Examples of real estate loan defaults have been relatively rare in Europe during the market dislocation of the past six months. However, in the US, challenging office market conditions have caused debt problems for one of the industry’s biggest names.
In February, a fund managed by Brookfield Properties defaulted on $784 million of loans on two well-known Los Angeles office skyscrapers, a move that could be the start of a period of defaults and delinquencies for the US office market.
Brookfield DTLA Fund Office Trust Investor, a Brookfield Properties subsidiary that owns and manages a portfolio of high-quality Los Angeles office properties, did not exercise an option to extend a $465 million loan on Gas Company Tower at maturity on 9 February.
Meanwhile, the fund did not obtain an interest rate protection agreement on a $318.6 million loan on 777 Tower, which also constituted an event of default.
The fund warned in a November SEC filing that as the cashflow on the assets declined, it might start missing loan payments. The default comes as Brookfield nears the end of the life of the 10-year fund, and its lenders had not foreclosed on the properties at the time of writing.
“Everything we are doing is to maximise recovery of capital as the fund liquidates,” a spokesperson says. “Discussions are ongoing to resolve in a constructive manner for both parties.”
The Gas Company Tower loan comprises a two-year, floating-rate $350 million mortgage provided by Citi Real Estate Funding and Morgan Stanley, and a $65 million mezzanine loan plus a $50 million junior mezzanine loan provided by Principal Financial Group. Meanwhile, Wells Fargo provided a $269 million mortgage for the 777 Tower loans, which also contains another $50 million mezzanine loan. Key is the master servicer and CW Capital is the special servicer on 777 Tower.
A Barclays research report published in February argued that the recent defaults increase the risks for the remaining loans in the Brookfield fund’s portfolio, citing a $275 million loan on EY Plaza that is coming due in October. Additionally, a loan on Bank of America Plaza also faces an increased risk of default at maturity despite the maturity date being in September 2024.
The Brookfield spokesperson notes the firm treats every asset on a standalone basis. “We finance assets individually and non-recourse to other assets, so no one asset can trigger an event of default on a broader portfolio of assets,” the spokesperson says. “A default on a specific office building in LA with its own operational circumstances and financing timeline has no bearing on our other properties.”
Rising office delinquencies
Toronto-based Brookfield’s decision not to exercise extension options on Gas Company Tower or purchase interest rate protection on 777 Tower comes as analysts are seeing a rise in office delinquencies in major US markets. As tracked by data company Trepp, the US CMBS delinquency rate decreased from 3.04 percent to 2.94 percent in January 2023, while the office delinquency rate grew as an outlier from 1.58 percent in December to 1.83 percent in January.
This increase in office delinquencies could rise further as the office sector continues to navigate headwinds from rising funding costs and downward property values, market participants say. It could also lead borrowers to exercise what were called ‘strategic defaults’ during the global financial crisis.
“We’ve heard periodically about this before, that borrowers will look to get the special servicers’ attention with the intention of trying to hammer something out that gives them more favourable terms,” says Manus Clancy, a managing director at New York-based Trepp.
“Sometimes a borrower truly wants to give back the property. It gets to special servicing and then over time, they have a change of heart [when] the special servicer offers something that is very enticing.”
Changing market conditions could also lead a sponsor to take a different route, with Clancy noting that some hotel owners managed to negotiate a workout during the pandemic as the economy recovered and the environment became more beneficial for borrowers to hold the properties.
LA office outlook
Brookfield is the largest commercial property owner in Downtown Los Angeles, with the spokesperson noting that while physical office occupancies are rising, the increase is much slower than expected.
This is particularly true when compared with the wider US office market, with a report from data and analytics provider VTS finding that most US cities saw a decline in office usage in 2022. The New York-based company’s VTS Office Demand Index found the largest declines in West Coast cities, with Los Angeles seeing a 31.1 percent year-over-year decline. By comparison, the US saw demand fall 20.7 percent during the same period.
Analysts who spoke with affiliate title Real Estate Capital USA cited occupancy concerns as a factor that could affect a wave of maturing CMBS loans in the office sector. An S&P Market Intelligence report cited $30 billion of maturities across all sectors over the next year tied to 400 commercial properties in Los Angeles and Orange County. Only about $3.5 billion of this total has been already paid back.
The city’s office sector has seen tenants give back space for sublease, which is a “precursor” for the occupancy falling, revenue falling and eventually, defaults, Clancy says. “Ultimately, properties [are] valued at less and if they’re valued to the point that there is no equity left, then borrowers may decide to give back the property.”
On the Brookfield defaults, Clancy says: “Sometimes the decision is one of not throwing good money after bad.
“Only Brookfield knows what comes next, but when debt service costs are soaring and interest rate caps are expensive, if they don’t see the value down the road of this building, it may be time to cut and move on.”
US office outlook
The situation could be seen in other major markets going forward, with Trepp identifying the five largest maturing office loans in the coming year. These include a $975 million loan on San Francisco’s One Market Plaza and a $783 million loan on 375 Park Avenue in New York. Chicago’s Aon Center is also facing a $533 million maturity.
Still, Clancy notes most offices with large loans are well occupied and have debt service coverage ratio levels above 1.0x, which makes it less likely the market will see a wave of distress in the first half of 2023. Having said that, borrowers could face refinancing challenges as hybrid work continues to slash tenant demand and as interest rates keep rising.