Office Values Falling, Office Building Debt Rising

Back in March, we wrote about the then-current news of some of the nation’s largest real estate owners defaulting on loans secured by office buildings. At the time, we envisioned a market ripe for borrowers and lenders to engage in work-out discussions; borrowers could retain ownership of their property and lenders could avoid taking losses or being saddled with office buildings with high vacancy rates.

Now, however, as a result of a confluence of factors, including interest rates (at their highest in decades), recent bank collapses, and the continuing normalization of “work-from-home” or hybrid models, it looks like that market may not be as robust as predicted. Office values are projected to drop 44% from pre-pandemic levels by 2029, up 22% from predictions made as recently as a year ago. Subsequently, it is proving difficult for borrowers to refinance the roughly $137 billion of office building debt coming due this year alone.

Some owners have chosen to default on their loans and rid themselves of failing office buildings, like RXR recently did at 61 Broadway in New York City through a deed-in-lieu of foreclosure. But perhaps what is more concerning is that lenders have shown a willingness to accept this course of action and the corresponding losses on their books.[1] In addition to deeds-in-lieu, whereby borrowers transfer to their lenders title to the asset (outside of foreclosure), some lenders are pursuing short sales whereby borrowers sell the property to third parties for less than the outstanding debt. Borrowers are then required to and pay the proceeds to lender, with the lender agreeing to accept such reduced amount and forego the difference owed.[2]

Nevertheless, there has been a recent push by the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) (among others), for borrowers and lenders to engage in work-outs. In recent guidance, US bank regulators have recommended that lenders “work prudently and constructively” with good clients and grant such clients short-term accommodations including payment deferrals and acceptance of partial payments.

In exchange for partial paydowns or the deposit of funds into reserves for leasing costs, commissions and tenant improvements, the owners of Manhattan office properties located at 300 Park Avenue, 375 Park Avenue and 515 Madison Avenue have all been able to reach agreements with their lenders to extend their current facilities. The aforementioned are all Class A properties; they are new, or recently renovated, located in the most desirable neighborhoods and offer amenities that set them apart from the herd of other commercial properties.  

And while Class B or C properties may be older and less desirable, after the new guidance from regulators, owners of these properties may be able to negotiate a work-out with their lenders. Lenders on such properties, when faced with the choice of a work-out or the unenviable position of holding the keys to a Class B or C property, would seemingly be hard pressed to take title to such assets (together with the struggles of leasing-up or reselling such a property). Further, the majority of commercial real estate lending (approximately 80%), is made by smaller lenders (holding less than $250 billion in assets).[3] Many of these smaller lenders may simply not have the luxury of accepting the financial loss a deed-in-lieu or short sale represents.

It is an equally challenging decision for property owners, trying to determine whether or not they let their property go, or throw more money into an asset to extend or modify existing debt. The real dilemma for many office owners arises when the value of the struggling office building asset falls below the current debt on the building (coupled with substantially higher interest rates). The ultimate decision will likely depend on whether or not the bank (or the owner) believe that the office building will stabilize and increase in value in years to come. 

What remains to be seen, however, and what we will be monitoring in the coming months, is whether these loan work-outs (and potential loan modifications) will amount to an opportunity for borrowers to stabilize their office building assets (as opposed to delaying the inevitable deed-in-lieu, short sale or foreclosure).

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[1] Cavanaugh, supra note 1.

[2] Cavanaugh, supra note 1.

[3] Lambert and Daniel, supra note 3.