The US Class B office sector has reached an inflection point. After weathering two years of pandemic-induced headwinds, real estate executives are asking a key question: is there a viable future for these properties or is the best option to clear the deck and start over? Either way, banks, insurance companies and alternative lenders will play a critical role in what happens next to this vast supply of aging stock.

The present challenge for Class B office buildings is considered straightforward. As workers return to offices, they generally want to be in newer buildings with top-of-the line accommodations, solid ESG credentials and good air and light. But in most major US cities, the vast majority of office space is made up of outdated properties which struggle to offer these things.

Sadhvi Subramanian
Sadhvi Subramanian: ‘Cap rates will probably increase in the long-term, we will have to look at re-tenanting costs and operating expenses which we have not looked at as closely in the past’

In New York City alone, there is more than 150 million square feet of Class B office space, and 90 percent of those buildings are at least 50 years old, according to broker JLL’s data. The conventional wisdom among commercial real estate debt and equity professionals is that, in order to survive, many of these buildings – and those in other cities – will either need to be comprehensively redeveloped or repurposed. Some might simply need tearing down.

Bryan McDonnell, head of insurer platform PGIM’s US debt business and chair of global debt for its real estate business PGIM Real Estate, tells Real Estate Capital USA he expects the conversion or revitalization wave to be a slow transition. “I do think you are going to start seeing more renovation plays in some Class B offices,” McDonnell says. “You are seeing them getting converted out of office into something else.”

Nonetheless, McDonnell is unsure whether the future of the office landscape will look dramatically different as a result of any such conversion wave, noting more people than may be anticipated could go back to an office-focused lifestyle over the next decade.

The leasing picture

Aa a result of the pandemic, New York City and other primary markets – including Los Angeles, Chicago, Seattle and San Francisco – all saw vacancy rates rise, leasing activity drop and absorption encounter similar disruption. Leasing activity in particular could have additional headwinds, with a record amount of US office space set to go back on the market in 2022 because of a flurry of expirations coming up this year. JLL data shows the leases for 243 million square feet will expire this year, nearly 11 percent of the country’s total leased office space.

The pandemic has spurred on the expiration trend in part because tenants sought out short-term extensions from 2020 onward to better accommodate hybrid setups. Even in burgeoning metropolitan areas such as Houston, the effects of such hybrid working plans are resulting in half-empty office floors, according to the local downtown advisory Central Houston.

Boulevard of broken dreams

Financing and refinancing existing Class B office assets in the current market has already proved to be its own challenge in New York especially.

850 Third Avenue, currently owned by the Chetrit Group, serves as one such example of a Class B office where headwinds have picked up as a result of the pandemic.

New York property company Chetrit bought 850 Third Avenue in 2019 from Chinese conglomerate HNA Group for $422 million, though its largest tenant – Discovery – was already set to move its headquarters away from the Midtown East asset at the time of the purchase. Mike Brotschol, managing director and co-head of New York-based data and research provider KBRA Credit Profile, tells Real Estate Capital USA occupancy subsequently declined at 850 Third Avenue from 91 percent at the end of 2019 to 57 percent by the end of 2020.

KCP data shows the property transferred into special servicing in June 2021 but its junior note was paid off the next month with its senior note later retired in October 2021. Chetrit did not respond to comment on the asset’s financing or occupancy history. In October 2021, Chetrit refinanced 850 Third Avenue with a $320 million loan to attract a sizable new tenant to what was previously a half-empty office space. Prior to securing the loan from New York-based manager HPS Investment Partners, the property was at risk of foreclosure after lagging on a $177 million securitized mortgage and the loan’s maturity timeline, according to sources familiar with the property.

“The price and value of Class A assets have appreciated more significantly than Class B due to a flight-to-quality,” Brotschol tells Real Estate Capital USA. KCP research indicated a 15 percent increase in Class A office sales between 2019 and 2021 compared to only a 6 percent gain for Class B properties.

Brotschol says offices with gyms, on-site dining, covered parking and operative areas where employees can easily move around and collaborate make the difference for attracting people back into the office. “That tends to favor Class A over Class B,” he says. “Looking at Class B, I do not think it is hopeless. They are still competing by offering rent concessions and tenant-specific upgrades. These strategies may ensure survival but will undoubtedly stress cashflows and values.”

KCP has also seen a higher level of functional obsolescence in Class B buildings because the inventory tends to be older and often less pandemic-friendly because it cannot accommodate social distancing standards.

Meanwhile, for US office tenants maintaining or upgrading space, demands for the ideal asset have ticked upward, according to investors and lenders steeped in the sector. Typical features associated with Class B buildings such as sparse natural lighting, outdated HVAC and filtering systems, and a lack of green space for workers have all lost favor under a new priority list.

