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The leaders of the country’s largest publicly traded office real estate owners have renewed their optimism that the latest push of companies forcing their workers back to the office will finally turn the tide of their troubled asset class. But investors to this point haven't bought the narrative, with share prices hovering near cyclical lows and continued weakness in some companies' earnings statements. Interest rate hikes, frozen capital markets and feeble leasing markets are causing major pain for office owners. Investors are responding; SL Green, the largest office owner in Manhattan, has seen its price come down about 36% this year alone.
Other office-heavy REITs like Vornado and Boston Properties are experiencing similar hits. Those prices, along with stubbornly sluggish office occupancy, made for a less-than-buoyant mood on first-quarter earnings calls in recent weeks. But company executives pushed hard on what they see as a waning public interest in working from home, and announcements from firms like JPMorgan and Amazon requiring workers to spend more time at the office. It was a similar story on the other side of the country at Kilroy Realty Corp., a San Francisco-based office REIT with a 14M SF portfolio, as company Chairman John Kilroy assured investors of a spike in office usage though the first quarter.
More and more, companies are looking to formalize their workplace requirements. Still, recession talk, the banking crisis and questions about hybrid work continue to have a dampening impact on the market. Plus, this week, the Federal Reserve raised rates for the 10th time in just over a year, marking the fastest set of increases since the 1980s. The range now sits between 5% and 5.25%, the highest since just before the 2008 financial crisis.
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First Republic, a prominent mortgage and multifamily lender that the Federal Deposit Insurance Corporation seized and sold Monday to JPMorgan, leases more than half a million square feet of office space across the country. Keeping it would give JPMorgan a larger office footprint in New York, Los Angeles and San Francisco. Exiting it would hurt landlords of those buildings and cut the bank’s real estate expenses. In those cities, First Republic leases 656,000 square feet across five buildings owned by Tishman Speyer, KKR, 601W Companies and CommonWealth Partners. All five have debt bundled into commercial mortgage-backed securities, putting those CMBS investors at risk. Like many commercial mortgages, CMBS loans often require the properties they back to produce enough income to cover their debt service — usually 1.25 times as much. If a tenant leaves and that income dips, that requirement could be breached. In announcing its purchase of First Republic, JPMorgan said it would spend $2 billion this year to “restructure” the bank. It did not offer details, but restructuring often includes paying lease-termination fees and employee severance.
In New York, JPMorgan is building a skyscraper large even by Manhattan standards at 270 Park Avenue, where it plans to consolidate its office space in the city. That could make First Republic’s New York space superfluous as soon as 2025, when construction of the 2.5-million-square-foot tower is expected to wrap up. First Republic is the second largest tenant at 410 10th Avenue, a roughly 630,000-square-foot building owned by 601W Companies. First Republic’s lease is for about 212,000 square feet and runs through September 2036. 601W Companies did not respond to a request for comment. When First Republic signed the lease in 2021, the bank was paying about $17 million per year in gross rent, according to documents associated with a CMBS loan on the property.
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A total of 1.5M SF of office leases were signed in April in Manhattan, marking a nearly 44% decrease from a year ago and a 7.7% drop from March. The activity was slow even for the pandemic era — the average month in 2020 saw nearly 1.6M SF of leases signed, while 2021 and 2022 had averages of 2.1M SF and 2.4M SF, respectively. The availability rate jumped again in April and is now at 17.4%, equal to the record high hit in February 2022 which found that a net of 1.35M SF of office space was vacated. Some parts of the city have even more empty offices, with downtown Manhattan ending the month with 20.5% availability after only 184K SF in leases were signed in the submarket. Manhattan's average asking rent was $75.13 per SF, a 1% increase. That figure is still 5% below March 2020’s average rent of $79.47 per SF, however.
