Distressed Office Property: What Does The Market Look Like?

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With five years of job numbers trouble and economic sluggishness, it’s no surprise that in markets everywhere  – primary, secondary, and tertiary –  plenty of office properties find themselves in the “wrong hands”.   Yet the bargain-hunter market in office properties has been characterized as a lot of money chasing a little product.  Which national trend actually prevails — a wave of distressed sales or a pick-your-shots character to most markets in troubled office property?

The case for more opportunity

Office properties have the greatest national volume of distressed loans.   According to Real Capital Analytics, one fourth of the current volume of distressed properties are office, coming to about $42 billion in troubled lending.  Sorting markets by total volume, some of the highest levels of distress include loans in default or held as REO, in Las Vegas, Manhattan, Phoenix, Chicago and Los Angeles.

Of course, primary markets aren’t the only source of distressed office space.  And in a general trend, property values have risen in the past year, meaning more sell-side pressure than would exist at a bottom.  As institutional sellers cautiously poke their heads up into the weather, REO departments and capital sources such as private equity firms are finding each other in ever-growing numbers:

Although pricing rose during the last two years, there is still a lot of opportunity out there, notes Joshua Zegen, managing member and co-founder of Madison Realty Capital in Manhattan. The private equity firm has been a large acquirer of distressed debt in recent years, and the company is continuing to pursue that strategy. Since 2010, Madison Realty Capital has closed on about $300 million of distressed debt transactions, mainly from banks and special servicers.

“The regulatory pressures are creating more momentum for loan sales,” says Zegen. Changes, such as the proposed Basel III, which will require banks to post more equity against sub and non-performing loans, is forcing banks to make strategic decisions to sell versus hold non-performing debt.

In addition, property values have moved off the bottom, which has created more flexibility to sell non-performing loans for those institutions that didn’t want to sell at the low point in the cycle, he adds.

For example, Madison Realty has been very active buying busted condo deals in the New York area. The investment firm has been able to buy the distressed assets and use its real estate expertise to complete the conversions and reposition the properties as rental units. “When the markets rebounded a bit, that was a great strategy, because the banks did not have to take the steep losses that they would have expected to take in 2009 and 2010,” notes Zegen.

The case for less

On the flipside, there’s an institutional bias to this market.  Unlike with the multifamily sector, investors tend to be more institutional and as such  have managed their portfolios more conservatively, allowing for more downside risk.   The presence of a “story” building or a “one-off” owner is far less common in this marketplace, and the chances are great that a distressed office property is being held off the market until values or cap rates move exactly where a master formula wants them.

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