For months, if not years, panic-inducing headlines have lamented the existential crisis facing the U.S. office market as a “wall of maturities” looms: $2.2 trillion of commercial real estate debt coming due between now and the end of 2027, according to Trepp estimates.
Despite the buzz, an actual shakeout in the office sector was delayed for a while as transactions slowed to a virtual halt. Valuations calculated in pre-pandemic highs grew too stale for buyers to trust them, and uncertainty around the worth of offices in the era of hybrid work abounded.
Now that valuations are trickling in, it’s clear that office values have decreased dramatically.
In 2023, special servicers–companies that manage commercial mortgage-backed securities (CMBS loans)--reappraised office properties that transferred to its oversight at prices 50-60 percent lower than their appraised value when the loans originated, according to Lonnie Hendry, chief product officer at Trepp, who added that properties transfer to special servicing when owners “haven’t made their mortgage payment, or they’ve broken some other significant covenant with the lender.”
Rather than sell at significant losses or refinance into interest rates that currently stand at 23-year highs, many office owners are clinging to backward-looking valuations calculated during cushier times by asking lenders for extensions—often granted only in the short-term—on loans that would otherwise mature.
The volume of loans extended recently and coming due this year is so high that the Mortgage Bankers Association recently revised upward its estimate of commercial real estate mortgages maturing in 2024 from $659 billion to $929 billion, or 20% of all commercial real estate debt.
The surge denotes the renaissance for so-called “extend and pretend” strategies, an approach that rose to prominence during the Global Financial Crisis (GFC) of 2007-2008, where a lender extends the maturity date on a borrower’s loan, allowing owners to pretend the value of the property hasn’t diminished.
By extending their loans, landlords hope they can lease up vacancies and pay off debts, all while the Federal Reserve lowers interest rates, making refinancing a less expensive pill to swallow, Hendry said. They may presume values will return, despite pandemic-fueled structural changes to the way we work, loosening their current impasse with buyers who only want steals.
Many in the industry, however, worry that the fallout from extend and pretend could ripple through the financial system if the circumstances owners are waiting out don’t improve and a significant amount of borrowers can’t refinance or sell at high enough prices to pay off loans, causing bank losses.
In the CMBS market, which has the most transparent data, there are signs of strain.
According to Matt Reidy, director of commercial real estate economics at Moody’s Analytics, 2023 was the worst year on record for timely payoffs of CMBS office loans. Only a third were paid off by maturity, while a third got formal extensions, and the final third “were unresolved just past the maturity date,” he said.
“There’s loans that still haven’t been resolved,” Reidy said. “That piles onto the volume that needs to be cleared.”
Office delinquencies have been rising by an average of 37 basis points for the past 12 months, according to Trepp. They rose in February 2024 by 33 basis points to 6.63 percent month-over-month, overtaking the retail sector, which had the highest delinquencies at the end of last year.
“[Extend and pretend] worked during the GFC because the Fed started lowering rates, debt was cheaper once it was available, and the assets were cash-flowing, otherwise viable except for an out-of-whack capital structure,” said Jim Costello, head of real estate economics at MSCI. “It’s not the same today.”
The cost of waiting
Extensions rarely come for free. According to Hendry, lenders typically require owners to either “pay down” some of their existing loans or fund reserves for “tenant improvement allowances, leasing commissions, and other property-related expenses” in exchange for the loan extension. This digs landlords’ heels in further on their bet on extend and pretend.
“This cash infusion increases the borrower’s commitment to the property,” Hendry said.
Take the investment subsidiary of Chinese automaker Wanxiang Group, which owns Prudential Plaza in Chicago. The firm spent $40 million in January to get a two-year extension on its roughly $386 million CMBS loan. The extension is among a slew of loan modifications made by CWCapital Asset Management, the loan’s special servicer, all of which required the borrower to cough up additional capital.
“We’re still seeing this optimistic perspective [with] owners who are still willing to put money in to try to salvage the investment, but, at some point, that’s [throwing] good money after bad,” Hendry said.
The landmark Montgomery Park building in Northwest Portland sold in a foreclosure auction for a $37.7 million in mid-February 2024, a stark drop from the $255 million it sold for in 2019.
Wikimedia Commons
Refinancing, into what environment?
Owners who extended hoping to refinance into lower rates may be in for a rude awakening.
Minutes from the Federal Reserve Board’s latest meeting affirmed that the Fed is not ready to cut rates. Most Fed officials remain more concerned about the risks associated with cutting interest rates too soon than keeping them high for too long.
Owners who refinance are likely to see increased rates at 6.5-10 percent, as opposed to 3-5 percent on notes currently coming due, according to Hendry.
“It’s going to make for some really tough math for those deals to pencil,” he said.
Several factors can make it difficult for an office landlord to secure a new loan to replace the existing one. When the valuation of an office property decreases, the existing loan amount may exceed the lender’s acceptable loan-to-value ratio (LTV) threshold for refinancing, the percentage of the property’s value that the loan represents.
“From the lenders’ perspective, if the gap between the loan value and the value of the asset is big, there’s probably not a lot left to do,” said Kai Pan, JLL’s national multi-housing valuation lead. “[Kicking] the can down the road isn’t going to help as much. So you are probably hearing or seeing more lenders willing to take action in 2024 compared to 2023.”
Decreased valuations also lower the owner’s equity in the property, potentially to the point where it doesn’t meet the lender’s equity requirements.
The perception of office properties as risky could compound these challenges. Late last year, the Fed and two other regulators suggested that banks assess large exposures to commercial real estate debt, saying they would scrutinize banks that rapidly piled up loans worth more than three times (300 percent of) their total capital.
