‘The Writing Is On The Wall’: Office Lenders May Have To Go All-Out Ahead Of Mass Surrenders
For the past few months, reality has been setting in for owners of U.S. office buildings.
Many of them have debt coming due on buildings worth much less today than when their loans were originated. That value destruction has distressed asset buyers lining up to pounce. But before the feeding frenzy can begin, office owners and their lenders have key decisions to make.
Traditional lenders like banks would prefer to extend and modify terms so borrowers can keep holding their properties until refinancing options become available once again. Yet borrowers must decide if those properties are worth the cost of owning them through 2025, when industry predictions say financing and leasing environments will improve.
“There was definitely a hopeful tone in February,” Kim said. “Now, the writing is on the wall. It’s a recognition that we’re in this for the long run, that it’ll be a multiyear recovery … Lenders are trying to restructure now rather than wait for rates to come down, and borrowers are more likely to walk away.”
Signs of that shift have been popping up both in the capital markets and in the public statements of large office landlords. The CMBS delinquency rate shot up in May, with the biggest one-month increase in missed debt service payments since June 2020, according to Trepp data.
Heads of companies like Related Cos., Cantor Fitzgerald and Prudential asset management arm PGIM have all predicted mass surrenders from owners of buildings with rising vacancy and high cost of ownership in the past week. Others, like Monday Properties and RXR, have been making such moves themselves.
Lenders are loath to take office properties back from borrowers in the current environment for the same reasons borrowers want to give them up, and are trying everything they can to reach extension and modification agreements, Kim said. High-profile extensions inked in the past few weeks include a two-year deal pushing Tishman Speyer’s maturity at 300 Park Ave. to August 2025 and a multiyear deal for RFR Realty at 375 Park Ave., also known as the Seagram Building.
“Despite all the pessimism, most people feel like we’ll be on the road to recovery by the end of 2024 or early 2025; that’s the timeline I hear talked about most,” Kim said. “And those are the extensions I’m seeing, too: for a year, two or three.”
The central question facing office landlords deciding whether to hold their properties or give them back is how much they will be worth at the end of a presumed extension, Clancy said. Remote work has all but ensured that most buildings are worth less than they were when their loans were originated, but borrowers have to project how much less, and if they can stomach the costs of maximizing the value that remains.
Beyond carrying costs like property taxes and insurance, property management staff is one of the biggest variable costs that can cut into net operating income, said Arun Nijhawan, managing partner for Atlanta-based office developer and landlord Lucror Resources. And when lease expirations and downsizing take chunks out of a building’s cash flow, the cost-benefit analysis shifts again.
Every block of space that comes vacant in an office building is one that takes millions in tenant improvements to make competitive with new construction, which is plentiful in major markets across the U.S. The wave of new deliveries that hit many urban cores in the past two years is slated to continue into next year, according to CBRE research.
“If you look at buildings up and down Sixth Avenue [in Manhattan] that were built in the 1960s, and one building has a 400K SF lease expiring with the tenant dropping to 100K SF or 200K SF, you’re not just competing with all the similar buildings around you, but with Hudson Yards and new stock like that,” Clancy said. “So you might think, ‘To keep such a tenant, we’d have to pump so much money to compete with new stock, just for them to jump to Hudson Yards anyway.'"
As little as lenders want to own and manage buildings, they have little choice if a borrower gives up and the loan in question is nonrecourse. But lenders still have leverage with owners smaller than giants like Brookfield, which have the clout to be “cavalier” with defaulting on massive loans, Kim said. Everyone else depends on relationships to secure new loans and can ill afford to burn bridges.
“Smaller owners and developers, we don’t have the muscle, we can’t play that game," Nijhawan said. “So it comes back to working with lenders, and we’ll do our best to service the debt, which is the No. 1 goal. Because what would a foreclosure do to our credit and our ability to borrow against other assets?”
As reluctant as they may be to foreclose on an office asset, lenders also know that if a landlord is unwilling to invest in a building for the next couple of years, recouping value at the end of an extension will be even more difficult, Kim and Clancy said. If the landlord shows any willingness to put in equity, then extension terms can get quite creative while a building is in special servicing.
“The one thing special servicers really want to see is some sign of good faith that the borrower is not just taking an extension and pocketing it,” Clancy said. “They want to see some contribution of equity, whether dipping into reserves, paying down the loan or otherwise investing in it. When some servicers balk is when the owner wants a two-year extension but says they’re not going to put another dime in it and don’t believe in it.”
Debt negotiations are carrying on with the assumption that long-term refinancing will again be possible in 2025 — not just because interest rates are projected to remain high until then, but because the office leasing market is not expected to meaningfully improve until then.
“The rainbows won’t emerge this year, but late next year or 2025, people will look around and say, ‘There’s no new construction, there’s excess demand for quality space,’” Nijhawan said.
Considering how little organic desire there seems to be among workers for more in-person work, the majority of companies have put hybrid work plans in place that require less square footage per employee, a Knight Frank survey found. But as the pipeline of new deliveries dries up over the next year and a half, the flight to quality is expected to remain the operative demand driver in most markets.
Optimists regarding the future of in-person work, like Nijhawan, remain, even as he acknowledges the reality check dealt to the office market in the past few months. But whether because of sheer optimism, the need to preserve lender relationships or the promise of sweetheart deals in special servicing, office owners aren’t likely to walk away from their properties en masse anytime soon, Clancy said.
“Offices that are dead buildings walking, like with a massive tenant leaving in 2024, they’re still cash flowing, and office owners could say, ‘You never know,’” he said. “I think finding a bottom is going to take a really long time.”