Rob Gilman, partner and co-leader of New York-based advisory Anchin, Block & Anchin’s real estate group, tells Real Estate Capital USA that filling office space, be it Class B or beyond, will often come down to how much build-out allowance is given to tenants, free rent allotments and amenities.

“Although I believe things are starting to change for the better in the real estate industry, I’m not so sure how many employees will be back on a full-time basis in three to six months. And then the question is: what is the new world going to be?” Gilman says.

A or B

There is a market of haves and have-nots for financing office deals.

Sadhvi Subramanian, senior vice-president and commercial real estate regional manager for US Bank’s Eastern division, tells Real Estate Capital USA the deal velocity for Class A assets has not lost its momentum compared with the Class B space, especially when the right sponsors and markets align.

While US Bank is not changing its own approach on the segment, Subramanian says any deals within the space will be sponsor-driven and require close attention to tenant rosters, lease expirations and any necessary enhancements depending on current cashflow at a building. “We know that interest rates are increasing, so the cashflow has to be strong,” Subramanian says. “Cap rates will probably increase in the long-term. We will have to look at re-tenanting costs and operating expenses.”

Subramanian says for the larger US banks, including her own, Class B deals will still be taken on if the sponsor is right, though the loan-to-value rates will likely adjust to build in more layers of risk protection for any lender. “US Bank is more cautious in the office space in general given that the return-to-office trends are still in flux. Early results in leasing volume appear to be more heavily weighted in the Class A office sector rather than Class B. If we pursue Class B office, we will likely do these at a lower leverage point,” she says. “We will likely do deals with a 9 or 10 percent debt yield, and then we will look more closely at if a tenant expires, what is the probability of getting a new tenant in.”

Previously with Class B offices, Subramanian says empty periods could last up to six months when finding new tenants to fill space. But in the current environment, that could take up to two years. Though US Bank has not signed many Class B office deals in recent quarters, Subramanian says banks at large will have to bulk up their underwriting parameters, especially to account for tenant loss in the evolving working environment.

Jason Hernandez, head of the US debt business at manager Nuveen, tells Real Estate Capital USA the future financing of Class B offices also must account for the nuances present in different cities where the supply and viability of assets differs in comparison to a stalwart such as New York City.

“I do think the office sector is a tale of haves and have-nots,” Hernandez says. “I do not want to take massive lease-up risk unless I am in a market like Austin or Raleigh, where I have got tremendous tailwinds through absorption. But in a market like Chicago, or even Miami, if I find a good asset at an attractive basis, I might take that liquidity risk.”

Hernandez says Nuveen does not want to take an asset risk in a city challenged for absorption and then also take liquidity risk on the back end of the deal, compounding the profile and in turn raising the stakes in an already-volatile market.

Head of the class

Michael Happel, co-head of equity investment for the Northeastern US at Philadelphia-based Rubenstein Partners, tells Real Estate Capital USA the value-add office specialist believes the shift toward best-in-class buildings is more nuanced than it may immediately appear.

Jason Hernandez
Jason Hernandez: ‘I do not want to take massive lease-up risk unless I am in a market like Austin or Raleigh, where I have got tremendous tailwinds through absorption. But in a market like Chicago, or even Miami, if I find a good asset at an attractive basis, I might take that liquidity risk’

“In most markets, office leasing activity is down about 50 percent from where it was pre-pandemic. Decision makers are postponing leasing decisions, and there is still a lot of uncertainty around this process,” Happel says. “There are questions around what the pandemic will do next or what the office will look like in the future.”

Moreover, there is a tenant flight toward quality that has thrown normal supply-demand metrics out of order. In New York, for example, rents have been going up over the past two years for fully renovated or new construction buildings. The bottom line is that for investors picking the right assets, there is financing. But picking them is now more difficult than it was in the past.

“The lender community is obviously nervous about the outlook for office buildings and about lending on them. Yes, you can get financing, but the lender pool is much thinner than it used to be, and the loans tend to be more expensive than in the past. It is a contrast to what is happening in the multifamily or industrial sectors,” Happel says.

As a consequence, Happel, like others, expects a rise in foreclosures in the coming months. “We haven’t yet seen a meaningful number of foreclosures. But that is something that could just be a matter of time,” he says. “In the past, if an owner did not have the expertise or capital to invest in a Class B building, they might have been able to get away with it. That is no longer possible in this leasing market.”

New avenues

Despite the current period of dormancy for interest in Class B office assets, potential opportunities are still brewing within the segment, even if a full transformation is required to restore profitability.

