The great reset: How the office sector is setting the stage for what comes next

The conventional wisdom in the US commercial real estate debt markets right now is that as far as performance goes, there is the office sector and then there is everything else.
Once the darling of institutional investors and fund managers because of its size and stability, the sector has seen extreme headwinds since the start of the covid-19 pandemic and the rising interest rates which happened after.

And it is now likely office will be the first sector that sees a far-reaching reset in valuations and, subsequently, use of leverage as lenders and borrowers go about refinancing what New York-based data and analytics provider MSCI sees as a $900 billion wall of maturities over the next two years.

The impact of the pandemic is one of the nuances affecting today’s market, says Mukang Cho, founder and chief executive of Boca Raton-based manager Morning Calm Management.

“Had it not been for the pandemic, which, for a short period of time, changed human behavior universally, we would now just be dealing with another phase of the credit cycle, and we might not have been reading about well-established sponsors giving back keys on office assets in marquee cities,” Cho says.

While the office sector is gaining the most attention at present, Fred Cordova, chief executive and founder of Los Angeles-based advisory Corion Enterprises, cautions the impact of 15 years of historically low interest rates and an abundance of capital will be felt across all markets and sectors as loans mature. “No economic models addressed such a dramatic change in interest rates, and no investment officer of any institution went to their investment committee and said, ‘We’re going to underwrite to a 5.5 percent stabilized cap rate and exit at an 8.5 percent cap rate,’” Cordova says. “The cost of capital today is not historically expensive, but it is relatively expensive to where it was before. That, combined with high inflation and dramatically lower demand for office space, is leading to this great asset valuation reset.”

Since March 2022, the Federal Funds target rate has risen from 0.25-0.5 percent to 5-5.5 percent at the start of May. This increase in rates, along with wider credit spreads, has provoked a stark change for activity in the market.

“Values have been impacted to the negative by the increase in rates. That is pure, simple math. If your cost of debt goes up, then the value of the equity will go down. I think of this period as the great reset, in which we are resetting the value of assets,” says Jonathan Roth, co-founder and managing partner of national lender 3650 REIT. “When someone tosses the keys back to the lender, the value will be no more than the debt and likely will be less than the debt. That is your new market.”

The process, however, will be slower than the valuation reset seen during the global financial crisis, when there was a basis reset across all asset classes, says Jonathan Pollack, global head of structured finance at New York-based manager Blackstone Group.

“During the global financial crisis, everything was over-levered, and the reset came more quickly,” Pollack says. “But what is happening today is much slower moving than what happened in 2008 because there is a lot less leverage in the system today than there was at that time.”

Lower overall levels of leverage and the amount of dry powder on the sidelines is helping sponsors hoping they can hold onto assets, potentially via cash-in refinancings or loan restructurings. But Morning Calm’s Cho believes it will not be possible for lenders to extend or restructure every loan.

“Unless there is real liquidity in the marketplace, kicking the can down the road on every loan will become problematic,” Cho says. “Even if the Federal Reserve puts a pause on rate increases, values have moved. That means your leverage is higher on a relative basis, and when your loan comes due, your leverage will have to come down as well.”

Daniel Blanco, a principal at New York-based manager Broad Street Development, says that in his more than 25 years of experience as a developer, he has never seen a market in so much turmoil.

“This is arguably one of the most dislocated marketplaces I’ve ever seen, both from a capital perspective, an unknowing of the future, and very tepid, anemic tenant demand,” Blanco says.

The firm, which develops, owns and manages a portfolio of office and residential properties in New York, in April rolled out Paradigm Advisory Group, a credit-focused advisory which aims to help lenders, borrowers and special ­servicers to stabilize office and residential properties in the city.

“My sense is, either the sponsor says, ‘I’m going to put more money into the asset’; the lender says, ‘I’m going to work with you on it’; or the third response is, ‘I don’t want it, you take it back.’ And I believe it’s going to be a mixed bag of all three in this in today’s marketplace,” Blanco says. “More than ever, granular expertise to implement both short- and long-term business plans is required.”

Despite today’s headwinds, Blanco believes the current problems will pass as transaction activity rises and rates come down – something that could happen as soon as the fourth quarter of 2023. “Right now, it is all based on if you can survive for two more years. I am an eternal optimist and I strongly believe the office market is going to come back – and come back incredibly strong,” he says.

Knowing when to fold

In the roughly 40 years since the Savings and Loan Crisis in the 1980s and 1990s, the commercial real estate market has become more adept at managing distress. As a result, there is a sense this distress cycle could be shorter than in years past.

Nitin Chexal, chief executive of Austin-based debt manager Palladius Capital Management, says the market is starting to see sponsors handing back the keys or executing strategic defaults, primarily in the office or regional malls sectors.

