Office buildings in default are becoming the new normal. Every week we read about new office buildings that have either defaulted on their mortgage, are being foreclosed upon or are going to special servicing. Examples in New York City include 475 Fifth Avenue, 521 Fifth Avenue, 340 Madison Avenue, 230 Park Avenue and 25 Broadway, among others. While this is just the tip of the iceberg, fortunately the situation does not resemble the Titanic.

But what does all this actually mean from an operational standpoint and for tenants who may be concerned about leasing space in a troubled building? In my view, not necessarily all that much. The buildings’ operating costs remain the same and their rent rolls only change at the glacial pace of real estate due to long-term leases. Further, the buildings aren’t going anywhere, the existing leases aren’t changing, and the tenants aren’t moving, except possibly when their leases expire. In fact, from what I can see in the market troubled buildings do not significantly alter their rents. For example, the Helmsley Building which is in special servicing is not suddenly offering discounts to new tenants as an incentive to take space in the building.

Of course, what has changed is the cost of financing and depressed valuations. That has major implications for the owners who are faced with the Hobson’s choice of obtaining new financing at substantially higher interest rates or selling into a depressed market. No wonder they seek short term extensions and hope for a better day. Every building with a mortgage coming due faces this dilemma.

This is a massive problem in real estate because it is a highly leveraged industry. Owners understandably loaded up on financing at historically low interest rates and those with loans coming due face a dramatically higher cost of funds, compounded by concerns about the diminished value of the underlying office buildings that serve as collateral. Looking at the other side of the loan transaction, banks with heavy concentrations of real estate loans are also at risk. However, thus far they have been able to sell off significant portions of their portfolio at a discount and Fed chair Jerome Powell has expressed confidence numerous times that this issue does not represent a danger to the banking system.

However, from a more micro tenant standpoint, what matters is that services are maintained if there is a change in management/ownership. This is generally not a problem in the better buildings, but is a situation to be monitored in class B buildings and lower.

The bottom line is that the financial phase of the office revolution is in full swing and will continue for years. However, it is possible that the impact on building operations and tenants will not be as cataclysmic as it has been for ownership, other than there has been a more competitive rental market with more availability, which favors tenants.

So this is today’s new normal. Until there is a significant drop in interest rates I expect more foreclosures, defaults, and appointments of special servicing agents. The damage to lenders has thus far been kept under control. As for tenants, they will be able to pursue their hybrid work strategies while enjoying cost savings on rent as the industry navigates its way through this very unsettled period. Watch this space.

Thank you,

Ruth Colp-Haber