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'What Do We Do Here?': Distress Signals Are Rising In Major Office Markets

Many questions about the office market's future remain unanswered as the pandemic nears the two-year mark, but one trend has become increasingly clear: Tenants are leaving older buildings in favor of newer projects.

This accelerated shift has left owners of some aging office buildings with large vacancies and insufficient cash flow to pay back their debt, putting billions of dollars of office-backed loans at risk. 

The Chicago office building at 175 West Jackson Blvd., owned by Brookfield Asset Management.

The flight to higher-quality assets had already taken off before 2020, but it reached new altitudes during the pandemic as tenants pushed for better air filtration, outdoor amenities and building sustainability ratings.

Additionally, some are now able to afford the higher-end space by shrinking their leased footprint because of the remote work shift and as the owners of newer buildings offer recordbreaking cash and rent incentives to sweeten their offers.

Given the long-term nature of office leases, these relocations have only occurred for a fraction of tenants that had expirations during the last two years, and this trend will continue to play out for several years. Experts say this will create not a sudden wave, but a continuous trickle of office assets becoming distressed in the coming years.

"The problems going forward are going to come from primarily markets that have sizable amounts of dated properties that are not particularly desirable to big drivers of demand these days," Trepp Senior Managing Director Manus Clancy said. "You’ll see episodes in New York, Chicago and other places where big buildings that back loans with nine-figure balances become distressed."

In December, the CMBS delinquency rate for the office sector rose to 2.53%, up from 1.81% in November, according to Trepp. It represented the highest level since June 2020 in Trepp's office delinquency rate metric, which measures CMBS loans that are 30 days delinquent or more.

A Trepp graph showing the uptick in the office delinquency rate (orange) compared to the overall delinquency rate for all property types (blue).

This increase was driven primarily by four major office buildings becoming 30-days delinquent on their loans last month, according to Trepp. The bankruptcy of Chinese investor HNA Group led its affiliates to become delinquent on loans backed by 245 Park Ave. in New York City and 181 West Madison St. in Chicago.

Two other Chicago office assets went into delinquency last month for reasons more tied to the underlying performance of the office market. Brookfield Asset Management became delinquent on its $259M loan for 175 West Jackson Blvd., which was 62% occupied as of September, Crain's Chicago Business reported. AmTrust Realty became delinquent on its $100M loan for 135 South LaSalle St. after losing Bank of America as a tenant. Brookfield and AmTrust Realty declined to comment. 

Experts foresee more distress coming to the office market this year, and it has become a growing concern among financial market players.

JLL Capital Markets Vice President Kyle Kaminski, a distressed debt specialist, said that while attending the Commercial Real Estate Finance Council conference earlier this month, he fielded more questions about potential distress in the office market than in any other sector. Earlier in the pandemic, he said the conversation typically centered around the troubled retail and hospitality sectors. 

"Hospitality had been the large driver of distressed-based loan sales and at the forefront of most lenders minds, but that has over the course of the last year shifted, and office in general has now replaced hotels as the new, ‘What do we do here?’" Kaminski said. "There’s this view that office has to have some level of distress, that it’s going to cause pain points in most markets.”

DBRS Morningstar Head of CMBS Research Steve Jellinek said he has begun to worry more about the office market in recent months. 

"Office is the sector that keeps me up at night," Jellinek said. "While my gut tells me that we’re going to be OK, that occupancies are going to remain relatively stable, there’s always that nagging in the back of my mind like, 'What’s the next shoe to drop?'"

More than $7B of CMBS loans backed by office buildings are scheduled to come due in the 12-month period beginning in October 2021, according to a Moody's Analytics report released that month. The report identified 28 loans it said had potential risk of not being able to refinance, either because the building has upcoming lease expirations or low cash flow relative to outstanding debt. 

In an update to the October report provided to Bisnow, Moody's said that nine of those potentially at-risk loans have since been refinanced, allowing the owner to hold onto the asset.

Looking forward 12 months from Jan. 1, Moody's found $5.3B of maturing CMBS loans backed by office buildings, down from the $7B October figure because of the recent refinancing deals, according to data shared with Bisnow. Moody's identified around 30 additional loans of $10M or more that are scheduled to mature in Q4 2022 and have potential refinancing risk, including properties in California, Texas, D.C., New York and Michigan. 

Moody's Analytics CMBS Researcher Darrell Wheeler said he was surprised to find that nine of the loans had been refinanced since his October report. He attributed it in part to the rise of a specific type of financing method.

Commercial real estate collateralized loan obligations — or CLOs — tend to finance transitional assets that don't have stabilized cash flow, and they have been growing in popularity. CLO issuances last year totaled $45.4B, according to Moody's Analytics, well above previous levels of $8.7B in 2020 and $20.5B in 2019.

While financing mechanisms may be available for properties without stable cash flow, many buildings do still face risk of default, especially older assets that don't meet the requirements of today's tenants.

245 Park Ave. in New York City

Wheeler said he sees older buildings with large lease expirations as a significant risk because so many of the office leases signed over the last year have been in newer buildings. 

"It is a real risk that we see going on, and the major leases we've seen announced always involve a LEED Platinum or Gold type building," Wheeler said. "There’s demand for that type of space, and we have seen a shift where you do have to be concerned. Can your building be upgraded to that standard?'"

In D.C., for example, the trophy and Class-A office sectors experienced a combined 334K SF of positive net absorption last quarter, while the Class-B office sector — typically older buildings with fewer amenities — had negative absorption of 233K SF last quarter, according to CBRE

The fate of older office buildings and their loans will likely depend on their landlords' financial wherewithal and willingness to put more money into their assets, Fitch Ratings Senior Director Melissa Che said. 

"You’ll have stronger sponsors that may have assets that go through a trough period as occupancy dips, but if they feel like that's a good asset, they'll continue to cover shortfalls," Che said. "Where it's concerning is weaker sponsors that may not be as well-capitalized that see some of these performance drops and occupancy dips."

In some cases where a property has strong underlying fundamentals, such as its location and nearby demand drivers, but an owner with less cash, Che said loan servicers may offer flexibility to help borrowers hold onto their assets. 

"Some of the ones we see that may go through a dip but there’s value in the real estate, some servicers are willing to work with borrowers to buy them more time, help with payment relief and give them time to stabilize," Che said. 

Owners of older buildings that don't have deep pockets or flexible servicers may default on their loan and lose the asset, leading to potential foreclosure sales.

JLL's Kaminski said he sees strong investor demand for distressed assets across all sectors. With distressed office assets, he said values may drop low enough to allow new owners to convert to another use, such as life sciences or multifamily. These conversions have become increasingly common over the last year as older office buildings become more obsolete. 

"You’re going to see a rise in distress, people who aren't able to continue to pay their mortgages, so we’re definitely going to see an uptick in defaults across the space," Kaminski said. "What that means at the office level, I think we’re going to start to see a reset in basis and you're going to start to see conversion into alternative uses."

Kaminski said he expects the rise in distress in the office market to be gradual rather than immediate, a point on which all the experts Bisnow spoke to for this story agreed. 

"I don’t think there’s ever going to be this gigantic wave that just hits the shore and all the sudden there’s all this distress," Kaminski said. "I think it’s just going to be a rising tide throughout the year, and at some point in the future we're going to look up and there’s going to be a significant amount of office out there, and you’ll know you’re in the middle of it. It slowly creeps up on you and continues to rise. Where it stops, I don’t know. That’s the million-dollar question."