New York Community Bancorp (NYCB), which posted a $252 million fourth-quarter net loss in 2023, largely because of outsized allowances and provisions for commercial real estate loan losses, fits this profile. (Hendry said NYCB had commercial real estate loans worth 468 percent more than their total holdings.)
These refinancing hurdles can leave landlords who extend scrounging for capital to offset values that could decrease even further from their peak when they refinance their debt.
According to Pan, what happens to properties that struggle comes down to “the underlying motivation of the folks that own or are operating versus their equity partners in the assets.”
“Take developments, for example,” he said. “With the shift in prices, a lot of developers are in a position where they’re not going to make any more money on the deal. They’re not necessarily forced sellers, but the card game is up.”
The time when owners have to face lowered valuations could be nearing, as the length of the extensions lenders are willing to give gets shorter. Pan said he’s hearing that fewer lenders are willing to give extensions at all in 2024, and if they do, they max out at four or six months.
“The sizable gap between the loan values versus the value of the assets is looming,” Pan said.
Meanwhile, according to Pan, the full impacts of recent rate hikes, which tend to lower property values, may not even be clear yet because sales volumes are low, stunted by sizable bid-ask spreads, the gap between the prices buyers are willing to pay (bid prices), and the prices sellers are willing to accept (ask prices).
Truly distressed properties, in most cases, are still not even for sale.
“There’s plenty of capital, there’s a lot of buyers out there, [but] the distressed [sellers] are still in a dark corner of the market,” Pan said. “They’re not [selling] yet.”
A Brooklyn branch of NYCB, whose stock has fallen more than 70 percent this year.
Lance Nelson/Getty Images
Risky business
In June 2023, the Fed and other regulators issued a policy statement encouraging lenders to be flexible with borrowers. It guided banks on how to extend and restructure loans to mitigate losses.
From a bank’s perspective, in addition to following the Fed’s guidance, extend and pretend delays some of the hurdles that come with trying to force a borrower to pay, Hendry of Trepp said.
If the current loan is “underwater based on market conditions,” he said, and “a maturity date is present,” in most cases, the borrower won’t be able to pay off the entirety of the loan and the lender runs the risk of receiving less than the loan value through the foreclosure process. They can seize and sell the building, but, in most cases, they’d rather not.
“Lenders are in the business of making loans and not operating buildings,” Hendry said. “Once they own it, they either have to operate it or try to sell it.”
Such sales usually come at a loss to the lender. Banks have to set aside reserves to ensure they have enough liquid assets on hand to meet withdrawal demands from depositors when they know a loss is coming, which reduces their interest income and liquidity.
“If the previous borrower couldn’t sell it to satisfy the loan balance and no one bid higher than the loan balance at auction, it is very unlikely the lender will have success selling it above the loan balance,” Hendry said.
If they extend the loan with the current borrower and the borrower can “just keep making the payments,” the bank “temporarily avoids” these challenges, Hendry said.
“If the market recovers during the extension period, both the borrower and the lender effectively get to walk away unscathed once the borrower can refinance or sell the property to satisfy the loan balance,” he said.
According to Hendry, for the extend and pretend scenario to benefit both parties, several things need to happen. The borrower needs to put in enough cash to pay down the loan “to satisfy the lender that the borrower is still solvent.” The property has to generate enough cash for “the borrower to maintain good payment history.” Finally, “the external market conditions” need to improve, “so the diminished property value is recovered prior to the loan’s new maturity date.”
According to Adam Dembowitz, JLL’s office valuation lead, “we’re probably close” to the bottom of office pricing, but transaction volume remains low.
“We may not be fully there,” he said. “People don’t want to sell at the absolute bottom, but the risk you run is if you wait a little bit longer, the price might go down even more.”
Dembowitz said that once an asset is non-performing and lenders are unwilling to work with the borrower, property owners have to either find funds fast or give the property back.
“If [lenders] are in a position where they have to take the keys back, they want to get that loan taken care of and have someone else take the property off their hands as quickly as possible,” he said.
Not all offices
Older, “value-add” offices in non-prime locations that haven’t seen a renovation in the last decade are the most likely to be seized by lenders, Dembowtiz said.
“There’s just not the level of demand in the market for that kind of space where a landlord can see optimism or hope for that extend and pretend scenario.”
Owners whose modern properties showcase up-to-date features at prime locations clutch a more stable investment, Dembowitz said, where value losses currently stand around 25% as opposed to upwards of 40% for less desirable properties.
Costello stressed that the pandemic tapered, but didn’t eliminate, physical office use. Landlords with high-demand properties may be able to make it through this cycle “even if tenants are not using space as intensely,” he said.
“[Owners] may still find business value in a somewhat stable asset,” Costello said.
Consolation prize
Property tax is calculated based on the assessed value of a property. While lower property values can reduce a significant source of funding for local governments— so much so that it drove Chicago’s Cook County assessor, Fritz Kaegi, to consider leaving out the most distressed offices in his calculations, there is a silver lining for owners: lower taxes.
Because not all properties have been reassessed in recent years, according to Pan, there’s a gap in many jurisdictions between actual market values and assessed values.
Owners are increasingly trying to save money on taxes by appealing or even litigating against the jurisdictions using outdated valuations, Dembowitz said, to “get some gains back on property values that have obviously decreased over time.”
“If you can’t sell and you’ve got a loan that’s maturing…you’re definitely going to look at any way you can decrease your tax burden, which is going to be your biggest real estate expense in almost all cases.”
