'Why Would I Throw Good Money After Bad?' Uptick Of Office Loan Defaults Is Likely On The Way

Turmoil in the economy has the CRE industry coming to terms with the fate of beleaguered office buildings as fourth-quarter reports paint a grim picture heading into the new year.

For some, that will mean giving up and handing over the keys.

National net absorption plummeted from over 3M SF in Q3 to negative 7.13M SF in Q4, per Moody's Analytics, while vacancy ticked up for the fourth consecutive quarter to 18.7%.

Even higher-flying markets like Dallas-Fort Worth saw average vacancy climb to its steepest rate since the 1980s, and though absorption had improved since hitting historic lows in the wake of the pandemic, it remained at negative 1.1M SF. Sublease vacancy was also at a 20-year high, according to Avison Young.

The industry’s sluggish recovery, complicated by high interest rates, means struggling buildings have a dwindling chance of surviving a recession.

Ownership groups that need new debt on a maturing loan will have to decide whether sinking more money into a low-performing asset is worth the investment, said Ben Brewer, a senior managing director in Hines' DFW office.

“People may feel like, ‘Golly, I’ve been trying to lease this thing for two years and it’s not working, why would I throw good money after bad?’” he said.

Accessing capital for office renovations has become increasingly difficult, if not impossible, Koa Partners Vice President of Brokerage and Investment Leander Johnson said. Those who have the money must ask themselves whether they will be able to command the rents needed to pay down their investments.

“The cost of debt is now twice what it was 12 months ago,” he said. “Folks are going to have to wrestle with, ‘Can I cover my expenses if I invest money in this building?’”

Whether the juice is worth the squeeze will likely come down to geography, Brewer said. Buildings located in desirable submarkets, with access to amenities and nearby transportation, are more likely to be viewed as worth saving.

“Conversations surrounding this topic will likely increase in 2023,” he said. “There will essentially be two silos or divisions — some call it the haves and have-nots — the ones you can build a narrative around, and others that need a little bit more help.” 

Vacancy at newer, Class-A office properties is more than 10% lower than the sectorwide average, per Avison & Young, but the flight-to-quality trend has yet to restore the DFW office market’s pre-pandemic vibrancy. 

Johnson said companies are slow-playing space decisions, which creates longer tails on transactions. As a result, the desire for high-quality office space has yet to fully reveal itself in absorption data.

“Business doesn’t like uncertainty, and that’s what you have right now — a lot of uncertainty,” he said. “Unfortunately, that translates to inaction. Once we have some clarity, and a better sense of what things are going to look like, you’re going to see some of that higher-quality product absorbed first.”

Many office buildings that have struggled with leasing during the pandemic don’t have quality or location on their side, and in those cases, Johnson said owners staring down maturing loans may choose to default.

“There will be some repricing in the market, and you could see a lot of assets come back to the market,” he said. “I expect those conversations to happen, and candidly, I think you will see keys handed back on some properties.”

The Metroplex has begun to see ownership of some high-profile properties taken over by banks. In November, lenders took control of an 846K SF, Class-B office property in North Dallas after its owner, California-based investor manager PIMCO, failed to pay its loan.

A few weeks later, news broke that ownership of Dallas’ famed Galleria mall and its adjoining hotel had been transferred to MetLife Investment Management. 

Beyond the Metroplex, the situation is even more dire. The Loop in Chicago has been especially hard-hit, with office values plummeting and several owners missing mortgage payments. In September, Hines relinquished a Downtown D.C. office building it had owned for over a quarter-century following the departure of its anchor tenant.

Loan defaults could have a broader impact on the performance of submarkets as a whole, Brewer said. Banks may choose to sell those properties at lowered values, which could have a ripple effect on appraisals. 

But the opposite could also be true, Johnson said. If former office properties are repurposed, or if new ownership is willing to spend the money on improvements, nearby buildings may see a boost in value.

“It’s hard to jump out there and make a blanket statement about what would happen,” he said. “As we go through the year, and there are trades that happen, we’ll get a better sense of what direction that’s going in.”

Delinquency rates on CMBS loans have thus far defied expectations. In November, office delinquency dipped by five basis points to 1.7%, though the overall rate across commercial asset types increased by three basis points to 2.99% month-over-month, according to Trepp data. The decline was mostly tied to a few delinquent apartment loans, per the report.

DFW is not immune to the national turbulence economists are predicting this year, Johnson said, and lower-tiered properties will have a harder time surviving the downturn. Nevertheless, the Metroplex’s strong fundamentals should keep its office market a cut above the rest.

“When you look at the number of companies that are still coming here and the number of people who are still moving here, I think we will be OK as it relates to demand,” he said. “There’s going to be a lot of B-class property that you’re going to see a lot of chop in, and it’s going to take some time to work through that absorption.”