Set of Office Buildings Financed in 2007 Face Daunting Journey Back to Stability, But a Potentially Profitable One
While property values and rents for most commercial real estate assets have been buoyed by the gentle tide of the slowly recovering economy, one group of properties -- those owned by office building borrowers who financed at the peak of market in 2007 -- remain deep underwater.
Investors had hoped that this vintage of loans would resurface post-recession to benefit from higher property values just as loan maturity and balloon repayment dates approached, allowing the borrowers to obtain loan extensions and refinances, a strategy among lenders that came to be known as ‘extend and pretend.’ For many of those 2007-vintage loans, the ‘pretend’ part has become more the reality.
According to Ann Hambly, founder and co-CEO of 1st Service Solutions, a CMBS borrower advocate in Grapevine, TX, approximately 85% of all outstanding CMBS loans were originated in the years 2005 - 2007. And, despite the improving CRE market, approximately 50% of those loans are still over-leveraged and not expected to be able to pay off at maturity.
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CoStar Group analyzed nearly 300 such office properties backing more than 200 loans with outstanding loan balances originated in 2007 and securitized in commercial mortgage-backed securities. All of the properties were identified by CMBS servicers as having outstanding loan balances greater than their current appraised value.
This group of properties has fared poorly since 2007. The vacancy rate for the properties has doubled from about 14% to 28% after posting negative net absorption of 4.67 million square feet. Asking rental rates have fallen from more than $26 per square foot to less than $22 per square foot. What’s even more surprising given what is happening across most CRE markets, is that vacancies for this group of properties are still trending up and rental rates still trending down.
All of the properties had been reappraised since 2009 -- and all at much lower property values. Taken as a whole, this set of office properties lost an average of 54% of their original value - losing more than $4 billion in value. Of the group, 37% (112 properties) had either already been foreclosed on, or are in various stages of foreclosure.
Problems That Can’t Be Addressed by Recovering Fundamentals
“Essentially, there are borrowers on over $6 billion of office product who are feeding underperforming assets with issues that can’t be addressed or solved by rising property values and recovering office fundamentals,” said Shlomo Chopp, managing partner, distressed debt advisory of Case Property Services in Brooklyn, NY. “In our experience, this is often a result of a prevalent lack of understanding, knowledge and misplaced pride."
As to what the lenders and borrowers are going to do to resolve the situation, Chopp said the news is not good.
We have “found that the disconnect between lender and borrower is most often related to value,” Chopp continued. “Simply put, the lender usually does not have the background or time to effectively perform its diligence on each defaulted loan. It would seem that all of these loans should be restructured, as it is improbable that the loan value will be realized. Yet we know, that the same mistake will be made over and over by many special servicing asset managers -- they will take adversarial action to their detriment.
“The lenders find it difficult to differentiate between borrower issues and property issues, and the borrowers do not understand the onerous regulations and trust documents limiting the lenders' creativity. This disconnect breeds distrust and the stagnation of the real estate recovery,” Chopp said.
Hitting Landlords Twice
“There are still a lot of underperforming office properties out there with a disproportionate share of distress in the suburban markets,” said Steve Pumper, executive managing director of Transwestern.
“These investors are caught in what’s basically a perfect storm, with tenants using less office space and paying lower rents,” Pumper said. “Healthier owners are able to steal tenants from some of these struggling owners who cannot pay commissions or tenant improvements. Landlords are losing out because tenants are rolling into more efficient space and getting that space at a lower rent rate, hitting landlords twice.”
“That, in turn, is putting a lot of downward pressure on some landlords and the rental rates they can obtain,” he said. “And that's why it is getting harder to underwrite such assets in the capital markets.”
“In reality, these investors are actually survivors of the last economic downturn who are in a position where they must determine if they can weather the next battle,” Pumper said. “For non-core office product, the distress story really may just be beginning.”
What’s A Borrower To Do?
“Appreciation and absorption that we would normally count is just not coming back fast enough,” said Bob Kline, CEO of R.W. Kline Capital in Scottsdale, AZ. “Without loans being modified in some capacity, it is likely that these loans cannot be paid off at par or negotiated par. These LTV's would be lucky to be brought into an 80-90 LTV with the modification and new capital,” Kline said.
“All this being said there are still some great deals out there," Kline added. "If the lender and/or servicers have the ability to take a write-down to the true net present value, then likely some of these deals will be able to be refinanced or have rescue capital applied to them and thus stabilize at sector.”
Kline said most such loans that have been successfully turned around have involved either a discounted payoff averaging 64 cents on the dollar assumption within A/B bifurcation of the loan, or an allocation of capital expenditures reserves with an average principal reduction of 25 cents on the dollar.
Kline Capital placed more than $519 million in the office sector in the form of discounted payoffs and assumptions last year. Kline sees his firm increasing that to more than $750 million this year.
“Some borrowers just ask us to take their position consumption, in the hopes of someday they can have recovery of some of their equity on the backside of our efforts as new investors in the properties,” Kline said. “We’ve been successful in allowing some of our clients’ properties to go REO and buy them back either at auction or from the OREO departments of institutions. This is a risky way to save a property, one that is highly not recommended unless all other legal means are exhausted.”
“The borrower could also ask themselves, ‘Is there an alternative use for this property and, if so, what kind of capital in time would it take to sustain?’ We find this approach to be very popular in areas that are over-saturated with heavy amounts of office product yet underserved with multifamily or mixed-use housing,” Kline said. “The conversion of some floor plates may allow for such an alternative use to consider.”
Another option is for the borrower to secure new capital, equity and/or rescue capital, and then submit a plan for recovering the net present value of the property to the lender and/or servicer, which will allow them to consider the transfer or sale of the property, he said.
Now Is the Time for Office Value-Add Strategies
According to Transwestern’s Pumper, the current market is an opportunity for value-add investors to place capital in office space due to a dislocation in the marketplace.
CoStar Group subsidiary Prperty and Portfolio Research (PPR) has been advising clients to kick the tires on value-add strategies in the office market since 2011, as vacancy remains on sale for those willing to take on the risk.
“As yields on core assets continue to tighten, a successful lease-up strategy could be prudent as the leasing and capital markets recoveries begin their second act,” said Paul Leonard, real estate economist, U.S. market research for PPR.
“As pricing for top assets in the best locations continues to balloon, investors are collectively warming up to the idea of taking on more risk in order to earn respectable returns. Capital is spreading to secondary locations,” Leonard added.
“During the bubble period from 2006-‘08, speculative investors were bidding up pricing on these assets ‘unencumbered by tenants’ at a faster rate than they bid on assets that were stabilized, but not full,” Leonard said. “Of course, that all changed in 2009, when the bubble burst and pricing fell for all assets, regardless of occupancy.”
“However, buildings without tenants and subsequent income streams were disproportionately punished,” Leonard added, “and their prices dropped by more than 50% from the peak as the flight to safety played out.”
“Fast forward three years, and most of the market has significantly recovered from those dark days,” Leonard said. “Pricing on assets in the other three occupancy buckets is up anywhere from 15% to 22% since 2009. By comparison, pricing on half-empty assets increased by a measly 4%.”
“But the case can certainly be made,” he said, “that now is the time to scoop up assets with challenged occupancies. On the aggregate, the office market recovery is in its infancy. Rent growth is expected to accelerate this year, and supply on the whole should not be a major threat. An exceptionally wide pricing spread between high- and low-occupancy buildings and a favorable outlook for rent and occupancies make now the perfect time for value-add investors to get in front of rent growth expansion.”
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