The phenomenon of hybrid work has resulted in a lot being said in real estate circles regarding office building vacancies, valuations and financing. Hybrid work has caused tenants of all sizes to shrink their office space as their leases expire. This will likely continue for years, as there is no regularity to lease terms or lease expiration dates. The adoption of hybrid workforces by businesses will be very detrimental to owners of office buildings.
Tech companies (that are some of the largest users of high-quality office space) have gone through multiple rounds of employee layoffs, following excess expansion during the pandemic. These actions have caused them to put substantial amounts of space on the sublease market, to cancel leases where they have that option, and to pull back on taking new space. The result is obvious: vacancy rates (which pertain only to space that can be leased directly from the building owner) and availability rates (which include space that tenants are paying rent on but are actively marketing for sublease) are both increasing and will continue to increase in the future.
When a commercial mortgage is expiring, refinancing is required. The conditions noted above are causing banks to underwrite new mortgages under new criteria. These criteria consider the building”™s current (frequently lower) value, current higher interest rates for borrowers, as well as the percentage of the value on which the bank will lend, known as the LTV (Loan to Value).
In today”™s environment, banks (being extra cautious in lending to an unpopular product type) typically will lower the LTV they will finance (for example, from the old 80% of value to +/- 50% of the now-reduced value) so that building owners frequently have to put cash into the deal in order to get a new mortgage. In many cases, the owner does not have that cash available, or does not want to increase the equity stake in the property.
If the owner cannot find a lender to refinance, the owner will have to either sell the building to pay off the current mortgage or (literally) give the keys back to the old lender and lose their equity. Prominent developer RXR caused a stir in the financial markets a number of months ago when it revealed that it was considering giving the keys back to the lender on some older, underperforming office properties.
Their reasoning was that the only way to improve their return would be to convert these properties to residential uses. Lenders would not provide the significant capital required to effect those conversions. RXR was not willing to continue to own office buildings whose future income is significantly clouded by the present leasing environment.
Building owners also frequently use the financing markets to pay for capital improvements (new lobbies, restrooms, public corridors, and other improvements) as well as for tenant buildouts, which have significantly risen in cost since the supply chain issues during the pandemic.
When interest rates increase, the cost of debt service increases, as many building mortgages are on variable rate schedules. The building income is based on already contracted rents, so the owner”™s net income declines as its debt service costs increase, often dramatically. This impacts the owner”™s ability to cover the debt service and to upgrade the building and pay for normal operating expenses and real estate taxes.
All of this, in concert with slowing leasing velocity, is putting increasing financial pressure on office building owners, particularly those who own older, less desirable buildings. In the current market, these owners are suffering the most with their “ugly duckling” buildings, while the super-expensive “trophy buildings” are getting most of the showings and a disproportionate share of new tenants, at rents of $150 to $250 per square foot. Tenants”™ reasoning is that they are willing to pay more per square foot for less square footage (as they downsize to accommodate fewer people in their office each day) with the expectation that they will attract people back to the office with the newest, most sustainable, most highly amenitized building.
These are the issues. Some of the proposed solutions are interesting. They include the obvious, such as renting pre-built office spaces for flexible or short-term use, rather than having tenants sign long leases. More expensive solutions include conversion to residential use, which can include all or part of the building. Tishman Speyer is considering converting ten floors of a building in Rockefeller Center to a high-end hotel use. The most interesting one I have seen is using vacant office floors to grow vegetables hydroponically, to be delivered fresh to their urban markets daily. There is no single right answer here, but the problem is clear. We need to find ways to repurpose a significant amount of office space into uses that will be economically sustainable.
Howard E. Greenberg is president of Howard Properties, Ltd., located in Valhalla, NY.
