Billions of Dollars in Commercial Real Estate Debt Pressuring California Markets
Billions of Dollars in Commercial Real Estate Debt Pressuring California Markets

By Travis Gillmore

High interest rates and a shift to working from home continue to impact commercial real estate in California, specifically the office sector, with lingering high vacancy rates and impending loan due dates creating both risks and opportunities, according to experts.

With approximately $21 billion in commercial mortgage-backed securities coming due in Los Angeles and Orange County in 2024, borrowers and lenders have several options, analysts say.

“The easy way for everybody is short-term renewals and kick the can down the road,” Chris Cooper, principal and regional managing director—western U.S. for commercial and global real estate advisory firm Avison Young, told The Epoch Times. “But that’s going to take everybody’s cooperation.”

The fourth-quarter reports for California markets released by the firm anticipate increased investment in the area as debt coming due will force properties to be sold or refinanced.

As interest rates are significantly higher than when most expiring loans originated, and property values are lower—by as much as 60 percent or higher in some instances—refinancing is complicated and costly, he said.

“Parties are going to create a partnership to preserve the asset and allow us to get through these very difficult times in terms of higher interest rates and a major disconnect between the bid and the ask price,” Mr. Cooper said. “Failing that, if debt owners want to own a lot of property, they’re going to own a lot of property.”

California is not alone, with estimates of approximately $1.5 trillion coming due over the next two years nationwide.

Commercial real estate properties sit on the market in Costa Mesa, Calif., on April 9, 2021. (John Fredricks/The Epoch Times)

Some borrowers could choose to walk away from properties if millions of dollars are required to keep deals intact, avoiding what the industry describes as “throwing good money after bad.”

Several premier buildings in San Francisco have already experienced such, including the Westfield San Francisco Mall in Union Square—recent estimates suggest the building has lost $1 billion in value since the pandemic.

Owners that retain equity can short sale to eliminate debt, but with declining values leaving some assets worth less than are owed on them, options are limited, he said.

“There are a lot of scenarios with a lot of complexity,” Mr. Cooper said. “The real takeaway here is: Are both parties willing to cooperate with one another? Otherwise, it ends in a bad situation.”

Though some in the industry are concerned about a repeat of the savings and loan crisis of the early 1990s that resulted in drastic devaluations and are questioning how bad things will get, others are expecting a period of uncertainty followed by stable growth.

“I’m not convinced it’s going to be the proverbial fire sale that we saw in that period of time,” Mr. Cooper said. “Everyone thought we were going to see that in the capital market crisis in 2008 and 2009, and it was a lot of dry powder.”

A recent survey of brokers found that most expect vacancy rates to return to about 12 percent in San Francisco by 2029, a significant improvement from the near 40 percent today.

Noting that rental rates are the cheapest they’ve been in at least 10 years, tenants can upgrade space and find deals that were unthinkable pre-pandemic, according to experts.

“Many landlords are providing outsized concessions to achieve longer term leases,” Ross Robinson, principal and market leader for Avison Young’s San Francisco office, said in a Jan. 4 press release. “On the bright side, the flight to quality continues and the best buildings are maintaining high occupancy and strong rents.”

The move toward luxury has persisted for the last few years, as the top floors with bay views and buildings with special amenities are coveted, while lesser quality buildings are experiencing higher vacancy rates.

A gate is locked in front of a retail space for lease in San Francisco on June 14, 2023. (Justin Sullivan/Getty Images)

More than 52 percent of buildings classified as “A” grade and typically regarded as the second-best after those labeled as “Trophy” are facing distress, according to a fourth quarter nationwide Avison Young report.

Those struggling to maintain tenants are expected to have financial challenges in the next year, according to the survey of brokers. Analysts note in the report accompanying the survey that well-capitalized investors will find opportunities, as “historically high-priced assets” could be purchased at a fraction of previous sale prices.

One factor that could benefit the office sector is a return to the office, which some believe is likely to occur, to some degree. As employers better understand productivity and the implications of remote work to company culture, a return of three days a week is expected in some industries, according to experts.

Further contributing to a recovery in the Bay Area is a surge in leasing for Artificial Intelligence companies. San Jose and the Silicon Valley are expected to see the fastest recovery, according to the Avison Young reports, with most of San Francisco’s activity coming from the industry last year.

Several lawmakers, academics, and real estate experts told The Epoch Times that California will come out of the current “boom and bust” cycle because of the unique opportunities presented by the state.

Citing geography, climate, education, talent, and intellectual capital as core strengths that will continue to attract talent, businesses, and individuals, they point to a rebound in the future.

San Francisco Mayor London Breed agrees and believes that the city will come back, though in a form different than what everyone is used to.

“Empty offices, shuttered businesses … I know we can overcome these,” Ms. Breed said during her 2023 State of the City address last February. “We must accept a tough fact. San Francisco, as we know it, is not coming back, and you know what, that’s OK.”

She suggested that naysayers forget the resilience of the city—having risen from an earthquake and fire that leveled San Francisco in 1906.

San Francisco is devastated by a great earthquake and fire on April 18, 1906. Property loss was close to $350 million. More than 60,000 buildings, half of them homes, were shattered or burned. Some 265,000 of the 360,000 residents were homeless. (AP Photo/Arnold Genthe)

“Empty office buildings have fueled dire predictions about economic doom and screaming headlines about the death of downtown, but let’s keep some perspective here,” Ms. Breed said. “In 1907, downtown was mostly rubble and ash, and that’s considerably worse than today’s shift in how people are working.”

While many experts say San Francisco’s long-term prospects are good, some short-term outlooks are less optimistic.

Delinquencies are increasing in office buildings in the city, with sales prices below the average debt held on buildings in 2023, according to a Jan. 18 LinkedIn post from Nigel Hughes, senior director and market analytics in San Francisco for commercial real estate analytics firm CoStar.

Faced with such financial circumstances and vacancy rates and rentals at prices similar to 2012, some borrowers are defaulting on loans due to a lack of faith in prices to rebound quickly, he wrote.

“While most defaulting loans are those facing upcoming maturity dates, loans with maturity dates as far out as 2029 have also defaulted, suggesting some borrowers have a dim view of the prospects for a recovery in values.”

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