Office Space: More Trouble for the Foreseeable Future
Previously published on July 21, 2023 in
By Milton Ezrati, Chief Economist at Vested
Office building developers are facing intensified headwinds. Both developers and lenders are set to lose in this environment. Delinquency rates have already spiked and show every sign of climbing still higher. Especially where the original lender failed to procure sufficient recourse with repayment options, the pain is passing through to those who commercial mortgage bond securities (CMBS). There is little sign of relief any time soon.
The problem lies largely, though not entirely, with the work-from-home legacy of the Covid lockdowns and quarantines. Office workers especially became accustomed to remote work and remain remarkably reluctant to make their former daily trek to city-center offices. That reluctance has found a powerful reinforcement in rising crime and a marked deterioration in the quality of city life. Firms have begun to adjust so that much space in the great glass boxes downtown lies empty and not earning the rents for which they were built. Developers unavoidably feel the pinch.
If that were not all the Federal Reserve’s (Fed’s) inflation fight has propelled interest rates upwards, leaving developers bereft of ways to ease pressures by getting better terms in a refinancing. Many of these developers had hung on, no doubt in the hope that the Fed would change policy soon. But with policy makers making it painfully clear that they intend to raise interest rates still further and hold them at heightened levels until inflation returns to the Fed’s preferred 2% target, those hopes have dissipated. With little way out of the pressures, developers in greater numbers are giving up, walking away from their projects and leaving the proverbial keys with the lenders. The pressure, already acute, is set to intensify, because this year will see the maturation of the interest-only mortgages that had become especially fashionable in recent years, rising from 51% of issues in 2013 to 88% in just this past year.
Figures from the industry are simply depressing. Office real estate values have declined across the country. In San Francisco, values have dropped 60-70% from their peaks of just a few years ago. This city is admittedly a dramatic extreme, but it captures the how bad things have gotten, while anecdotal evidence suggests strongly that value declines on city office space have spread out of the big cities and beyond the big projects.
With values falling and rent rolls thinning, delinquency rates on all forms of commercial real estate jumped to 3.6% in May, the most recent period for which data are available, up considerably from 3.09% in April and 2.99% six months ago. Among the different sorts of commercial space, retail continues to be the most troubled, with a 6.67% delinquency rate. Lodging is second with a 4.25 rate. But the overall May spike was due almost entirely to a sudden rise in delinquencies on office space. There the rate hit 4.02% in May, a major jump from April’s 2.77% rate and a delinquency rate of only 1.70% six months ago.
Anecdotal evidence confirms these dry statistics. Blackstone, one of the largest real estate developers in the world, has given up on two of its prominent properties: the $350 million loan for a Las Vegas office park and a midtown Manhattan office tower that it bought in 2014 for $605 million. Blackstone also alludes to a $274 million loan it took for Club Quarters Hotels in Chicago, San Francisco, Boston, and Philadelphia. These loans have already been transferred to what are called “special services,” a common step when a loan that is headed for default. Nor is the experience of this prominent player unique. And it looks as though the pressure will become still more intense. The Mortgage Bankers Association estimates that some $92 million in non-bank mortgage debt will mature before year end.
Problems have begun to pass through to CMBS investors. Already in May some 6.2% of these securities have transferred to special services, exceeding 6% for the first time since 2013. A disproportionate 41% of this number involve office properties. Accordingly, overall CMBS delinquencies have risen from 2.88% in April to 3.43% in May, well above the year-ago figure of 2.78%.
Little promise of relief exists, at least not any time soon. The trend for remote work becomes more firmly entrenched each day. Crime and quality-of-life matters in major cities will take time to turn. Even the Fed promises months at least before it considers reducing interest rates. Tough times for office properties seem likely to last.