Office landlord defaults are escalating as lenders brace for more distress

The number of big office landlords defaulting on their loans is on the rise, fresh evidence that more developers believe that remote and hybrid work habits have permanently impaired the office market. 

The giant investment manager Brookfield Asset Management recently defaulted on a total of over $750 million in debt for a pair of 52-story towers in Los Angeles, according to a February securities filing. Real-estate firm RXR is in talks with creditors to restructure debt on 61 Broadway, a 34-story tower in Manhattan’s financial district, according to people familiar with the matter. Handing over the building to the lender is among the options under consideration, these people said. 

In another sign of distress, a venture of an investment manager affiliated with Related Cos. and BentallGreenOak is in similar debt-restructuring talks over a $150 million warehouse-to-office conversion project in Long Island City, N.Y., that hasn’t filled up as much space as expected, according to people familiar with the matter.

Five to 10 office towers each month join the list of properties at risk of defaulting because of low occupancy, expiring leases or maturing debt that would have to be refinanced at a higher rate, according to Manus Clancy, senior managing director with data firm Trepp Inc.

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Concerns over the health of the office building industry have mounted throughout the pandemic. The weak return-to-office rate has led to soaring vacancy levels in many cities. Last year’s spike in interest rates increased the cost of buying and refinancing properties and squeezed property values.

Until now, most landlords have been able to stay current on their mortgages because office leases typically run for 10 years or more and lenders have been willing to extend expiring mortgages. 

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The delinquency rate for office loans that back commercial-mortgage-backed securities remains low, but it is heading higher. The rate last month rose by a quarter of a percentage point to 1.83%, its largest increase since December 2021, according to Trepp. Loans backed by office buildings in Philadelphia, Denver and Charlotte, N.C., have also either been transferred to special servicers in recent weeks or have been parts of bond issues that have been downgraded by credit-rating firms.

"Commercial real-estate markets are currently in a recession," said Owen Thomas, chief executive of Boston Properties Inc., one of the country’s largest office building owners, on an earnings call earlier this month.

The growing number of distressed office buildings reflects a recognition by owners and lenders that the robust return to the office they had hoped for isn’t likely ever to materialize. The number of employees returning to the office rate has plateaued at around half the level it was before the pandemic, reflecting the popularity of remote and hybrid work policies. Cutbacks in the tech sector are adding to property owner woes.

Scott Rechler, chief executive of RXR, which owns 91 commercial properties with more than 30 million square feet, said the rise in the office vacancy rate "gives tenants the ability to push pricing. So the market suffers through the transition."

Landlords are taking some comfort that the highest quality office space in good locations still attracts demand. Some also predict that an economic downturn would empower managers to insist that employees work in the office.

But hardly anyone is suggesting that office usage will return to its prepandemic rate. Indeed, in a soon-to-be-released report, commercial real-estate services firm Cushman & Wakefield PLC is projecting that the U.S. will end the decade with a record 1.1 billion square feet of vacant space, compared with 688 million square feet in 2019. 

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"The economy built all this office space for a workforce that was going into the office most of the time," said Kevin Thorpe, Cushman’s chief economist. "Most businesses simply don’t need as much office space as they had before."

For most landlords, losing buildings to creditors after a default would be painful but not devastating. Many investors structure buildings as separate financial entities. If they default on debt, creditors generally can foreclose on the building but have no recourse against the rest of the company.

But the pain from foreclosures is likely to ripple through the financial system. About $1.2 trillion of debt was backed by office buildings at the end of the third quarter last year, according to Trepp.

Banks are bracing for more troubled loans. Wells Fargo & Co. said in January that its nonaccrual loans backed by office buildings—meaning the bank isn’t expecting full interest and principal payments—increased to $186 million in the fourth quarter, up 8% from the third quarter.  

Loan officers are steering away from new mortgages backed by office buildings unless they are fully leased for long periods of time by creditworthy tenants. "It’s like you’re taking a career risk" by making an office loan, said Mr. Clancy of Trepp.

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Office building restructurings often involve deals in which owners agree to put in fresh equity in exchange for reductions in the loan sizes or other new terms. Or an owner might try to persuade a lender to agree to a new business plan, such as one that would involve converting an office building into residential space. 

But at some point, when buildings are clearly worth less than the value of the mortgage, owners are going to return the keys to the lender. "If you think the debt is too high to make the business plan work, there’s no reason to put money into that deal," Mr. Rechler said.

The stress on the office sector will likely take years to resolve. Lenders have numerous financial disincentives to foreclose on properties. Such transactions mean writing down the value of the loans and, in many cases, require the lender to pay transfer taxes.

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In an earlier high-profile distress situation last March, the loan backing 1740 Broadway in Manhattan was transferred to a special servicer because a major lease was expiring. The status of that 26-story office building, owned by Blackstone Inc., hasn’t changed since then, according to people familiar with the matter. 

"There’s a transition period that takes time," said Mr. Rechler, who has been through two other sharp commercial property downturns. "You have to cross the chasm into the new regime."