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The Brutal Reality of Plunging Office Values Is Here

The shakeout in the $20 trillion US commercial real estate market has long been delayed for a simple reason: No one could figure out just how much properties were worth. And, more crucially, few wanted to.

Since the Covid-19 pandemic upended the use of real estate around the world, lenders have had little incentive to get tough on borrowers squeezed by soaring interest rates and take on loans that had lost value. Transactions ground to a halt as potential sellers were unwilling to unload buildings at distressed prices — an outcome that allowed them to pretend that nothing had fundamentally changed.

For many, the time to wait it out is nearing its end.

Across the country, deals are starting to pick up, revealing just how far real estate prices have fallen. That’s spurring widespread concern about losses that can ripple across the global financial system — as underscored by the recent turmoil unleashed by New York Community Bancorp, Japan’s Aozora Bank Ltd. and Germany’s Deutsche Pfandbriefbank AG as they took steps to brace for bad loans.

In Manhattan, brokers have started to market debt backed by a Blackstone Inc.-owned office building at a roughly 50% discount. A prime office tower in Los Angeles sold in December for about 45% less than its purchase price a decade ago. Around the same time, the Federal Deposit Insurance Corp. took a 40% discount on about $15 billion in loans it sold backed by New York City apartment buildings.

It’s a turning point for the market as the Federal Reserve ends the fastest pace of interest-rate hikes in a generation — providing more clarity to real estate investors on where borrowing costs stand. Some property owners will have little choice but to sell as their debt come due: More than $1 trillion in commercial real estate loans are set to mature by the end of next year, according to data firm Trepp.

The fallout stands to reverberate widely. In the past decade of rock-bottom rates, global investors piled into offices and other commercial buildings as a perceived safe alternative to bonds. American cities from Los Angeles to New York have counted on top-dollar office values to help fill their property-tax coffers. And lenders — particularly US regional banks — are loaded up on loans for buildings that are now worth a fraction of their initial price.

Eventually, they’ll be left with no choice but to grapple with the black hole on their balance sheets and the ramifications of recognizing reality.

“Things can’t just sit forever,” said Josh Zegen, a co-founder of Madison Realty Capital. “If you have some trades, and values are coming down, that’ll force some of the mark-to-value conversations.”

The magnitude of the crisis is up for debate. Treasury Secretary Janet Yellen said last week that losses in commercial real estate are a worry, but that the situation is “manageable,” a similar sentiment expressed by Fed Chair Jerome Powell in a 60 Minutes interview on Feb. 4. Others have more dire outlooks, with real estate investor Barry Sternlicht predicting $1 trillion in office losses.

As more transactions add transparency to the market, investors will have to recapitalize loans to reflect lower values, said Scott Rechler, chief executive officer of New York landlord RXR. His firm defaulted on a $240 million loan tied to a lower Manhattan tower last year after determining it wasn’t worth putting more money into it. But it has also formed a venture with Ares Management to potentially snap up distressed properties.

Rechler compared the market’s pain to the five stages of grief, which start with denial, anger, bargaining and depression.

“In 2024, we’re at that fifth stage of grief,” he said. “People are now in acceptance.”

Extend and Pretend

For years, lenders have employed the so-called “extend-and-pretend” strategy, focusing on lengthening loan terms during periods of turmoil while ignoring short-term valuations. It worked well during the pandemic, when they faced delinquent loan payments as offices, stores and hotels emptied out. It didn’t make sense taking giant cuts on loans, since it wasn’t clear whether the issues were just a short-term, pandemic-related blip.

Unfortunately for them, the crisis gave way to runaway inflation and eventually, a series of interest rate hikes that sent the paper values of buildings plummeting. The problem is exacerbated across the office sector, which hasn’t recovered from record vacancies spurred by remote work. That issue is particularly acute in the Americas, where return-to-office metrics are lower than in Europe and Asia, according to real estate brokerage Jones Lang LaSalle Inc.

While prices for offices have tumbled in financial centers from London to Tokyo, US cities have seen particularly big declines. San Francisco, which for years benefited from booming demand from tech companies, had the country’s highest rate of available office space in the fourth quarter, at 37%, according to brokerage Savills. New York is faring better, with a more diversified tenant base including financial services, legal and media firms, but nearly a fifth of its office stock is available to rent.

Even as building values in those areas slump, prices would have to decrease more for transaction activity to reach normal levels, according to MSCI Real Assets.

The plunging US values are being felt around the world because properties in top-tier American cities were once magnets for global investment. Offices were seen as super safe bets backed by high-quality assets with long-term leases and rising rents. That’s now coming back to bite.

It’s why pockets of distress have cropped up in areas as far away from the US as Germany and Japan. As more loans near their maturity dates and investors write down properties or walk away, lenders across the world will have to stockpile more reserves to deal with possible losses. But exactly how this plays out for each company will largely depend on the qualities of each of their loans, meaning distress may pop up in different areas at a variety of times.

Germany’s Deutsche PBB and Aareal Bank AG have seen their unsecured borrowing costs climb as investors scrutinize their books for bad US loans. South Korean banks and asset managers, among the largest investors in European and US commercial buildings in recent years, are also bracing for a wave of problematic debt.

