Brokers Demand Closer Look At Landlords' Books

Office tenants are asking to take a closer look at their landlords' books as a wave of distress threatens to upend the market.

Landlords have in the past been reluctant to disclose financial documents, said Jihane Boury, vice chairman at Savills North America. But as interest rates rise and a wall of office maturities looms, savvy brokers are inquiring about those items upfront.

Tenants are voting with their feet if they don't like what they see, according to Boury and other speakers at a Bisnow event last week. 

Owners have become more receptive to sharing information about their loan terms or their capital stack, but if they aren’t, brokers are doing their own investigating and, in some cases, even calling the lender themselves.

“The tables have totally turned,” Boury said. “Even though landlords are still wanting to perform due diligence on their tenants, we are looking out for our clients, especially in the next wave of leasing the market will experience.” 

Owners unable to prove they are in good financial standing are seeing clients move to other properties. That phenomenon, dubbed the flight to capital, is beginning to play a significant role in site selection, Boury said.

Companies approaching lease renewal are in some cases finding their landlords are unable to fund renovations. This was the case for a tenant in Uptown Dallas who chose to relocate after the landlord's financial woes meant it could no longer uphold its tenant improvement obligations, Boury said.

To protect their clients from similar situations, brokers are pushing for stronger lease terms and even asking for TI dollars to be placed in an escrow account, she added.

“We are pushing for offset rights,” Boury said. “In the event the landlord is not able to pay tenant improvements or commissions, then the tenant will have the right to stop paying rent and [instead] pay the contractors.” 

Tenants and brokers are approaching renewals with extreme caution, but leases in new buildings are also subject to heavier scrutiny, Boury said. Oftentimes, if a tenant isn't the first signed lease in a building, a landlord’s TI budget may be spent once their space is ready to be built out.

“We need to make sure the math is right and that there’s going to be enough TI if we are third or fourth in line to go into a new building,” she said.

Commercial real estate loans on bank balance sheets showed signs of serious trouble in the second quarter, with a dramatic increase in charge-offs for the office sector, according to Trepp. The net charge-off for the office sector increased nearly tenfold over the past two quarters, from $49M in Q4 2022 to $459M in Q2 this year.

Although DFW is often regarded as fairly insulated due to its pro-business environment and strong population gains, office buildings in the area haven't been immune to economic turmoil.

Lenders filed foreclosure notices on three Dallas-area office buildings in mid-August, and in late September, Pillarstone Capital reported it had defaulted on its loan for a 253K SF office building in Uptown.

The Federal Reserve’s campaign to slow inflation has imperiled a vast number of office buildings, especially those backed by floating-rate debt. Landlords approaching the end of their loan terms are finding that capital to refinance is scarce, and some are having to consider handing their keys back to the bank. 

“The explosive nature of interest over the last six months is really unprecedented,” Ramsey March, executive managing director and partner at Stream Realty Partners, said during a Bisnow event Tuesday at the Allen Tech Hub. 

“Budgets are being exploited from an interest perspective, and if [a building] didn’t have the right rate cap, if it didn’t have a financial strategy or plan in place going in … then there may be owners and developers that didn’t realize what kind of trouble they are in.”

The rise of remote and hybrid work has made it much harder for landlords to fill buildings, and the loss of rental revenue is preventing some owners from paying down the debt on their loans.

Add in interest rate hikes, and some loans could be badly underwater, Scott Beck, president and CEO of Beck Ventures, said at the event. Tenants should be asking owners on the front end whether their exposure to volatility is hedged through rate caps, he added. 

“Do they have the financial wherewithal to actually weather the storm and do what is in the nice, glossy brochures they’re proposing to you and your tenant?” he said. “Can they actually execute in a continued environment like this?”

Tenants prefer to stay where they are because relocating can be expensive, but in the coming months, Boury said she expects growing distress paired with shifting office dynamics to prompt more movement between buildings.

“The workplace has changed,” she said. “If tenants don’t have the TI allowance to be able to accommodate a new layout and bring back their people, then they will absolutely look to another landlord to help them achieve that.”