New York’s ‘zombie’ office towers wobble as interest rates rise
During a protracted bull market fueled by historically low interest rates and nearly free money, Doug Harmon and his team presided over record sales for many Manhattan trophy office buildings.
Not anymore. These days, Harmon, president of capital markets at Cushman & Wakefield, the real estate services firm, spends much of his time doing “triage,” as he puts it.
The world’s biggest office market has recently suffered from the departure of big spenders from China, the rise of remote working in the age of Covid and the economic fallout from the war in Ukraine. Now there are growing fears that the dramatic rise in interest rates will be too much for many homeowners to bear and that a long-awaited death toll is approaching.
“There’s a consensus sentiment that capitulation is coming,” said Harmon, who likened rising rates to gasoline setting off a firestorm in offices. “Everywhere I go, all over the world now, everyone who owns an office says, ‘I would like to lighten my load.'”
The industry is rife with talk of coerced severing partnerships, converting office buildings to other uses and speculation about which developers might not make it to the other side. Meanwhile, opportunists are bracing for what they believe will be a slew of distressed sell-offs, possibly in the first quarter of next year.
“We’re going to see distress,” said Adelaide Polsinelli, a veteran Compass broker. “We already see it.”
Since January, shares of SL Green and Vornado, two publicly traded REITs that are among New York’s largest office owners, have fallen by half.
New signs of tension emerged this week. Blackstone, the private equity firm, told investors it would limit redemptions in a $125 billion commercial real estate fund.
It also emerged that Meta, Facebook’s parent company, would free up around 250,000 square feet of space in the new Hudson Yards development to cut costs. It and other tech companies had been among the latest sources of expansion in Manhattan’s pandemic-era office market.
The small collection of offices like Hudson Yards — with new construction and the best amenities and locations — are always in high demand, according to Ruth Colp-Haber, who as head of Wharton Properties consults with businesses on leasing.
But, she warned, the real “danger lurks downstairs in Class B and C buildings which are losing tenants at an alarming rate with no replacements”. In total, Colp-Haber estimated that about 40% of the city’s office buildings “now face a big decision” about their future.
Forecasters have been predicting disaster for the office sector since the start of the Covid pandemic, which has accelerated a trend towards remote working and therefore a decrease in demand for space. According to Kastle Systems, the office security company, average weekday occupancy in New York offices remains below 50%. A particularly dire and oft-cited analysis by professors at Columbia and New York University estimated that the collective value of US office buildings could decline by around $500 billion – more than a quarter – by 2029.
The sector has so far defied these predictions. Leases typically last seven to ten years, so tenants continue to pay their rent even if few of their employees come into the office. In the depths of the pandemic, lenders were also willing to show leniency or, as some say, “extend and pretend”.
But the sharp rise in interest rates could finally force the debate. Financing has suddenly become more expensive for owners and developers – if available at all. “If you have debt that’s coming due, all of a sudden your rates are doubled and the bank is going to have you invest money in the asset,” one developer said.
Lower quality buildings may be the most vulnerable. As leases expire, many tenants are taking over or demanding rent reductions. Even though their incomes go down, owners still have to pay taxes and operating expenses.
Bob Knakal, president of investment sales at JLL, sees a growing horde of “zombie” office buildings in Manhattan that are still alive but have no obvious future. The typical zombie may have been purchased generations ago and provided monthly checks to an ever-growing list of beneficiaries.
“Now the building is not competitive from a rental perspective because it needs a new lobby, new elevators, new windows and new bathrooms. What if you go and see these 37 people and say to them, “You know what? You have to write a check for $750,000 so that we can fix the building. Those people would have a heart attack,” Knakal said.
If there is debt to be refinanced, lenders will require owners to provide more equity to compensate for the decline in value of the building. “There’s accountability,” Knakal said, “and I think a lot of these people will find it difficult to refinance.”
This appears to be spurring a flurry of behind-the-scenes talk between borrowers, banks, private lenders and others.
Manus Clancy, an analyst at Trepp, which monitors commercial mortgage-backed securities, compared the situation to brick-and-mortar shopping malls five years ago as their outlook deteriorated. Many eventually fell into foreclosure. Whether an office loan could be refinanced, he predicted, would depend on how new the building is, its occupancy levels and the length of leases. “There’s not a lot of distress per se, there’s a lot of worry,” he said.
Some outdated office buildings could be converted into housing, which, in theory, would help alleviate New York’s chronic housing shortage. But that’s easier said than done, say many experts. This would require zoning changes. Even then, many office buildings may not be suitable candidates for residential conversions – either because their floor plates are too large, their elevators are poorly located, their windows do not open or their quarters do not are not attractive. To make such projects worthwhile, owners would have to sell at very favorable prices.
It didn’t happen – at least not publicly. “Nobody wants to be the first to dive into it because nobody wants to set a new low unnecessarily,” said David Stern, founder of Townhouse Partners, a consultancy that does due diligence for commercial real estate underwriters. “That’s what everyone’s been waiting for: this incredible upgrade.” In more colloquial terms, one developer joked that some landlords, used to owning properties for years, hadn’t “seen Jesus” yet – but they would.
Meanwhile, some recent trades have hinted at a market shift. In July, RXR and Blackstone sold 1330 Sixth Avenue for $325 million, down from the $400 million paid by RXR in 2010. In 2014, Oxford Properties, a Canadian investment firm, paid $575 million dollars to win a bidding war for 450 Park Avenue, a 33-story tower. It was sold by a subsequent owner in April for $440 million.
“What is it worth today? asked a broker. “Less than $440 million.”