Across the country, those with investments in office buildings — owners, investors, tenants, lenders, and bondholders — are staring down a perfect storm of distress: rising interest rates, record-high vacancies and operating costs, constrained capital, and more than $900 billion in commercial real estate debt set to mature. Meanwhile, others see opportunity.
To help clients navigate those challenges, national law firm Ballard Spahr has formed a cross-disciplinary team of attorneys focused specifically on distressed office buildings. The group brings together lawyers with specific skill and experience in real estate, finance, leasing, enforcement, and bankruptcy matters involving office buildings.
Alicia B. Clark leads the firm’s Western Real Estate Finance team and co-leads the firm’s Insurance Company and Institutional Investments and Distressed Office Buildings teams.
You’re the new co-leader of Ballard Spahr’s Distressed Office Buildings team. Why do clients need this kind of support, and why now?
Right now, owners of all types of commercial real estate are facing significant headwinds, including rising interest rates, higher operating costs, tightening credit, and mortgage debt maturing. Owners of office buildings, in particular, have a fifth negative market force on top of that — remote work leading to a decline in the need for office space, and thus decreased tenant demand. Some office building owners likely could handle one or two of these factors, but all five at once might be just too much. Our Distressed Office Buildings team strategically brings together attorneys from a range of disciplines, including real estate, finance, leasing, enforcement and bankruptcy, so that we can provide creative, comprehensive solutions to the problems faced by office building owners. The coming few years might be a bumpy road, and we wanted to be proactive in order to marshal our resources in the right way for the benefit of our clients.
The Denver commercial real estate market has been a bright spot nationally for a long time. Do you see that changing, and if so, will it be temporary or longer-lasting?
Denver has a lot of good things going for it. It is a very desirable place to live, which leads to a positive influx of talent and capital, and our downtown has a healthy mix of sectors, from health care to technology to professional services. However, I recently read a CommercialEdge report that said 10 percent of Denver office stock is subject to a maturing loan in 2023 — making it one of three of the largest office markets with the most loan maturities in 2023 — and the Downtown Denver Partnership’s most recent High Frequency Economic Update puts the downtown Denver office vacancy rate at 22 percent. While those are not positive signs, our fundamentals are strong and so we should be able to weather a downturn. How temporary or long-lasting that downturn may be is anyone’s guess.
Many observers think we’re heading toward a recession, and may be in one as early as the second half of this year. Given the economic roller coaster we’ve been on over the last few years, is it possible to predict what might happen to the Denver office building market in the next year or so?
I don’t think anyone can say for sure, but it certainly looks like the challenges office building owners are facing will result in depressed property values, continued softening of tenant demand and defaulted loans. In addition, the development pipeline for office buildings may slow in the coming few years. One thing that has become clear is that flight-to-quality is still a prevalent trend in this market, which means that newer and amenity-rich office buildings will be in the best position to weather market troubles, with older and outdated office buildings bearing the brunt of a downturn.
Are there certain types or classes of office buildings you see as being more at risk than others?
Broadly speaking, Class A office space seems to be having an easier time attracting tenants, because organizations want newer buildings and nicer amenities to try to coax workers back to the office. Older office buildings and Class B office space can’t easily compete on those fronts, and with demand as lukewarm as it is, there’s only so much they can do in terms of attractive lease pricing. Conversion to another use, like multifamily housing, may be a good option for this kind of office space, although that can be costly and is not the right fit for every project.
Generally speaking, if the owner of a Denver office building is having difficulty attracting tenants or receiving rent from clients, are they just out of luck, or are there other options to pursue?
I definitely would not say they are out of luck. As I mentioned earlier, conversion to another use may be an option for some office buildings, or there may be solutions the owner can pursue such as a loan extension, modification or restructuring or a rescue capital transaction. At the moment, I have not seen one strategy rise in prominence over others, but I think it’s wise to think creatively and avoid assuming that there is nothing that can be done, particularly when the mortgage lender may not be keen on taking the property through foreclosure or deed-in-lieu of foreclosure.
Given the oversupply of office building real estate in many markets, and that hybrid work models seem unlikely to change any time soon, are office buildings still an attractive investment opportunity?
So much of that answer depends on the exact circumstances of each project — its market/submarket, its location in a geographic area, the financing terms, etc. I would not say all office buildings are not still an attractive investment or will never be an attractive investment option again but it would certainly seem that the investment thesis regarding many Class B and Class C office has changed materially for the worse. Right now, there are many factors that an investor would need to consider to analyze the potential investment. That said, we do expect to see many investors with a strong interest in this sector, but likely with very different financial criteria than we have seen in a while with many looking to take advantage of these distressed situations.
You’ve been practicing for almost three decades. In your time working with real estate finance clients, can you recall an era comparable to the one we’re in now (or are about to be in)? If so, do you think there are any lessons from that time that would apply here?
Commercial real estate has gone through hard times before, certainly. I do think the convergence of anemic tenant demand, rising interest rates, constrained capital, and pending loan maturities is something we have not seen in the modern era, though. The Great Recession that started in 2008 taught us that along with problems come opportunities, and strategic thinking, anticipating issues and developing practical solutions can go a long way. I think those are good attributes to apply here, too. That being said, there is no exact blueprint, and it will be really interesting to see what unfolds in the next few months and years. In the meantime, our focus will continue to be on providing our clients with the benefit of the full range of our legal services and experience to assist them throughout this cycle.
Alicia Clark practices general real estate law, with a focus on financing, leasing, acquisitions, and dispositions. She has substantial experience representing lenders and borrowers in acquisition loans, permanent financing, and bridge loans. She also represents lenders, servicers, and investors in connection with workouts and foreclosures. Alicia regularly represents institutional owners in commercial leasing of industrial, office, and retail properties, as well as various data center and industrial tenants in their leasing activities across the country.
