The good news is, only old office buildings are doomed. The bad news is, that's 70% of them.
Except the mediocre ones
Gas Company Tower was once a gleaming model of downtown America's ascendancy. Located squarely in Los Angeles' central business district, the 52-story skyscraper has a strong pedigree. It's home to a collection of major corporate tenants, including the Southern California Gas Company, the white-shoe law firm Sidley Austin, and Deloitte, one of the Big Four accounting firms. Its owner, Brookfield, is an $800 billion investment firm known for its blue-chip portfolio of real-estate assets. The tower's lobby even had a Hollywood cameo when it was featured in the opening shot of the 1994 film "Speed."
More recently, though, the glassy office property has become an example of the alarming financial turmoil that is engulfing once-bedrock real-estate assets. Brookfield disclosed in a February filing that a subsidiary it controls had defaulted on $753.9 million worth of debt tied to the tower and another nearby office building — one of the largest since the great financial crisis. But as Brookfield grapples with its lenders, it's also facing a potential exodus of the building's most visible occupants.
The Southern California Gas Company, the Gas Company Tower's namesake tenant, is in the market to relocate its 360,000 square feet at the property. Sidley Austin, which has about 136,000 square feet in the 1991-vintage building, is also prowling the market for new space, according to two people with knowledge of both tenants' real-estate decision-making. Spokespeople for Sidley and Brookfield declined to comment. A spokesperson for the Southern California Gas Company did not reply to a request for comment.
Brookfield has slim chances of holding on to the occupants, market experts say, without promising the perfunctory upgrades that landlords often rely on to entice tenants, such as improvements to the building's lobby, amenity spaces, and outdoor areas. With its future control of the tower in jeopardy, the investment giant is hardly in a position to lavish the millions of dollars necessary to undertake such renovations.
The situation at the Gas Company Tower is the latest example of the doom loop taking hold in America's office market, where snowballing disinvestment and financial distress have ensnared a growing number of buildings.
The brewing problems can be traced to a fundamental shift in office demand. Remote and hybrid work has transformed office attendance and allowed companies to cut back on their physical footprints. It has also made tenants more choosy about the spaces they do take, favoring offices with the "wow factor" to draw employees back in. It's not only staid properties that risk being left behind — even offices that do boast amenities can fall short of tenants' rising expectations.
"For years, office owners have been in an amenities war, spending millions of dollars on upgrades," Michael Soto, the head of US office research at Savills in Los Angeles, said. "The competition has reached the point where an owner can complete these upgrades and it might not even be enough to push leasing activity."
Rising interest rates, higher operating costs, and reticent lenders, meanwhile, present another financial hurdle for landlords who are contemplating spending tens of millions of dollars on upgrades. Those owners may have to spend huge sums to pay down expiring mortgages that have become outsized in the current lending market as commercial properties fall in value.
A huge swath of America's office market is vulnerable to these twin threats of being under-equipped with amenities and underwater financially. Seventy percent of the country's 5.56 billion square feet of total office space was built before 1990, according to a recent report issued by the real-estate giant Cushman & Wakefield, and is more likely in need of substantial upgrades to remain competitive. Almost $400 billion of office debt, meanwhile, is set to come due in the next 5 years, saddling owners simultaneously with refinancing costs that are likely to tally in the tens of billions of dollars.
'Tenants are taking less space'
Landlords insist that the pessimism in the sector is overblown and that diminished office attendance will be a pandemic-era fad. A growing number of companies are forcing workers back. But there is also growing evidence that remote work could become a permanent offshoot of the pandemic. Placer.ai, a real-estate-data firm that tracks office attendance, said in a recent report that there are currently about 40% fewer workers in the office on an average workday than before the pandemic. That rate has held steady since mid-2022, signaling "the entrenchment of a new hybrid normal," the report stated.
"We had been seeing a steady recovery of occupancy, but now it's flattening," Ethan Chernofsky, a senior vice president of marketing at Placer.ai, said. "What it tells me is the current situation is far closer to the new normal than I had expected it would be."
This behavioral shift has deeply cut into demand for office space. Cushman predicted that 1.1 billion square feet, or nearly a fifth of the entire US office market, would be empty by the end of the decade — a 55% increase in vacant space compared to the end of 2019, just before the pandemic began. Space reductions created by remote and hybrid work would account for about 330 million square feet of that vacancy, the report said. There's also been a major uptick in companies subleasing parts of their offices as their needs for space shrink, the real estate services firm Colliers said. Sublease space is often offered at a discount compared to spaces being marketed directly by landlords, putting more downward pressure on the leasing market — and by extension, building values. The amount of sublease space nationally more than doubled from 118.5 million square feet at the end of 2019 to 242.8 million square feet at the end of 2022, Colliers stated.
"There's no doubt that tenants are taking less space now," Aaron Jodka, a research director at Colliers, said. "Anecdotally, we're seeing many users take about 20% less space during lease renewals."
The tenants that do remain in the market for offices have become more particular about the spaces they take, according to real-estate experts, and for good reason. Companies have found that employees are more willing to trek into the office if a space and the building it's in are compelling enough to make the commute worth it.
