US office buildings face a $1.1 trillion obsolescence problem
One of the tallest office towers in St. Louis has lost 96% of its appraised value. Denver’s former World Trade Center complex faces foreclosure. A vacant oil company workplace in Houston sold this year at a loss of $67.4 million to lenders.
According to Randall Zisler, independent consultant and former director of real estate research at Goldman Sachs.
Some companies reduce their space. Others revolve around newly developed or newly renovated, environmentally friendly offices with lots of fresh air and natural light, fitness rooms and food courts. There are still older buildings that would be expensive to renovate to today’s standards. As the values of these properties drop, some owners are moving away.
“We’re not saying the bulldozers are coming in droves,” Zisler said. “But you’re going to see repricing and, in some cases, reuse of those buildings.”
Average office values in the United States remain 4% below their pre-pandemic levels, the worst performance of any type of commercial real estate, according to Green Street data through February. A closer look shows a divided market: While prices for newer, equipped offices have risen about 15%, they’ve fallen 20% for smaller, older properties, Zisler said.
Buildings that have opened since 2015 have seen more than 51 million square feet in occupancy gains since COVID hit, while vacancies have ballooned elsewhere, according to Jones Lang LaSalle. The divide is more pronounced in big city markets where more than 70% of office stock is at least three decades old, such as New York, San Francisco, Los Angeles, Boston, Chicago and Philadelphia, the brokerage reported.
Workers have been slow to return to their offices two years after pandemic shutdowns sent them home. With many people vowing never to return to their old commutes, companies are reconsidering their real estate needs, with downsizing or listing space for subletting. Demand for in-person space could drop 15% from pre-COVID levels over the next five years as remote or hybrid schedules become more common, according to Green Street.
To entice reluctant workers to return to their desks, employers are looking for lavish offices with some of the perks of home. Many top-paying tenants, such as technology companies, only want low-carbon buildings, while regulations such as New York’s Local Law 97 may require heavy investment to meet energy goals.
Renovations do not guarantee the success of buildings in weak locations. Empire State Realty Trust added a gym and dining room in 2019 to a building in Norwalk, Connecticut, which was only 46% occupied in December. The company stopped paying a $30 million mortgage rather than spend more money renting space, chief financial officer Christina Chiu said on a conference call last month.
“The calculations favored handing over the keys to the lender,” said Danny Ismail, principal analyst at Green Street. “Increasingly, it’s a risk for the future.”
Some lenders give up. MUFG Union Bank is selling a $190.8 million mortgage on a Chicago complex with its largest tenant, BMO Harris Bank, which is moving to a new riverside tower this year. The debt matures on March 31, positioning the note buyer to assume ownership on an “attractive basis relative to new construction,” according to a JLL marketing note.
A spokesperson for MUFG Union Bank declined to comment. Chicago’s downtown office vacancy rate hovered around 31% at the end of 2021, according to JLL data.
The mortgage default rate for offices remains well below that of hotels and retail due to long-term leases and contractual obligations to be paid even if tenants are not using the space. In a sign of growing caution, some new mortgages include “cash trap” clauses diverting rent payments from tenants directly to lenders rather than landlords when offices remain dark for long periods, said Elizabeth Murphy, real estate finance lawyer at Alston & Bird.
“It sets off alarm bells,” Murphy said in an interview from Charlotte, North Carolina.
Values plunge after delinquencies. Revaluations over the past two years of 60 office buildings with distressed commercial mortgage-backed securities have fallen 67% on average, wiping out more than $1.2 billion in collateral, according to data compiled by Bloomberg. .
This group’s biggest wreck was 909 Chestnut in St. Louis, which was valued in August at $9.2 million, up from $207.3 million in 2014. Built in 1986 as the world headquarters of Southwestern Bell, the 1.2 million square feet of the building is available for lease, according to a broker presentation.
The property is under contract and the sale is expected to close this year, according to loan documents. The broker, Tony Kennedy of Colliers, declined to comment.
Houston’s vacancy rate hit 28% in December, JLL reported, compounded by years of contraction in the U.S. oil industry. Three Westlake Park, an empty former office of BP and ConocoPhillips, was sold in January for around $21 million, resulting in a loss of $67.4 million for lenders, according to ratings agency Kroll Bond. The new owners plan to transform the offices into apartments.
In Denver, where downtown offices are 24% vacant, one loser is the former World Trade Center I & II towers, built in 1979 and valued at $176 million in 2013. Owners have failed to find a buyer who would cover the $132 million mortgage and agreed to transfer the property, now called the Denver Energy Center. A foreclosure is expected this month, according to loan data compiled by Bloomberg. A spokeswoman for the owner, Los Angeles-based Gemini Rosemont, did not respond to requests for comment.
More losses threaten homeowners across the country.
“We’re going to see a substantial drop in prices for obsolete buildings,” Zisler said. “You will see it over the next four years, maybe even sooner.”