San Francisco, L.A. Office-Tower Vacancies Threaten CMBS Loans

Office-tower vacancies are rising again as the Covid-19 delta variant rages and as large tenants end leases, especially in tech hubs that have older buildings. That could lead to cash-flow problems for commercial mortgage bonds containing loans tied to the properties.

Two San Francisco office properties, 225 Bush and 300 Montgomery, as well as the Cahuenga West Office Building in Los Angeles, have seen occupancy drop, according to a report from Morningstar Credit Information & Analytics. The rising vacancies potentially threaten cash flow for three loans that were securitized in various multi-loan, or “conduit” commercial mortgage-backed securities deals, MCIA said.

A $350 million loan tied to the 225 Bush property is secured by a nearly 600,000-square-foot, Class A office building in San Francisco’s financial district. Previously known as the Standard Oil building, the structure was built in 1922 and renovated in 2010, according to MCIA. Occupancy fell to 73% from 92.6% in the first-quarter of 2021 after a series of smaller tenants vacated, the firm said. Three of the top-five tenants’ leases, collectively accounting for 32.4% of the gross leasable area, expire in the next 12 months. 

The 2020 net cash flow was already 15% lower than what was expected when the deal was underwritten. To make things even riskier, the loan pays interest-only for its entire term, which elevates refinancing risk at its November 2024 maturity, MCIA said.

The loan is split into five notes securitized in commercial mortgage-backed securities:

Meanwhile, a $66 million loan for the 300 Montgomery building, split in two different CMBS transactions, is collateralized by a nearly 200,000 square foot building in San Francisco. The property lost tenants in 2020, pushing occupancy down to 57% as of December 2020 from 83% the year before. 

On top of that, around 29% of the leases are set to expire in 2021 and 2022, MCIA said. 

“Although the property has historically benefited from its location within the San Francisco financial district, uncertainty regarding the future of office work, especially within the tech center, could make backfilling the vacancies challenging,” analysts Heena Chheda and Sneha Ananthakrishnan said in the report. The loan is interest-only, they wrote, making the loan-to-value more than 90%.

“As many tech jobs can be done remotely, some companies are reducing their footprints, creating a glut of office space,” the MCIA analysts wrote in July. Asking rents in San Francisco may not reach 2019 rates until 2026, they said, citing CBRE Econometric Advisors.

Even urban cores of Midtown Manhattan and Chicago’s Central Loop have suffered. In Midtown Manhattan, vacancy is up to 12.2% in 2021 from 7.5% in 2019, with vacancy as high as 17.1% in Midtown’s East Side, MCIA wrote in July. In Chicago’s Central Loop, 25.9% of all office space is available, said MCIA, citing CBRE EA. 

In Los Angeles, occupancy at the Cahuenga West Office Building, which backs a $24.7 million loan that accounts for 2.5% of a mortgage-backed security, dropped to 54% in March 2021 from 81% in December 2020. The building’s largest tenant, Extreme Reach, left when its March 2021 lease expired. Extreme Reach occupied 24.7% of the gross leasable area. Three additional tenants, representing about 42% of the area, have lease expirations in 2023, MCIA said.

The Los Angeles office depends on the entertainment industry — it’s near Hollywood, Studio City, and Burbank. The property owner has indicated that it has leases out for review for two spaces, totaling 8,000 square feet, the MCIA analysts said. Even with that progress, filling the vacant space will be a challenge, they said.

Despite shrinking demand for office space, lower rents and uncertainty about how much telecommuting will occur post-pandemic, investors this year have been willing to put money into commercial real estate they see as high quality, known as Class A properties. They have even bought bonds backed by portfolios of well-performing shopping centers and malls. Investors have clamored for securitized bonds that offer a little more yield than other asset-backed debt and corporate paper. 

“The rule of thumb is that you can’t go wrong with Class A office space,” Jake Remley, senior portfolio manager at Income Research + Management, said in an interview.  “That will still hold up; but there is lots of volatility due to the fact that urban interiors and downtowns are really struggling, putting pressure on what would otherwise be the top of the CMBS hierarchy.”

Read more: Office Tower CMBS Still Hot Despite Vacancies

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