"We're seeing tenants move out of commodity spaces and into the very best offices they can afford," David Smith, Cushman & Wakefield's head of global occupier insights, said. "It's left older spaces that haven't seen reinvestment less likely to find takers."
The double whammy of businesses needing less space and wanting only the nicest offices means that competition for tenants is even fiercer. For older buildings trying to survive, a physical overhaul may be the only option to remain relevant.
A different formula
Transforming a building with older bones into a high-quality, modern office tower has never been easy, but it generally followed a well-worn blueprint: borrow money for the work, hire brand-name architects, install the latest amenities and shiny upgrades that businesses want, and then wait for those tenants to rush through the door.
Rockefeller Group, a New York-based real-estate-development firm owned by the Japanese real-estate conglomerate Mitsubishi Estate Group, executed this playbook with the office tower it owns at 1271 Avenue of the Americas in midtown Manhattan. Rockefeller spent $600 million renovating the 2-million-square-foot property between 2016 to 2020, redoing the building's block-wide lobby and replacing its facade with a new glass exterior. All that investment paid off, as a collection of top-tier tenants filled virtually all of the tower's space: the corporate offices of Major League Baseball, the law firm Latham & Watkins, the Japan-based bank Mizuho, and others.
But Bill Edwards, an executive vice president at Rockefeller who helps oversee its New York portfolio, said that it might have reconsidered the scale of such a thorough and costly makeover today.
"We would probably have reconsidered that dollar amount given how leasing costs have increased tremendously," Edwards said, referring to the incentives landlords award tenants to take space, including periods of free rent, rent discounts, and contributions to the costs of setting up their offices. "The fact that tenant improvement and free rent periods are much more elevated would affect the math."
At 1221 Avenue of the Americas, an almost identical-looking office tower a block away that the company also owns, Rockefeller has recently completed a more modest $50 million makeover of the building's expansive outdoor plaza along Sixth Avenue, where it has 65,000 square feet of retail space it hopes to lease to a mix of stores, fitness centers, and restaurants that will serve as a draw for tenants. It previously upgraded the plazas on the north and south sides of the tower and, in 2015, redid the lobby. About 20% of the building's leased space, totaling roughly 500,000 square feet, is set to expire beginning in 2025, meaning the tenants in those spaces could depart. For now, the company doesn't have any further work planned to lure takers.
"This is a time in the market where you want to be cautious about investments and make sure you're managing the downside risks," Edwards said.
Spiral to the deep
The financial gambit of lavishing money on upgrades has become even more challenging as cracks have formed in the financial foundations that underpin a growing number of office properties. About $80 billion of office mortgages on bank balance sheets are coming due in 2023, according to data from Trepp, and $400 billion will expire in the next 5 years, more than any other segment of the commercial real estate market.
If a property is underwater, investing in more cash can be seen as putting good money after bad
Commercial real-estate financing is generally structured differently than residential mortgages. The loans often don't amortize and include only interest payments, meaning that when they expire, usually after a period of 10 years, owners must replace them with mortgages of commensurate size. In a market where building values have fallen — the National Council of Real Estate Investment estimated that average office values reported by its members fell 7.4% in 2022 — and lenders have become more cautious, that swap has become increasingly difficult.
Data from Trepp suggests that at least a quarter of the roughly $68.3 billion of securitized mortgages tied to office buildings and set to expire in the next two years is too large to be fully replaced, considering the rental income of the office buildings they're tied to. The disconnect leaves owners with huge sums to pay down. If a landlord has, for instance, an expiring $100 million mortgage, but can only find $70 million of debt to replace it because of the lower value of their building and the more cautious lending standards of banks, that owner must pay the $30 million difference or risk turning the property back to its lender.
"If a property is underwater, investing in more cash can be seen as putting good money after bad," Soto said, explaining why even landlords like Brookfield, which faced a debt maturity at the Gas Company Tower in February, have chosen to default rather than pay up.
This leaves owners, their buildings, and the wider office market in a precarious position. Robert Verrone, a principal at Iron Hound, a commercial real-estate-financing firm and advisor, said he now spends the majority of his time working on ailing debts. Lenders are often reluctant, he said, to seize office buildings because of the costs and expertise required to operate the properties. In some cases, a compromise can be struck in which an owner pays back a portion of their loan in exchange for forgiveness on some of the debt by the lender. Few lenders have been in a forgiving mood so far, but that could change, Verrone said.
"They're being tougher now than in 2010," Verrone said, referring to the workouts that became commonplace in the aftermath of the great financial crisis. "But you can get a deal done if you negotiate."
Lenders with troubled loans may also resort to selling off those debts to investors who are intent on seizing properties through foreclosure. But the discounts will be steep. On a call Wednesday hosted by CBRE, Spencer Levy, a global client strategist and senior economic advisor at the company, said that it has increasingly been called on by lenders to help them value their commercial real estate loan portfolios and identify potential debts to sell.
"We are currently valuing those deals in an enormously wide band," Levy said of office loans, in particular. "50 to 90 cents on the dollar."
Daniel Geiger is a senior real estate correspondent for Insider.
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