The issues have also hit Canada. Sun Life Financial Inc. saw the value of its US office investments plunge, with particularly pain around one San Francisco building. Pension fund CPPIB recently sold a stake in a Manhattan office tower for just $1, on top of the assumption of mortgage debt and working capital, according to a person familiar with the matter.

Mounting Distress

The distress traces back to issues stemming from Covid — like reduced office demand or apartments that were overbought in the pandemic frenzy at peak values — and is exacerbated by much higher borrowing costs.

As of December, offices accounted for 41% of the value of distressed US properties, which stood at nearly $86 billion, according to MSCI. Potential distress, which refers to the erosion of an asset’s current financial standing, is at nearly $235 billion across all property types.

Apartments are high on that list, with more than $67 billion in potential distress. More than 30% of that value is tied to buildings bought in the last three years, many at peak prices.

Apartment landlords are facing much different issues than office owners with a glut of space; there’s still a shortage of housing across most cities. Distress in the sector instead stems mostly from surging borrowing costs. After investors clamored into the market in the easy-money days of 2021, spiking interest rates took a bite out of building values, just as owners needed to refinance. Rent growth has flattened since then, as developers added new apartments at the fastest clip in generations.

Some lenders are already quietly trying to offload loan portfolios attached to real estate. Capital One Financial Corp. sold a large office loan portfolio last year, and was in the market with portfolios comprised of both performing and non-performing debt tied to offices and apartments in New York. Canadian Imperial Bank of Commerce is looking for buyers for roughly $316 million of loans tied to US properties, too.

Many banks still prefer to work out deals with existing landlords, such as offering loan extensions in return for capital reinvestments toward building upgrades. Still, that approach may not be viable in many cases; big companies from Blackstone to a unit of Pacific Investment Management Co. have walked away from or defaulted on properties they don’t want to pour more money into. In some cases, buildings may be worth even less today than the land they sit on.

“When people hand back keys, that’s not the end of it — the equity is wiped but the debt is also massively impaired,” said Dan Zwirn, CEO of asset manager Arena Investors, which invests in real estate debt. “You’re talking about getting close to land value. In certain cases people are going to start demolishing things.”

With all the headlines of doom and gloom, it’s easy to lose track of the fact that it’s still early. It’s common for commercial mortgages to have five-year or 10-year terms that amortize on a 30-year schedule, leaving balloon payments that need to be paid off or refinanced when a loan comes due.

To a large degree, lenders have been willing to modify loans to avoid foreclosure for as long as possible, increasing the chances of finding better solutions. There’s still the chance office demand will improve or a borrower will gain enough confidence to inject new capital, particularly if the US is successful in avoiding a recession.

“I think if interest rates go down, which they’re supposed to, some of these guys are going to skate through this narrowly,” said Nicole Schmidt, managing partner of Oberon Securities. “The government isn’t interested in any kind of financial meltdown.”

Delaying also gives banks time to build reserves they’ll need to write down the value of troubled loans. Other lenders have shown a tendency to stretch things out as well. In the last cycle, delinquencies on commercial mortgage-backed securities peaked at more than 10% in July 2012, nearly four years after Lehman Brothers Holdings Inc. filed for bankruptcy protection. The current delinquency rates on securitized loans is 4.7%, according to Trepp.

Bank Reserves

Some banks have been stashing away extra cash to help insulate themselves from falling values and potential defaults. Wells Fargo & Co. had $3.9 billion set aside for potential commercial property losses at the end of last year, up from $2.2 billion a year earlier. U.S. Bancorp, the biggest regional bank by assets, increased its provisions for credit losses in the fourth quarter by $111 million — or nearly 28% — compared with the same period a year ago, a move partially driven by commercial real estate, it said.

Bigger banks can weather the turmoil more easily since they have built large reserves to deal with potential losses and can also rely on other large lines of businesses, like credit cards and investment banking. For smaller to medium-sized banks, the problems could be much greater.

Regional lenders account for 70% of the commercial real estate debt maturing through 2025 that’s on banks’ balance sheets, with the top 25 banks making up the rest, according to a Morgan Stanley report this week. The regulatory landscape for regional lenders also is changing, which could boost the cost of their liabilities and limit their ability to deploy capital, making them even more vulnerable, the company said.

As with any market dislocation, there’s opportunity: Potential buyers and investors have armed themselves with some $402 billion to target commercial real estate deals, according to JLL’s data as of October. Firms such as Blackstone, which had written off the Manhattan office tower at 1740 Broadway two years ago, are looking to put money to work. The world’s largest alternative-asset manager closed a record-breaking property fund last year after securing more than $30 billion in capital commitments.

In San Francisco, buyers are scooping up steep discounts. The downtown office tower 201 Spear St. was recently taken over at close to half of its value a decade ago after the previous owner turned the building over to its lender. On a square footage basis, the city’s office properties are selling at prices near those of market bottoms after the dot-com bust and the financial crisis, according to JLL.

Such deals may wind up looking like prescient purchases, but they’re also potential bombshells on the balance sheets of lenders.

“You can’t ignore that anymore,” Rechler said of falling values. “Depending on the severity of it, we’ll see who has actually marked appropriately and who hasn’t.”

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