“The good news is that apart from offices and regional malls, these other asset classes are largely performing. You’ll continue to see keys getting handed back because there is not a lot that can be done to solve some of these issues,” Chexal says.

Costs top of mind

The biggest concern for commercial real estate lenders and borrowers today is the cost and limited availability of debt

This has led to a prolonged disconnect between buyers and sellers and has hampered capital markets activity, says Shawn Kimble, managing director and head of US Real Estate Capital Markets at manager Barings Real Estate.

According to data from MSCI, transaction volume fell from 56 percent from the first quarter of 2022 to the first quarter of 2023, with pricing dropping -8 percent during that period.

“Asset values must be reset based on the cost of leverage, which is creating a meaningful disconnect between where buyers and sellers are willing to transact. There is not currently a great meeting of the minds, and that is playing out across the entire market,” Kimble explains.

Kimble notes that the increased cost of leverage affects every part of a firm’s business, including corporate, fund or asset-level debt. “Lenders deployed record amounts of capital at aggressive yields over the past five years because benchmark rates were so low for so long.”

Managers are now working to right-size their portfolios. “But we are doing it in a relatively illiquid enviornment. We are seeing many situations in which refinancing means borrowers must inject additional capital or take on negative leverage.”

Daniel Berman, partner at New York law firm Kramer Levin, believes managers are being strategic in shedding assets, and the analysis is different for smaller sponsors than for their larger peers.

“It is my sense they’re focusing on properties that don’t have a chance because they want to live to fight another day,” Berman says. “Smaller sponsors are more reluctant to hand over the keys because these properties make up a larger percentage of their portfolios and for some family offices and smaller investors, there may be a personal attachment to the asset. But I also don’t think anyone is ruining their reputation by handing over a property in this context.”

3650’s Roth notes the way in which sponsors handle the process and the timing around it is critical. “[Handing back the keys] will follow you and impact your ability to obtain credit down the road,” Roth says. “But if you express a problem early on, there are many more solutions. If you let that problem grow and fester, your solution set narrows.”

Jay Neveloff, a partner at Kramer Levin, says sponsors are trying to make deals work. “The analysis around walking away from a deal is very nuanced and you’ll find that with some deals – even if they are crummy deals – sponsors aren’t necessarily walking away,” he says. “If you have a deal that you think could run negative for a little bit and your way of making it better is to raise additional capital, the smart owner will dilute its interest and hope we are in a two-year cycle and not a five-year cycle.”

“Alternative credit providers and debt funds will have an opportunity to expand their relationships”

Nitin Chexal
Palladius Capital Management

But the equation becomes more complicated when it involves an office building. “If that property has substantial near-term vacancies and releasing requires extensive tenant improvements, the analysis could become much different,” Neveloff says.

With an eye on returns, market participants note handing the keys back also means handling tax consequences, which are more easily absorbed by a big institutional owner than a smaller owner-­operator, Roth adds.

“The question is, ‘If we give the keys back to this asset, what does that do to our overall returns?’ If the overall returns are still at an acceptable level and the sponsor can show that during the worst time in 15 years, they still managed to get a net seven or eight, they think they are doing well enough to fight for a new day – I promise you that is the analysis that is going on,” Roth says. “How will this impact the returns in the vehicle is which this asset sits? For some of the mega platforms, you can wipe out $50 million or $100 million of equity. That would be a life-ending blow for some of the smaller platforms.”

There is a consensus that nearly every market participant is grappling with the same issues.

“No one is immune to having some exposure to the office sector or assets that need some love and care,” Pollack says. “One of the core principles of our business is to lend to high-quality borrowers who have the depth of capital to manage these challenges. When you tick those boxes, and sponsors are contributing capital to support their assets or finish business plans, it is a very different conversation. Where we can, we help with deferring covenant tests or using reserves to help cover some of the elevated interest costs alongside sponsors supporting their assets.”

Elephant in the room

Since March, the US banking market has seen substantial volatility through the failures in March of Silicon Valley Bank, Signature Bank, and Credit Suisse and the May collapse of First Republic Bank. While the failures were not real estate related, the fallout is affecting the great reset.

“We have turmoil in the banking system created by a rapid increase in rates which are making the bond holdings of those banks worth half of what they were worth. It also makes the deposits less sticky and creates havoc,” Roth explains.

“One of the core principles of our business is to lend to high-quality borrowers who have the depth of capital to manage these challenges”

Jonathan Pollack
Blackstone

“The net result is that the footprint of those banks will shrink, and they will have less capital available to lend within the real estate sector.”

