While it might not seem possible, the mood around the U.S. office market got even gloomier this summer as a variety of media reports painted the commercial real estate sector as being in disarray and distress. The news was bad everywhere, including the Big Apple, where New York Magazine’s July cover story used the banner headline, “Worth Less,” to discuss the sad state of many Manhattan office towers.
The clever pun was followed by the phrase, “New Glut City,” and everyone’s favorite term, “Office Apocalypse.” Some of the city’s office landlords are reportedly “panicking.” Author Andrew Rice makes a compelling case that the office situation in New York is frightening, especially if you own Class B or C spaces.
According to Scott Rechler, CEO of commercial real estate company RXR, these types of office space are “competitively obsolete.” He went on to opine that lower-quality properties — which account for about 70% of the city’s office space, according to Rice — will have to be “redeveloped, repurposed or torn down.”
Even if Rechler is using hyperbole to make his point, the comment is a brutal beatdown of New York’s office market. While the office sector appears to be suffering an existential crisis, the situation may not be as dire in other parts of the country.
“This is a large country and there are lots of different markets behaving in different ways.”
– Jamie Woodwell, vice president of research and economics, Mortgage Bankers Association
One of the issues that has spooked industry observers is the large number of commercial mortgages that must be refinanced in the next few years. Here’s where things get tricky: The amount of money involved in these loans varies based on the source. For instance, the Mortgage Bankers Association (MBA) estimates the total volume of commercial loans that will need to be refinanced by the end of 2024 at $1.4 trillion.
This figure, however, includes all commercial sectors (including industrial, multifamily, retail and others), some of which are doing well or at least holding their own. The troubled office sector is looking at refinancing needs of about $189 billion in 2023 and $117 billion in 2024, for a total of $306 billion, according to Jamie Woodwell, MBA’s vice president of research and economics. Meanwhile, the Commercial Real Estate Finance Council (CREFC) estimates office refinancing requirements for the next two years at more than $600 billion.
Based on the MBA figures, the refinancing issue may be bad, but it’s not as crushing as many believe. One of the biggest issues facing landlords is to discern the value of their property in light of higher interest rates and declining valuations.
“Each property and each loan is going to be different,” Woodwell says when discussing how each property may face unique issues. “It will depend on what is happening with the space issues of that particular property, how much leverage the borrower has taken on the property, and how much equity they would have in the property when they come to refinance. This will help them adjust where property values would be.”
Lisa Pendergast, executive director of CREFC, says that plenty of hurdles exist when seeking a new loan. In a written response, she stated that today’s office mortgage rates are in the 6% to 7% range, compared to rates for existing loans that are often in the 4% range.
“Combining higher refinance rates with any degradation in the property performance suggests that many office owners will need to pay out of pocket to successfully refinance,” Pendergast writes. “That is likely to happen only for those well-occupied offices with long-term leases in places for which an owner doesn’t view moving forward as throwing good money after bad.”
Woodwell says that one mistake impacting the industry is the generalization about cities and even entire regions when it comes to the office sector. Some locations may be doing well while others face challenges. “It’s a pretty big mistake to generalize from particular cities, or even areas within a city,” Woodwell says. “This is a large country and there are lots of different markets behaving in different ways.”
Another area that falls into the “not as bad as many thought” category is the relative strength, at least so far, of the nation’s banking system. Many observers expected more banks to fail following the collapses that took place this past spring. Combining a shaky financial system with troubled office loans initially appeared to be a recipe for disaster. But it’s one that hasn’t arrived — at least, not yet.
Woodwell says there were misunderstandings early on about which banks had the majority of office loans. Since then, Woodwell says bank executives have made more of an effort to inform investors and depositors about the levels of their commercial mortgages. According to consulting firm McKinsey & Co., the majority of commercial loans are held by midcap banks, regional banks and private equity firms. The localization of loans should lessen the chances of the banking system as a whole being in danger due to office-space troubles.
There is also a bright spot in the fact that some see opportunity in the hobbled office sector. Dutch Mendenhall, CEO of Tampa-based RAD Diversified REIT, says his company may be bargain hunting for office space in the next few months.
“I feel like by the end of this year, or early in 2024, it’s going to be a really good time to buy,” Mendenhall says. “We are near the bottom of this cycle. I’m a very aggressive discount real estate buyer, so I look at an office market having trouble as an opportunity to be able to go in and buy.” ●