Though costs for such plays can run high, renovation and repurposing are two common lenses to look through when considering the future of viable Class B space for lenders, borrowers and their prospective tenants.

Gregory Kraut, co-founder and CEO of New York-based private equity manager KPG Funds, says there is still potential for finding returns with Class B offices so long as the right parameters are in place. His firm specializes in transforming older buildings into high-end office space and has run multiple plays using the same thesis in recent years.

Kraut says KPG looks for older undermanaged and underfunded buildings with architectural significance for renovation plays. “In the high demand submarkets, there is still a huge opportunity to purchase Class B offices and convert them into Class A tailor-made buildings,” he adds.

KPG’s proprietary relative strength submarket index – which measures the velocity and magnitude of tenant demand in New York – shows demand for Manhattan office space has surpassed its 2021 levels within the first quarter of 2022. The majority of new demand was in Midtown South as interest ebbed away from Downtown. The shift in local demand spurred KPG to build out its portfolio in Midtown South especially, acquiring new assets to scale upward as tenants demand more vibrant offerings within the neighborhood.

Peter Merrigan, chief executive and managing partner at Boston-based manager Taurus Investment, has taken a similar approach to bolstering Class B office assets, with a bigger focus on energy retrofits to make buildings self-sufficient. Taurus closed on the acquisition of a $100 million portfolio of Boston-area offices this year as part of the revitalization strategy. “We are modernizing those properties from an energy perspective that will bring them up to more modern standards. Otherwise, these buildings will continue to become obsolete,” Merrigan says. “With proposed SEC guidelines, tenants are going to have to start reporting their carbon footprints and environmental impact and they will be under pressure to find a green building.”

Convert or crumble

Beyond upgrading office assets into higher tiers, the alternative route available is repurposing – or more simply put, converting – the asset into another style of property such as multifamily, hospitality or even more specialized life science or medical office space. Subramanian says the capital required to convert older office buildings is quite sizable and does require landlords to weigh the costs compared to how much they may get back in rent. She says it is difficult to fully revitalize Class B offices and switching the product type altogether could bode better for lagging properties.

But outside of renovation and conversion, plain and standard Class B offices are not without a future, according to David Roth, founder and head of real estate equity at Los Angeles-based manager Ares Management. “While the nature of office use is changing, you will still need to go to the office. In a city like New York, there could be some contraction of demand and you will see companies trade up and some properties be converted to another use,” Roth says. “And for Class B buildings, there are ways to have an impact – folks need to figure out how to change lobbies, add restaurant space and provide amenities for tenants.”

Jaran Burt, director of valuations at the Kennett Square, Pennsylvania-based risk management advisory Chatham Financial, says the potential of Class B office being obsolete is a big question mark with no clear answer for some market participants at this time.

For lenders and borrowers still seeking opportunities in the office sector, Burt says Class A properties with short-term weighted average lease terms might look better compared to assets with longer-term WALT because of the flexibility around resetting leasing rates over a shorter span of time. He notes lenders are more willing to underwrite deals where there is a credit tenant and short-term WALT.

While lenders and borrowers sort their future approaches toward Class B office deals, it is clear the only commonality across US locales is the office supply is getting older. Without a redesign or renewed purpose, these assets – whether half-filled or struggling with re-tenanting – will simply continue taking up increasingly valuable mid-block space in major metropolitan areas on a nationwide basis.

PGIM’s McDonnell says the transition toward a shifted Class B office landscape will likely happen over the next 10 years, even if the sky seems to be falling for the segment in the short term. “Because of existing term on leases, it will not be where we will wake up and B offices have no cash flow and that gives the industry time to adjust.”

If you Vanderbilt it, they will come

When lenders speak about what their ideal office space now looks like in any major market, the template often pointed toward is New York’s One Vanderbilt.

“Everyone is interested in financing assets like One Vanderbilt, the new 270 Park, the Spiral Building and the like,” Tom Traynor, vice-chairman in debt and structured finance at CBRE and co-head of US large loans, tells Real Estate Capital USA.

Traynor says in the same manner employees are not dying to be in Class B buildings compared with offerings such as One Vanderbilt, lenders are not dying to lend on every Class B opportunity.

The New York City trophy office – owned through a joint venture between SL Green, Hines and the National Pension Service of Korea – represents everything Class B office spaces are not. Proximity to a major transit hub, quality air systems, an abundance of natural light and even sustainability-minded measures toward making the office a greener space all contribute to One Vanderbilt’s favorability compared with other assets in the marketplace.

By comparison, New York’s Class B office stock is best described as beige. Akin to the color that dominated interior paint schemes through the 1990’s, the Class B office stock can often lack the luster needed to attract tenants, borrowers and lenders with office conditions misaligned in some way or another.