Midtown South recorded the highest average rents in April at $81.77 per SF, while downtown rents fell to $58.69 per SF, now nearly 11% below that submarket's pre-pandemic average. Overall sublet inventory was up by 8.5% over last year, although it ticked down by 690K SF from March's 15-year high, and is now almost 80% higher than it was in March 2020. Just two leases larger than 100K SF closed during April: HPS Investment Partners’ renewal and expansion at 40 West 57th St. and Sheppard Mullin’s 108K SF expansion at 30 Rockefeller Plaza. Still, the weak month comes after a particularly rocky time for the city’s leasing market, with the widespread adoption of hybrid working arrangements, economic uncertainty and an ongoing banking crisis discouraging tenants from leasing space at a rapid clip.
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The eye-watering price of interest-rate hedges could push more property owners to put up a “For Sale” sign. Lenders in the U.S. commercial mortgage-backed securities (CMBS) market and banks usually require borrowers to hedge their interest-rate risk when they take out a variable-rate loan. If a landlord buys an interest-rate cap with a 3% strike rate, they receive a payment whenever benchmark rates—often the secured overnight financing rate, or SOFR—rise above that level. This reassures lenders that the borrower will be able to meet its debt payments even if interest rates rise. Protection bought by real-estate investors can last for up to five years, but typically runs for three.
Many of the interest-rate caps bought during the pandemic are still shielding landlords from higher debt costs but are due to roll off this year and next. Buying new hedges will be expensive. A three-year cap at 3% for a $100 million loan cost $98,000 in April 2019. Today, the same cap costs $3.48 million. Owners who can’t afford to pay can try to refinance their loans at fixed rates, but this will be difficult and expensive for riskier assets such as offices. Landlords may need to inject more equity, sell up, or default if a loan is already underwater. To make matters worse, property buyers loaded up on unusually large amounts of variable debt during the pandemic.
In 2021 and 2022, the share of floating-rate loans in total CMBS issuance was around 60%, according to Trepp data. Back in 2005 and 2006, when interest rates were also rising, the share was below 15%. The cost of interest-rate hedges has already been behind one of this year’s largest defaults. A subsidiary of Brookfield Asset Management defaulted on a loan against two Los Angeles office blocks after it didn’t buy fresh interest-rate protection on one of the towers. Interest-rate caps on two other offices in the same subsidiary’s property portfolio are also due to expire in October. If landlords are lucky, interest rates will be cut before their current hedges end. But the problem could also get worse if the Federal Reserve’s fight to control inflation takes longer than expected.
The one-month SOFR forward curve is currently pricing in peak rates of 5.07% in July, before dropping to 4.39% at the end of 2023. This is more optimistic than the central bank’s own guidance. Delinquency rates on commercial real-estate loans are still surprisingly low, and the interest-rate caps that are shielding landlords may be one reason why. Once these hedges end, borrowers and their lenders will face a much harsher reality.
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The Flatiron Building’s current deed-holders are now suing its would-be new owner several months after he bid a still-unpaid $190 million at auction for the iconic Fifth Avenue property. Plaintiffs, including some of the triangle-shaped icon’s current owners, are taking Abraham Trust to court over allegations that Jacob Garlick, a managing partner at that firm, won ownership but has yet to put forth a penny towards its down payment. The debacle was a “fraudulent bid” to get the small trust “15 minutes of fame,” the suit also charges. The filing also alleges that Abraham Trust invested significantly in marketing and other materials, including a list of multimillion-dollar properties, to bolster its position as a genuine contender for the terracotta skyscraper — and not just an aspiring amateur.
The 31-year-old Garlick came out of nowhere to win the court-ordered March auction with the enormous bid, sending the New York real estate world into a tizzy, which only became more wild after the apparently deep-pocketed newcomer failed to pay a $19 million deposit shortly thereafter. Despite not appearing to be able to afford the price he put on the 121-year-old edifice’s head, Garlick reportedly still tried to retain the property, which was up for auction in the first place because its multiple owners faced a very expensive ongoing impasse.
Meanwhile, the property is now also among the city landmarks being considered as potential shelters for the busloads of migrants arriving daily in the city. Struggling to locate living spaces for them, City Hall officials are looking to structures including JFK Airport hangars and Aqueduct Racetrack. Sale-wise, however, as the drama heads to court, the Flatiron is heading back to the auction block on May 23.
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