often trying to rationalize using the existing physical structure,” he said. “In Dallas, we have a bunch of older buildings in really good locations, and the value of the land is far more valuable than the quality of the improvements.” 

The future of office is uncertain, and the next several months are poised to be especially challenging. But there are opportunities in a downturn, and companies that are well-capitalized and willing to pivot will likely make it through stronger than before, said Derek Alley, CEO of VCC Construction

“In some of this pain, great opportunity can manifest,” he said. “These painful moments will be looked back on by many as the inflection point of where they rethought their business and brought some really great innovation to the table.”