Show Me the Financials: Office Tenants Now Grilling Landlords Before Inking Deals

Article originally posted on CoStar on April 7, 2023

Prospects Look To Avoid Financially Distressed Properties

Forget gyms, outdoor balconies, air filtration systems and parking.

The biggest question office tenants have for landlords these days: Who’s your lender?

Turmoil in the U.S. office market — which has triggered missed loan payments and foreclosure warnings — has meant prospective tenants are now taking a closer look at the financial health of property owners. The queries are an about-face for many office owners, which previously were the ones demanding information on tenants’ financial standing before inking deals.

The questions come as prominent building owners from New York to Los Angeles are experiencing a worsening cash crunch as tens of billions of dollars in debt is slated to come due this year alone. Tenants fear that higher debt costs could mean office landlords may not be able to fund standard operations, including making promised tenant improvements and maintaining properties in the years ahead, real estate analysts across the country told CoStar News.

“It’s not just a flight to quality for what tenants want,” Whitley Collins, global president of advisory and transaction services for CBRE in Los Angeles said. “They want a flight to capital.”

Many tenants have a stronger hand to play these days because a solid lease can materially boost a building’s value in a worsening market, Collins said.

“If you have a problem getting [information], then you know who you’re negotiating with,” Collins said.

Turning the Tables

The shifting power dynamic between office landlords and prospective tenants is only expected to continue as major landlords — such as Brookfield Asset Management, Vornado Realty Trust, RXR, Related Cos. and BentallGreenOak — have encountered financing issues with some buildings.

Average U.S. office values have fallen to about 4% below pre-pandemic levels, the worst performance of any type of commercial real estate, according to CoStar data. Lower values only compound the struggle to secure new financing in a lending environment that is growing tighter in the wake of rising interest rates and recent bank failures.

Around 30% of U.S. office buildings, collectively worth an estimated $1.1 trillion, are at high risk of becoming obsolete as factors such as hybrid work, increased economic uncertainty and widespread layoffs have resulted in lower demand for space, according to research from Randall Zisler, an independent consultant and former head of real estate research at Goldman Sachs.

The volume of new leases for office space across the country was about 10% lower than the annual average between 2015 and 2019, according to CoStar data. The picture has only worsened, with leasing volume in the final quarter of 2022 reported at about 20% below the quarterly average during that same period.

“Commercial real estate markets are currently in a recession,” Owen Thomas, the CEO of Boston Properties, one of the country’s largest office building owners, recently told analysts.

As demand has weakened, building owners face increased pressure to upgrade their buildings to stay competitive. More than 70% of office buildings in markets such as New York, San Francisco, Los Angeles, Boston, Chicago and Philadelphia are at least three decades old, according to JLL data, putting those cities at an even greater risk of rising vacancy rates and decreased demand.

For example, one of downtown Los Angeles’ largest landlords, Brookfield DTLA, disclosed in its annual report published late last month that it faced an increasing risk of being unable to finance tenant improvements — due in part to maturing debt and weakening demand for office leasing. Those improvements are critical in luring tenants to spaces and bringing lease agreements across the finish line.

Return of the ‘Zombie Building’

None of this is new for Ken Ashley, the Atlanta-based executive director of Cushman & Wakefield and chairman of the company’s tenant advisory group. These sorts of conversations were happening during the Great Recession as tenants attempted to avoid so-called “zombie buildings,” he said, or offices where an owner gives the keys back to lenders and a property’s ownership becomes opaque.

The difference between then and now, however, was that most companies worked in physical offices as opposed to today’s working environment when some employees come in on abbreviated schedules, if at all, Ashley said.

Declining office usage has meant the U.S. is projected to end the decade with a record 1.1 billion square feet of vacant space, compared with 688 million square feet in 2019, according to a Cushman & Wakefield report. Separately, about 330 million square feet of U.S. office space could become obsolete on that same timeline if working from home remains popular.

For those tenants who are still in the market for space, Ashley said they’re asking landlords for their loan information and whether there are any problems with the lender. Some tenants are even requesting landlords to put tenant improvement dollars into an escrow account along with agreeing that tenants won’t pay equivalent rent if a landlord fails to make promised tenant improvements.

“You have to go into transactions this year with your eyes very wide open,” the Cushman & Wakefield executive said.

Even so, assessing a landlord’s financial picture can be difficult, Shlomo Chopp, managing partner for New York-based real estate investment firm Terra Strategies told CoStar News. Office landlords are typically asset rich, not cash rich, and an understanding of a building’s finances can get complicated.

For example, office landlords may be able to obtain multiple loans from different sources against a pool of cash, Chopp said.

“That liquidity is stretched thin across multiple different assets,” he said. “The reality of real estate finance is everyone grins and looks the other way.”

Some landlords tout their financials as a source of strength. These landlords, including real estate investment trusts, family offices and high net worth investors, may not have any debt on their buildings. Debt-free landlords are making it known to prospective and existing tenants that they have the financial resources necessary to build out tenant spaces and improve properties.

In general, though, today’s office market uncertainty raises the stakes for leasing, Cushman & Wakefield’s Ashley said, regardless of what kind of landlord with which tenants are negotiating.

“You can do a building with debt,” he said, “but you just got to be careful.”