While the volatility seems to have ebbed, there is a sense it might not be over. At the PERE Europe Forum 2023, hosted by affiliate title PERE in London in May, Nathalie Palladitcheff, chief executive officer of investor Ivanhoé Cambridge, cited the period of relative calm which followed the March 2008 collapse of Bear Stearns – until Lehman Brothers failed in September of the same year. “We may be somewhere between [the collapses of] Bear Stearns and Lehman Brothers,” Palladitcheff told attendees.

Chexal notes one of the biggest risks to regional banks comes from short sellers or hedge funds that could cause a collapse in a bank’s stock price, even if the bank is in good health. There is also a chance that banks, under greater public scrutiny, could pull back on real estate lending.

“We see that as an opportunity where we can step into the gap that regional and local banks have pulled back from. I think alternative credit providers and debt funds will have an opportunity to expand their relationships,” Chexal adds.

The process of refinancing loans has been further affected by inverted Treasury yield curve, with substantial volatility around the two-year Treasury.

“The volatility we are seeing has a direct impact on sponsors who are trying to underwrite deals. Seeing the 10-year [Treasury yield] move 15 or 20 basis points a day pre-covid would have been a bigger move but not unprecedented,” says Christina Ochs, president of Chicago-based consultancy Corporation for Interest Rate Management. “Watching the two-year move 30 basis points in a day means that it is really hard to underwrite a loan, whether you’re in the acquisition, development or value-added space.”

Blackstone’s Pollack notes that the firm has been more active in originating longer-term loans. “The yield curve is deeply inverted and with the [yield on the 10-year Treasury] at about 3.5 percent – a historically moderate level – if you’re buying a multifamily or industrial property with good leases in place, you can borrow in the 5 percent range with agencies or insurance companies,” he says.

Bright spots

There are bright spots. There is a feeling that today’s market includes participants with substantial dry powder able to acquire properties at steep discounts – and shorten the length of the distress cycle. Moreover, there is the potential for rates to drop in the second half of the year.

“We have turmoil in the banking system created by a rapid increase in rates which are making the bond holdings of those banks worth half of what they once were worth. It also makes the deposits less sticky and creates havoc,” Roth explains. “The net result for the banks that survive is that the footprint of those banks will shrink, and they will have less capital available to lend within the real estate sector.”

“There is not a great meeting of the minds, and that is playing out across the entire market”

Shawn Kimble
Barings Real Estate

Morning Calm in April formed a venture to finance office buildings, both via originations as well as through buying existing senior loans, mezzanine debt or other structured debt products, and so is taking a contrarian view on the sector. “That is more about us trying to fill a void that exists today as a result of a result of lenders pulling back,” Cho said.

“Valuations will continue to reset across the board across every asset class, not just office.”
Chexal notes what while there has not yet been major distress in sectors like multifamily and student housing, this could happen in the coming months. It is not, however, a foregone conclusion. “It has so far been quiet and orderly. But this distress could accelerate into the back half of the year. But if rates come down as the market expects them to into the end of this year and early next year, a lot of that distress could go away,” Chexal says.

Cordova, who has focused on the Los Angeles area for most of his career, believes a recession and subsequent interest rate stabilization will spur activity. Longer-term, he feels the new normal for non-agency commercial debt will probably settle in the 5.5-6.5 percent range, with a Federal Funds rate in the 3.5-4.0 percent band. “The great reset means resetting asset values to that norm,” he adds.

Figuring out values is trickier and, like all real estate, will be intensely local and specific. “In my opinion, in downtown Los Angeles office, nothing is worth more than $250 a foot and frankly, I think many of these assets are going to trade between $150 and $200. That means the equity in any office leveraged over that amount is gone,” Cordova says.

But Cordorva, like many of his peers, holds out hope for a better day. “The dry powder will stay dry for now, although there are a lot of people licking their chops and waiting to get in,” he says.

“It’s going to be horrible for a while, but this too shall pass, and the dry powder will help to reset the market and the data points once interest rates and inflation stabilize.”

Strategic options

Lenders and borrowers are having hard conversations about the future of properties

The market has seen a handful of high-profile situations in which marquee sponsors have handed back the keys, executed strategic defaults or sold assets for substantial discounts. A case in point is Toronto-based manager Brookfield Properties’ DTLA Fund Office Trust Investor, which is entirely comprised of prominent office towers in downtown Los Angeles.

The firm did not exercise an option to extend a $465 million loan on Gas Company Tower at maturity on February 9. Meanwhile, it did not obtain an interest rate protection agreement on a $318.6 million loan on 777 Tower – an event of default. Consequently, Gas Company Tower is in receivership. Brookfield is not alone. Newport Beach-based PIMCO in April defaulted on a $1.7 billion loan backing its 2021 privatization of New York-based real estate investment trust Columbia Property Trust, which owned and operated a portfolio of marquee properties in major markets.

The headwinds the CPT portfolio are facing are universal, a CPT spokesperson says, adding the firm is working to restructure its debt.