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Do Not Disturb: Tenants brace for more office landlords to go belly up on their property debts

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It used to be that building owners worried about tenants not paying rent.

But as U.S. landlords struggle to fill half-empty offices, tenants increasingly have been asking for safeguards in case a property owner defaults, which can throw a building into foreclosure and put lenders in charge.

When renewing a lease or looking to rent new space, companies also frequently want to know their building owner’s recent record, before signing on the dotted line.

“If it’s not the first conversation, it’s going to be in the second or third conversation, said Gabe Marans, vice chairman at real-estate firm Savills, where he focuses on office leases in Manhattan for corporate tenants.

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“It’s a very big concern for tenants.”

A string of high-profile property defaults early in the year put landlord risks front-and-center, even before overall loan delinquencies picked up dramatically.

Brookfield Properties defaulted on two Los Angeles skyscrapers in February, including the 54-story glass Gas Company Tower. Around the same time, Pimco-controlled Columbia Property Trust defaulted on a $1.7 billion loan on seven office buildings in New York, San Francisco, Boston and Jersey City, according to CrediQ. MarketWatch is a tenant in one of the San Francisco buildings.

Brookfield and Pimco declined to comment.

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Major landlords often seek funding from Wall Street for big property loans that can range from $100 million to above $1 billion. The debt backs a specific property or a group of buildings, but is “non recourse,” meaning a lender can’t go after a defaulted owner’s other properties or assets.

“A name matters more than in the past,” said Marans of a landlord’s reputation, even though he also sees some silver linings in the fallout. “They are not exiting all of their holdings, which is a huge sign of encouragement,” he said, adding that older, obsolete office buildings likely face a grim road ahead.

“It is not alarming, I think it’s encouraging that there’s a degree of proactivity in the market.”

That said, it isn’t a picnic for lenders or tenants if a landlord can’t pay their mortgage, or simply walks away from a building and its debt.

Landlord woes for tenants

Office properties have been in the eye of the storm as the Federal Reserve has jacked up interest rates to tame inflation that peaked above 9% yearly last summer. That’s meant the end of cheap and abundant debt for property owners with billions of debt coming due.

For tenants, it may seem like a golden opportunity, where renters finally have the upper hand in negotiating with landlords, but it also can be a minefield, even if rents are falling, available space is wide open, and incentives like months of free rent have increased.

The problem is that even if a landlord promises incentives to a tenant, their lenders or financial partners can nix a deal that doesn’t produce enough income to satisfy debt-service requirements. Then, it’s back to square one, after months of lease negotiations.

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The ugly backdrop for many buildings, outside of an elite group of high-end properties, points to the risk of increasing landlord defaults in the months ahead. With that in mind, some tenants may want to consider renegotiating their leases, fighting to include a non disturbance clause.

“That essentially means that if a property is thrown into a bankruptcy, foreclosure or default, the lender will not disturb the tenant, or kick out a tenant, so long as they continue to pay rent,” said Chris Okada, chief executive of Okada & Co.

His brokerage focuses on office leases in midtown Manhattan, putting it on the front lines of landlord and tenant negotiations through the pandemic and its wake.

“It’s not so much smaller companies, but larger ones in a down market will definitely look at who is the owner and what’s their situation,” Okada said. That’s especially been the case with bigger leases for large law firms or accounting companies that tend to seek bigger leases.

“If you have a non disturbance clause, that’s how they protect themselves,” Okada said.

Wide-open vacancy

Manhattan, San Francisco and other major U.S. cities that serve as a home to many of the world’s biggest companies have been stung by a record amount of available office space since the pandemic took hold.

The national office vacancy rate was pegged at 18.6% in the first quarter, according to Cushman & Wakefield, which expects the rate to peak in 2024.

While a few big office-lease deals in New York City to start 2023 helped lift activity, it remains sluggish, with stress at regional banks in March adding to the slowdown.

Available Manhattan office space was pegged at nearly 93 million square feet as of the first quarter, according to Colliers, slightly below the record 93.7 million square feet in February 2022. That’s roughly equivalent to the size of 10 Tesla

Gigafactories in Austin, Texas.

“To say that the office is absolutely dead, I would say, no,” Okada said, adding that his firm has done 227 leasing transactions in midtown since January 2021. Still, many companies have been downsizing, bargain hunting and negotiating with staff about how frequently they will be coming into the office.

“There’s a huge evolution that’s just begun. As with any kind of change, there are growing pains,” Okada said.

U.S. stocks were higher Friday, with the Dow Jones Industrial Average

up about 300 points, or 0.9%, the S&P 500 index

was 1.3% higher and the Nasdaq Composite Index

was up 1.6%, according to FactSet data.

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