Last month’s $111 million deal for the 40-story tower at 445 South Figueroa Street in Los Angeles came after the seller, KBS, sold the class A property as part of a planned liquidation of KBS REIT II. The asset, the last in the fund, was acquired by New York-based Waterbridge Capital for about half of what KBS paid Hines in 2010. BH Properties, a local investor, originated the loan.
“The Union Bank Plaza sale was a significant sale for downtown Los Angeles. While it is a data point, you have to remember that the building is approximately 50 percent leased and has a significant value-added profile,” said Kevin Shannon, co-head of capital markets at advisory Newmark, which arranged the sale on behalf of KBS. “The comp for the sale was $111 million, or about $165 per foot as leased, which is much lower than historical DTLA comps which were in the $400 to $550 psf range for stabilized A buildings and lower for B assets.”
While market participants agree that KBS completed substantial renovations to bring the kind of amenities and finishing tenants want to the property during its hold, the building – like others in the downtown Los Angeles sub-market – are being affected by the same headwinds.
“The office sector has had headwinds to varying degrees and Los Angeles, which is made up of roughly 30 sub-markets, has markets like Century City that are doing great and others that are struggling with higher vacancy rates,” Shannon said. “Downtown Los Angeles will take a while to come back but buyers who take advantage of this down cycle will make significant profits longer term, this is just a moment in time. The other factor contributing to lower sale comps is uncertainty. The cost of capital is uncertain, and the lending environment is uncertain because of recent bank failures.”
There was a final factor affecting the sale – tight deadline that stemmed from the need to close the transaction prior to the implementation of a transfer tax in the city of 5.5 percent for assets of this size, Shannon added.
Los Angeles in the spotlight
The situation with Union Bank Plaza unfolded shortly after a fund managed by Brookfield Properties defaulted on $784 million of loans on two well-known Los Angeles skyscrapers. Brookfield DTLA Fund Office Trust Investor did not exercise an option to extend a $465 million loan on Gas Company Tower at maturity on February 9. Meanwhile, the Brookfield fund opted not to obtain an interest rate protection agreement on a $318.6 million loan on 777 Tower, which also constituted a default.
The situations have some similarities, with a pair of sponsors facing time constraints in the execution of their business plans on high-quality, urban assets at a time of unexpected volatility. Brookfield opted to default ahead of pending maturities at a time when the office leasing and occupancy market in Los Angeles has been slow while KBS was coming up against the end of the life of a fund.
Data from Newmark pointed to a vacancy rate of 21.8 percent in the first quarter amid distress in downtown Los Angeles and solid activity in Century City. Starting rents in the entertainment-heavy Century City sub-market are about $7 per square foot, compared to about $4 in downtown Los Angeles. Additionally, vacancies in trophy-quality properties in Century City are at 8.2 percent, compared to 17.9 percent for similar assets in downtown Los Angeles.
Despite these headwinds, there is a growing play from contrarian investors. While Newmark has observed that institutional equity remains largely on the sidelines, family office investors, syndicators and foreign buyers are all using the current dislocation as a change to expand their portfolios and are showing interest in assets like Union Bank Plaza.
“Office is more of a contrarian play but historically, contrarian plays have paid,” Shannon added.
Another brick in the wall
The sale also comes as the US office sector has been hit by a series of negative metrics, with a record vacancy rate in New York’s office market, a negative outlook from Standard & Poor’s for office-focused real estate investment trusts, and lower real-time demand for office leasing in major markets. A report released on April 6 from Trepp highlighted an uptick of 34 basis points in specially serviced office loans on a month-over-month basis.
Alex Killick, a managing director at CW Capital, said the special servicer is seeing a measured approach from sponsors and lenders. The firm has closed a few loan extensions on large office loans with sponsors that are committed to the assets.
“[The sponsors] are willing to put in new money, willing to just get through a downturn and come out on the other side,” Killick said. “We are seeing, though, a lot more office distress, particularly as loans mature, and we are seeing some institutions who are being very just coldly rational about their investments and saying, ‘This doesn’t work when we’re not going to be able to pay off the loan at maturity.’”
He continued: “No one is in a rush to foreclose, if you can get a deal done. Office is very capital-intensive. There’s a perception right now that we have probably not hit bottom on office. I think that’s holding up [activity] across the industry. But that doesn’t go on forever, so I do think we’ll see more office distressed before things improve.”
The view from New York
Performance throughout the US varies by market and New York’s once high-flying office market hit a dubious milestone in the first quarter – a record vacancy rate of 16.1 percent, according to data from advisory JLL.
The firm, which tracks 470 million square feet of space, saw first-quarter leasing activity of 4.6 million square feet; this number reflects a continued slowdown. It also is demonstrating more signs of potential distress, said Andrew Lim, director of research at JLL.
“This was the most forecasted recession we have ever had but so far, it hasn’t yet actually happened,” Lim said. “We are still not seeing a correction in asking rents in New York, but we have seen vacancy rise to the highest levels we’ve seen. When you look at vacancies, it is important to understand that about a third of the space that is vacant has been vacant for two years. In the downtown market, for example, 40 percent of vacant space downtown has been vacant for two years.”
There is a confluence of factors which are concerning to landlords and lenders – including higher interest rates, increased borrowing costs, tighter access to capital and the banking crisis – which are starting to play out. JLL is starting to see valuations drop, with Lim noting about 27 percent of trophy, class A and class B assets are now valued less than their last sale price.
“The next couple of quarters will really tell us how deep the situation may get in terms of landlords going under or assets becoming distressed,” Lim said. “A drop in valuations will have an effect as loans mature and landlords have more difficulty servicing that debt. [It] will also affect their ability to attract and retain new tenants. One of the reasons why rents haven’t changed is that landlords can negotiate on other parts of the lease, with more concessions. But if their access to capital changes, they will have to use rent as a negotiating tool.”
Like many other market participants who have spoken to Real Estate Capital USA, the focus is on surviving the current period of dislocation, Lim said.
“Landlords are doing what they can to live another day,” he explained. “They want to maximize profits and sign 10-year leases but they’re now willing to break even on a five- or seven-year lease because they’re trying to wait it out, if they can. Office attendance rates have been creeping up and with the softening of the labor markets, more companies are saying you need to be in the office two or three days a week or even more. Whether or not it comes in time for landlords or a lot of buildings is still not clear.”
There is a broad consensus that the office market will be soft for a few years, with particular concern for the impact of near-term maturities. But there are things that are improving.
“The work-from-home impact has been real and while the trendline is improving, with employers requiring their workforce back in the office, it will still take time to heal,” Shannon said.
The uncertain cost of capital is also a factor.
“As of today, people are betting the Federal Reserve will raise rates by 25 basis points on May 3, but I think we are getting closer to the end of this cycle. From there, we will start to see spreads tightening,” Shannon said. “The 10-year Treasury has been at a level around 3.75 percent recently but because we don’t know how high rates are doing, spreads are wider than they should be. Historically, this has calmed down when lenders have more clarity on what the Fed is doing but right now is a moment of time when there is a lot of uncertainty.”