Opportunistic Investors Awaiting A Wave Of Office 'Value Destruction'

Owners of older office buildings across the U.S. are facing hard times ahead as financing deals get more difficult — and opportunistic buyers are lying in wait.

“I really haven't invested in office in the last 14 years,” PGIM Real Estate Global Chief Operating Officer and Head of U.S. Equity Cathy Marcus said at Bisnow’s National Finance Summit last week. “I think that in the next year or two, it'll be a heck of a lot more interesting than it has been for a really long time.”

Last week, the Federal Reserve introduced its third consecutive interest rate increase of 75 basis points in response to persistent inflation, with Chairman Jerome Powell promising that the Fed would continue to "act aggressively" to bring inflation down. The latest hike brings the current interest rate over 3% — making the cost of borrowing significantly higher than at any point in the last decade.

Between high interest rates, inflation and the future of in-person work in question, office is looking increasingly like a source for future distress. Seeing as it has long been the asset class of choice for large commercial real estate investment, there is angst simmering throughout the market.

"We’ve done a fair amount of office and certainly we are very, very nervous on this one. As a general rule of law, [office] is something we’re just not really chasing. It’s just an abysmal market out there," Tremont Realty Capital Senior Vice President Thomas Lorenzini said. "It just keeps compounding wrong, it's not a good long-term story there."

The Fed's aggression has diminished hopes of a soft landing for the overheated economy, with many in the industry already bracing for the downturn. While banks have pulled back on all forms of real estate lending, panelists at the event last week said the equity and debt markets for office is essentially frozen. 

"Office used to be about two-thirds of our [deal] flow," Square Mile Capital Senior Managing Director Jeffrey Fastov said at the event. "If you go into office, there's no capital that's interested right now."

As traditional financiers back away, opportunistic capital is preparing to draw closer. For buyers seeking distressed properties, office owners' current predicament presents new opportunities in the future — once the markets thaw and prices fall.

“Obviously as a distress fund, we see a major dislocation in the capital markets as an opportunity for us,” said Shannon Stott, managing director at Island Capital. “We expect to see more, but we think there's a little bit of time before that happens.”

One early potential of distress, the special servicing rate on commercial mortgage-backed securities, has stayed low for office properties throughout the pandemic, but ticked up 45 basis points between August 2021 and last month, CMBS tracking firm Trepp reported.

Until more debt starts turning sour, there is unlikely to be a wave of distress transactions. But that day is coming, PGIM's Marcus said.

“I think the value destruction of an office is going to be really severe,” she said. “I think that will ultimately lead to interesting opportunities. I don't know that we're there at present.”

While distress investors are waiting for the right moment to start snatching up older properties, some experts believe the first signs of life are returning to the office sector.

“Every day, I see more and more employees coming into the office, and employers are requiring employees to come in,” said Susan Saslow, a partner at law firm Hunton Andrews Kurth. “Especially in a recession, where the employer has a little bit more leverage to force their employees to come back into the office, I think they'll see the market there also may stabilize.”

While the financing environment still poses a challenge, ultra-high-end office spaces remain appealing as they draw a larger share of new leasing activity, said Robyn Sorid, co-founder of real estate investment firm G4 Capital Partners.

“We don't say no to office, but what we say is it has to be highly amenitized, it has to be an office where people want to be working,” she said. “That's what we're hearing from all sides of the business.”

Brand-new buildings are safe bets and not likely to trade at a discount anytime soon — so the best investment opportunity are the buildings that aren't quite in the same class where prices are likely to fall, Eastdil Secured Managing Director Grant Frankel said.

“We are big believers in office,” Frankel said. "There's a decent subsection of the uber-luxury, uber-trophy assets that are going to perform very well. I think there's a tremendous opportunity if you're able to identify the next cut down, and there's going to be a tremendous value reset down.”

That same value reset has led the owners of some office buildings to hand back the keys to their lenders — most recently Hines in Washington, D.C. Those stories are still few and far between, but Morgan Stanley co-CEO and Head of Americas for Real Estate Lauren Hochfelder said at the event to brace for many more.

“In the last few days, I feel like we've been talking about a handful of reasonably core office buildings going back to the lenders," Hochfelder said. "I think it's really the beginning of a wave of that."