A Brookfield fund delivered a small shock to the US CMBS market last week after it defaulted on two top-tier office towers in Los Angeles.
The default from the fund – Brookfield DTLA Fund Office Trust Investors – comes against the backdrop of a US office property sector that is struggling with the surge in interest rates, declining property prices and uncertainty about corporate demand for workspace. One of Brookfield’s two defaulted mortgages secures a US$350m commercial mortgage bond issued in 2021.
More office owners, even deep-pocketed ones like Brookfield, are expected to default in the coming months.
“We do believe there will be many more stories like this one,” said Harris Trifon, a portfolio manager at Lord Abbett.
CMBS investors like Trifon will be keeping a close watch on defaults as a hefty amount of securitised office loans come due in the coming months. Some US$61bn will mature from now to 2024 – around 40% of all office loans in US CMBS deals – Yield Book said in a January report.
Office property loan delinquencies are projected to rise to 3.5%–4% this year, which is still well below a historic 2011 high of 8.8%, Fitch said in a 2023 forecast report issued in November. Office delinquencies were 1.2% at the end of 2022.
Cost jump
Refinancing has also become more pricey as rates on office mortgages doubled over the past year to reach 6%–7% as the US Federal Reserve continued its anti-inflationary rate increases.
And a popular way to hedge mortgage rates has also become much costlier. The price on an interest rate cap for a floating-rate mortgage used to run about US$50,000 on a US$25m loan, Alan Todd, head of CMBS research at Bank of America said. After the Fed rate hikes, the cap would now cost about US$1.1m.
The latest defaults, on the fund's Los Angeles Gas Company Tower and 777 Tower, followed a default in 2021 from a different Brookfield fund on a US$256m loan for an office property in downtown Chicago.
Brookfield did not respond to requests for comment.
"Friday is dead"
There had been expectations among bankers that CMBS issuance in the second half of the year would be bolstered by more workers going back to offices. But so far those expectations have not been met.
On Tuesday on an earnings conference call with analysts, Vornado Realty Trust chief executive Steven Roth said achieving 90% in-person office rate is “fictitious". He said few workers went into the office on Fridays. “I think you have to assume Friday is dead forever.”
Roth said 70% was a more reasonable in-person office rate to achieve – from the current 60%.
Office building owners are seeing more vacancies as companies downsize their office space requirements or go entirely online, something particularly damaging for owners sitting on long-term leases which means they can't increase rates.
“The higher yields that property owners will have to pay in order to refinance loans could be difficult without the ability to raise rents commensurately,” said Gunter Seeger, PineBridge’s senior portfolio manager in US rates and securitised products.
The Brookfield defaults last week may prove a wake-up-call for the CMBS market that has enjoyed a rebound along with the rest of the credit market this year.
But market participants are taking a wait-and-see approach. There have been no signs of large lots of the Gas Company Tower CMBS backed by the Brookfield defaulted loan changing hands this week, a senior CMBS trader said.
Investors are waiting to see how lenders and special servicers that work with defaulted loans to avoid owners turning over their keys for liquidation (as has been the case with many mall loans) deal with these issues, market participants said.
"A likely outcome is many loans are modified. These credit issues take a long time to work out," said Deutsche Bank's head of securitisation research, Ed Reardon.