Since the early days of the pandemic, owners of large buildings in New York and other major cities have been eager for their commercial real estate businesses to rebound as workers return to the office.
Four years on, hybrid working has become the norm, putting increasing strain on property owners, with some properties being foreclosed and sold well below their appraised value in less than a decade, resulting in huge losses for investors.
The number of office buildings in crisis remains small, but the number has surged this year. Investors, lawyers and bankers expect the pain to grow in the coming months as demand for office space remains weak and interest rates and other costs reach their highest levels in years. Older buildings with lots of vacant space and big loan repayments looming could be especially in trouble.
The impact goes beyond the owners and lenders of these buildings. A sustained decline in commercial real estate values threatens to reduce the property tax revenues that cities like New York and San Francisco rely on to pay payroll and provide public services. Vacant or nearly vacant office buildings also hurt the companies that occupy the space and the restaurants and other businesses that serve their employees.
“There's going to be a lot more problems ahead,” said Mark Silverman, partner and leader of the CMBS special services practice at law firm Locke Lord, which represents lenders in disputes with commercial mortgage borrowers. “If you think it's bad now, it's going to get a lot worse.”
The scale of the problem is difficult even for real estate experts to assess because of the variety of ways commercial buildings are financed and the varying rules about what must be disclosed.
Roughly $737 billion in office loans are spread among big banks, regional banks, insurance companies and other lenders, according to real estate research firm CoStar and the Mortgage Bankers Association.
Delinquency rates for office building loans, which are part of commercial mortgage-backed securities, rose to about 7% in May from about 4% a year earlier, according to data and research firm Trepp, but only about $165 billion of office loans are packaged into such securities.
Foreclosures, which can happen months or even a year after property owners fall behind on their payments, are also on the rise: About 30 buildings financed by commercial mortgage-backed securities were foreclosed on in April in Dallas, New York City, San Francisco and Washington, according to Trepp, up from 12 at the start of 2023.
Several buildings around the country have recently sold for a fraction of their pre-pandemic prices.
In May, insurance companies, banks and other investors in the top-rated triple-A bonds of commercial mortgage-backed securities exchanges, generally considered to be roughly as safe as Treasury bonds, lost $40 million, or about 25%, of their investments. Holders of lower-rated bonds in the same commercial mortgage exchanges lost their entire $150 million investment.
The 1740 Broadway building that secured those bonds was purchased by Blackstone for $605 million in 2014. Blackstone had borrowed $300 million against the 26-story building near Columbus Circle. This spring, it was purchased for less than $200 million.
“When you see delinquencies and foreclosures rising, it means we're getting closer to the acceptance stage of the office property loss process, and that's healthy,” said Rich Hill, head of real estate strategy and research at investment firm Cohen & Steers. “But we haven't hit bottom yet.”
Hill said it could take until later this year or around 2025 for the extent of the office market's problem to become clear.
Office leases are often long-term, around 10 years, to give property owners time to recoup their investments and brokerage fees, and the longer leases allow investors to collect interest on the hundreds of millions of dollars, sometimes as much as a billion, they lend to developers.
As a result, tenants' decisions to downsize may take a long time to affect the market. Plus, some mortgages written at low rates haven't yet had to be refinanced. But the longer rates remain high, the greater the chance that buildings that were profitable when rates were near zero will find themselves in trouble.
A slow negotiation process then takes place between borrowers and lenders, looking for ways to reduce potential losses by renegotiating or extending the loan.
“Expectations are building, but they're going to take some time to materialize,” said Anthony Paolone, co-head of U.S. real estate equity research at JPMorgan.
Part of the delay is due to the difficulty of appraising buildings in the wake of the pandemic, making it hard to know a building's true market value until enough units have sold.
“A lot of it is just spreadsheet calculations at this point because there's no trading activity to prove it,” Paolone said.
The sales that took place signal a serious decline in commercial real estate values.
This spring, a 1980s office building at 1101 Vermont Avenue in Washington sold for $16 million, a big drop from its $72 million valuation in 2018. And near Chicago's Willis Tower, an investor late last year bought a landmark building at 300 West Adams Street for $4 million that sold in 2012 for $51 million.
“There's been a long period of no activity, so there's been a lull,” said Alex Killick, managing director at CW Capital Asset Management, a special services firm that works with delinquent debtors to recover funds for holders of commercial mortgage-backed securities. “Now we're starting to see some activity. Finally we have data to work with.”
Some data suggests the problem is concentrated in a small number of buildings: U.S. office building vacancy rates are about 22%, but about 60% of that vacancy is in 10% of the nation's office buildings, according to commercial real estate services firm Jones Lang LaSalle, suggesting the problem is concentrated rather than widespread.
Another silver lining, analysts say, is that the problems at office buildings don't seem to be putting banks at risk. After the collapse of Silicon Valley Bank and First Republic Bank last year, some investors had worried about the health of other regional banks that are big lenders to the commercial real estate industry. But few commercial mortgages held by banks are in arrears, according to the Commercial Real Estate Finance Council.
Newer luxury buildings in New York have been largely unaffected by the situation and can charge as much as $100 per square foot in rent, double what older buildings can charge, according to the New York City Comptroller's Office.
The problem is most acute for building owners who are facing large numbers of tenants as mortgage payments come due: About a quarter of existing office mortgages held by all lenders and investors, or more than $200 billion, are due to come due this year, according to the Mortgage Bankers Association and CoStar.
Investors are eager to lend new money to warehouse and hotel owners, but few are willing to refinance their office loans.
This could mean the end of a tactic that has grown popular in recent years called “extending and cheating,” in which lenders agree to extend mortgages in the hope that giving building owners more time will allow them to attract more tenants.
That approach is born in part out of an expectation among landlords and lenders that the Federal Reserve, which has been raising interest rates for the past two years, will ease or cut them relatively quickly. In recent months, most economists and Wall Street traders have concluded that the Fed is unlikely to cut rates too quickly or return to the ultra-low, pre-pandemic levels.
“Everyone was systematically holding their breath, hoping that the Fed's sharp rate hikes would be tapered off just as quickly, allowing people to breathe easier and rates to return to lower levels,” said Ethan Penner, CEO of Los Angeles real estate firm Mosaic Real Estate Investors. “But that hasn't happened, and lenders have a limited amount of time to offer borrowers patience and a blind eye, especially as rental income starts to decline.”
Another widely held hope in the real estate industry was that more companies would ask employees to return to the office more frequently, but that also failed to materialize.
While law firms and the financial services industry leased slightly more office space than pre-pandemic levels, many other industries scaled back. As a result, new leasing, measured by square feet, was down about 25% from 2019, according to Jones Lang LaSalle.
Over the course of a week, on average, about half of New York's office workers show up to the office, roughly in line with the national average, according to Castle Systems, which tracks how many employees swipe ID badges in commercial buildings.
These figures illustrate the smaller role that the office now plays in the lives of many white-collar Americans. The change is occurring at a time when the U.S. economy is doing well, suggesting that problems in the office market may not pose a systemic risk to the financial system.
But property owners, their lenders and others involved in commercial real estate remain under pressure.
“We're going to see some tough headlines for a little while longer,” JPMorgan's Paolone said. “These issues are just going to take a long time to resolve.”