With some of the nation’s largest real estate owners defaulting on, and looking to restructure, loans backed by commercial office buildings, what may have seemed like an impossibility a few short years ago, is now very much a reality. The combination of higher interest rates, reduced occupancy, and an overall devaluing of office assets is driving defaults across the United States.
How Did We Get Here?
Remote Work. While we may live in a post-pandemic world, work-from-home and the hybrid work model have become commonplace. As a result, the traditional five-day workweek has, to a degree, been rendered obsolete. Indeed, office vacancy levels paint a worrying picture for office owners. Avison Young’s Q4 2022 Manhattan Office Report cites a record 18.6 percent availability rate. A survey conducted by The Partnership for New York City found that employers’ expected “new normal” occupancy rate was only 56 percent – as of late January that figure stood at 52 percent. Looking forward, Cushman & Wakefield sees as much as 330 million square feet of U.S. office space becoming vacant by 2030 attributable to work-from-home and hybrid work models (that is in addition to 740 million square feet becoming naturally available).
Higher Rates. As we noted in January, for years, owners have been able to refinance their way through vacancy issues thanks to lower borrowing costs. From April 2020 to March 2022, the 30-day secured overnight financing rate (SOFR) hovered below one-tenth of one percent. Today, the 30-day SOFR sits above 4.50 percent. Half of the debt on office properties maturing in 2023 has a variable rate – and a variable rate often means borrowers are required to purchase interest rate caps. Chatham Financial put the cost of one-year protection on a $25 million loan with a two percent rate cap at $33,000 in early March 2022. Today, that number is over $600,000.
Are There Potential Solutions?
Conversion. An office building owner treading water might be tempted to consider a conversion to residential (or another mixed-use repurposing), a popular option discussed due in part to the constant need for more housing (particularly in New York City). While conversion presents a potential long-term solution, these projects are often challenging or otherwise not feasible due to zoning regulations. Conversions are also expensive to construct as a result of the existing building’s configuration or building systems (plumbing to each unit, for example). Given that most office buildings cannot be easily or efficiently converted, what is an owner to do?
Work-Outs. Now is the time for borrowers and lenders to engage in meaningful discussions if a default has occurred or is looming, or if borrowers are unable to meet loan extension conditions. In almost all instances, borrowers need to be prepared to pay their lender to reach a work-out agreement. Thankfully, most lenders are not in the business of owning and operating office buildings, and therefore will be hesitant to foreclose, especially in this market. In fact, if lenders foreclose, they will then simply be in the same position as their existing borrowers – forced to determine long-term solutions to office building vacancies.
It is in the best interest of all parties to reach a work-out resolution, and each property and loan will present its own unique set of facts. While a lender is unlikely to work-out a default (or failure to meet extension conditions) without additional payment, those payments can come in many different forms. Whether payment takes the form of an upfront fee, a partial paydown, additional reserves (or reshuffling the existing reserves), an increase in interest rate, or even PIK interest paid on the back end, the parties can get creative to achieve a result that works for everyone. In almost all scenarios, it is beneficial for the borrower and their lender to agree to a work-out, in lieu of foreclosure.
 Avison Young, Manhattan office market report Q4 2022 (Jan. 11, 2023).
 Partnership for New York City, Return to Office Survey Results (Feb. 2023).
 2023 WLNR 7633737.