- Office owners small and large facing loans they can’t pay or refinance increasingly have chosen to give the keys back to their lenders.
- The resulting losses eventually impact the $1 trillion U.S. market for commercial mortgage-backed securities (CMBS).
- Real estate investment giant Blackstone, the world’s biggest commercial landlord, has bailed on numerous office properties.
The downturn in the market for commercial office space has caused an increasing number of distressed property owners to make the decision to simply walk away—from mortgages they either can’t pay now or can’t afford after they refinance at starkly higher interest rates.
Owners from small niche property developers to private equity giants such as Blackstone, the world’s largest commercial landlord, have all made that decision in recent months. The trend adds another troublesome wrinkle to a commercial office market riddled with troubled loans, rising delinquencies and plunging property values.
“There are a lot of owners kneeling down and going to church,” said Vince Schwab, executive managing director in the San Francisco office of real estate investment broker Marcus & Millichap. “I’m kidding, but it’s kind of true.”
“It’s going to be a long haul. There’s a lot of stuff going back to the bank,” said Schwab.
Darin Mellott, vice president of capital markets research with commercial real estate and investment services firm CBRE, concurs.
“There are some market players who have made the determination that, ‘We’re giving the keys back,'” Mellott said, adding there’s a basic problem with that: “Lenders don’t want to be asset managers.”
That means loan losses will flow substantially to investors in securities backed by expected cash flow from commercial mortgages—a $1 trillion U.S. market.
Bad Loans Don’t Discriminate
In a disparate office market that fluctuates depending on property type and location, some attractive properties continue to command record-high rents.
However, other swaths of large metropolitan downtown areas face outright collapse. Schwab said office values in downtown San Francisco, on a square-foot basis, have dropped 60-70% from their peak just a few years ago.
Though property age, type and location may discriminate, the size of the deal or loan does not. Schwab, who specializes in deals of less than $30 million, said offices of all types and sizes face loan problems. And when owners bail, the downstream effects take time to work out.
“It’s really a case-by-case basis,” Schwab said. He noted a lot depends on a lender’s recourse agreements, the terms of any commercial mortgage-backed debt security (CMBS) containing a defaulted note, and underwriters and brokers involved in the original deal.
Regardless, he said, it’s always a complex process.
More and More Troubled Notes
It’s also a process that’s becoming more common. Delinquency rates on U.S. commercial office property reached 4% in May, more than double the 1.7% rate of just six months ago.
Meanwhile, the number of commercial mortgage-backed securities loans transferred to so-called “special servicers” have spiked. Special servicers take over troubled loans or loans in default from master servicers of CMBS loans, who normally handle payments and communicate with borrowers.
In May, loans on office property made up 41% of all commercial property loans transferred to special servicers, and the number of office loans in special servicing increased to 6.2% of all office property loans. That’s up from 3.6% just six months ago and the first time in 13 years the special servicing rate exceeded 6%.
As they did during the subprime home-lending frenzy that precipitated the 2008-09 global financial crisis, interest-only loans now haunt the market. Such loans accounted for 88% of CMBS issuance in 2021, up from 51% in 2013.
Surging interest rates have made refinancing those loans a losing proposition for office property owners. This year alone, the Mortgage Bankers Association estimates that $92 billion in non-bank office debt will mature. Borrowers will either need to refinance that debt, default on it or sell the underlying property.
Blackstone, the real estate investment giant that earlier this year raised $30.4 billion for its latest fund, has chosen to walk away more than once.
The firm stopped making payments in March on both a $325 million loan for a Las Vegas office park it owns and a Midtown Manhattan office tower it bought in 2014 for $605 million.
In addition, the firm reportedly has considered walking away from a $274 million loan it took it in 2017 to buy Club Quarters hotels in Chicago, San Francisco, Boston and Philadelphia. A special servicer took over that loan in June 2020, as travel halted abruptly in during the Covid-19 pandemic. Blackstone hasn’t made a payment on the loan since then.
Correction—June 27, 2023: A previous version of this article misspelled the name of the expert from CBRE. It’s Darin Mellott.