2023 is already shaping up to be the year when the tsunami of office building defaults, foreclosures, and large losses for lenders and equity investors comes on with full force. Cracks have already appeared, and it is only going to get worse. The office building sector is impaired, and it has been so for a long time despite very low delinquency rates.
This chart shows an example of the dramatic underperformance of a REIT with large exposure to office buildings, Voranado. Its total return over the last year has been -46%, which is far worse than the S&P 500’s -3.4%.
Investing in Vornado has been disastrous over the last five and ten years as well as the Total Return line in the following table shows.
And to show that Vornado is not an outlier, here is Hudson Pacific Properties (HPP), another REIT with large office exposure. Its performance has been even worse than Vornado’s, with a one-year return of approximately -63%.
HPP has also produced dismal returns over the last five and ten years as well.
Last week there were some very significant announcements about major defaults related to office building loans from a couple of substantial companies.
PIMCO, the giant investment firm, made a big bet only two years ago that has now gone bad. It bought an office building company in 2021, and it has already defaulted on a large loan collateralized by multiple properties.
The loans were floating rate and the much higher interest rates, along with a terrible office market, led to the borrower not being able to or unwilling to service the debt.
Brookfield Properties, one of the largest real estate firms in the world defaulted on two prominent office buildings in downtown Los Angeles. The loans had principal balances totaling $784 million.
Recently I spoke with a lender who has a loan on an office building in downtown Los Angeles with a very prominent borrower who has a lot of experience in owning and operating office buildings. The combination of having a floating rate loan with low occupancy has resulted in negative cash flow. The borrower had been writing checks to support the investment to avoid it going into default. Once Los Angeles passed a tax on all real estate transactions in excess of $5 million, however, the borrower called the lender and said they were done. They were not going to put another dime into the property as this new tax would cost them $10 million if they were to sell the building. They were not going to throw good money after bad. The lender told me that he thought every major office building in downtown Los Angeles was worth less than the debt encumbering those properties. There is no question that Brookfield’s two defaults are just the tip of the iceberg for downtown Los Angeles office properties.
Here is another headline from the Wall Street Journal discussing the deteriorating office market and the inevitability of much higher mortgage distress in that sector.
In the most recent minutes from the Federal Reserve, there was some discussion about the prospects for deteriorating property values for homes and commercial properties.
This headline from Redfin is what the excerpt from the minutes of the Fed meeting is probably concerned with in terms of residential properties.
On the other hand, these charts show just how massive the gains have been, even with the current drop.
And to show a mirror image of the dreadful office building REIT returns, here is the total return for Lennar, one of the country’s largest homebuilders. It has significantly outperformed the S&P 500 in spite of materially higher mortgage rates.
The market must believe that the current housing freeze is temporary, so perhaps it thinks long-term interest rates are heading lower.
Now back to office buildings. A lot of interesting information can be gleaned from transcripts of earnings calls by management teams. M&T bank’s took place at the end of January and in the call it was revealed that 20% of its $5 billion of office loans are criticized, which means that they are at risk of going into default.
I thought these comments, observations, and thoughts were interesting about how they think that office utilization will almost assuredly go higher as more people go back to work but that it will most likely never be what it was pre-Covid.
Over the long run, we debate this a lot internally, and we go back and forth with our Chief Credit Officer, that this trend of more remote work, hard to handicap where that’s going to end up, right? You can see some changes in the economy. You see some movements with some of the tech firms with employment. That may or may not drive people back into the office, we don’t know.
But when you see younger people early in their professional career, you can see the benefits to being co-located with their co-workers. And so that trend, I think, ultimately starts to come back. Is it five days a week probably not, but it’s not going to be zero, at least this is Darren’s opinion. So take it for what it’s worth.
To me, the bigger issue is when you look long-term at the population, there’s a big chunk of the population called the baby boomers that are approaching retirement age. They’re not enough of them to come in up in the next wave to use all the space that they needed to sit in to be employed. And that’s a longer-term cyclical trend, which will affect these things. And so there’s going to be some pain in the short term, no doubt. Over time, rates will move up and down and refinancings will happen. There will be some movement in and out. But to me, the longer-term trend is what’s happening with the population and the working population and what’s the capacity that exists today versus what the likely future looks like, absent any other changes in politics. And I will leave it at that before we get into a discussion I don’t want to get into.
Finally, along the same lines as M&T’s longer-term concerns is a much more pessimistic report from Cushman & Wakefield
C&W is projecting that by 2030 U.S. office vacancies will reach a record 1.1 billion square feet, of which 330 million will be redundant and the remaining 740 million “normal or natural” vacancies.
Last year Bloomberg cited a report that a significant percentage of office buildings are no longer desirable.
Along the same lines, C&W estimates that 25% of US office space is already undesirable, and 60% is at risk of obsolescence and might require “significant investment” to upgrade or repurpose it. The report notes that these trends are evident not only in North America but also in Europe and Asia.
And why does all of this matter? Because when an office building loan defaults, the evidence suggests that losses can be tremendous. In the Bloomberg article, the author cites an analysis done by Bloomberg analysts showing the huge deterioration in value after a loan goes delinquent.
Reappraisals in the past two years of 60 office buildings with distressed commercial mortgage-backed securities fell by an average of 67%, erasing more than $1.2 billion in collateral, according to data compiled by Bloomberg.
|909 Chestnut (formerly One AT&T Center)||St. Louis||$9.2||-$197.8||-96%|
|Three Westlake Park||Houston||$25.2||-$96||-79%|
Source: Bloomberg loan data
There is already a huge credit crunch in the office lending market that is only going to get worse. Banks and private lenders are going to experience enormous losses. In order to clear the market, entrepreneurial pools of capital will have to form to buy these loans or properties at huge discounts. It will be similar to the Resolution Trust Corporation (RTC) that was formed in the late 1980s and operated through the early 1990s to clean up the Savings & Loans.
It will be interesting to see what collateral impact this issue will have on other aspects of lending and the overall economy. Will it create a bit of a credit crunch, and will the Fed have to step in with lower interest rates? Overall the banks are much healthier than they were in 2008 and 2009, but this is a pretty big problem unfolding, so no one knows how it will play out.
All I can say is Woah!