KCP Insights: Free Rent Climbs in Bid to Lure Office Tenants

Markets Wrap: Fed Holds Rates Steady, Sees Three Cuts This Year
The Federal Reserve held interest rates steady for the fifth straight meeting on March 20, keeping its benchmark at a two decade high between 5.25% and 5.5%. Fed Chair Jerome Powell said that benchmark rates are likely at their peak and that it will become appropriate to cut later this year, without giving a timetable. The CMBS market is expected to see limited monetary relief this year with the Fed currently anticipating three 25-basis point cuts to its benchmark.

The K-LOC designation identifies loans that are in default or at heightened risk of default, based on KCP’s proprietary research and analysis.

Struggling Office Landlords Entice Tenants With Free Rent

Office landlords are offering more competitive concession packages to lure tenants as vacancy rates climb. The spread between asking and effective office rents is widening nationally as tenants maintain leverage in negotiations after the pandemic. Landlords paid more in tenant improvements in 2023 than before the pandemic, with contributions increasing more than 30% in Los Angeles and over 40% in New York City, according to CompStak data.

Concession packages could continue to rise, particularly in markets like downtown Los Angeles, where average tenant allowances on new leases are more than 60% above 2019 levels and free rent periods average 12 months versus 10 months. As office vacancy rates increase, committed borrowers will continue to creatively structure lease packages that require short-term financial sacrifice for long-term revenue growth. Significant allowances offered to boost occupancy, however, may ultimately erode principal recoveries in CMBS as receivers position assets for sale.

The city of Los Angeles received generous concessions upon signing a new lease at the Gas Company Tower. The tenant signed a 310,000 sf, 15-year lease for $48/sf, which is in line with typical market asking rents. However, the lease outlined $55.3 million for tenant improvements and moving costs, of which $21.4 million would be funded by the city. This amount will be largely offset by 15 months of free rent and parking, which carries a value of $19.8 million.

Sony Pictures Entertainment received roughly one year of free rent when executing its lease for 224,000 sf (21%) at the Wilshire Courtyard ($384.3 million; NCMS 2019-MILE), which is located six miles west of the Gas Company Tower. The company is also benefiting from a tenant improvement allowance and other light concessions on the lease that starts in June.

Express Bankruptcy Could Impact $34 Billion in CMBS
American fashion retailer Express Inc. has hired advisors for a debt restructuring that could include filing for bankruptcy, according to media reports, a move that would impact more than $34 billion in CMBS collateral. Express, which predominately occupies space in malls, continues to report operating losses in its earnings filings and was recently delisted from the New York Stock Exchange. KCP identified 284 deals with exposure to at least one Express-operated store. Subscribers can access the list here.

Joann Inc.’s Bankruptcy Hits $3.1 billion in CMBS
Crafts and fabric retailer Joann Inc. filed for bankruptcy March 18, according to the company. CMBS exposure to the company comprises 115 properties ($3.1 billion by allocated loan amount), where Joann serves as either collateral or noncollateral tenant, according to a KCP report published on March 8. Subscribers can access the list here.

CREFC Recap:
Read our full recap of CREFC’s High-Yield, Distressed Assets, & Servicing Conference held earlier this month.

The current CRE outlook is largely dependent on expectations of economic growth and lower interest rates. Assuming these macroeconomic forecasts pan out, both CMBS issuance and overall liquidity are expected to improve.
Market participants expressed cautious optimism for 2H 2024, as the prospect of Fed rate cuts has spurred momentum.
Servicers are becoming wary of single-borrower large loan (SBLL) transactions, citing the need for increased surveillance due to the lack of cash flow diversification. The importance of holdbacks and nonrecoverable advance determinations cannot be understated.
Multifamily, the darling asset class of recent years, has started to show some cracks, as operating expenses (particularly insurance costs) continue to rise while revenues stagnate.
The feasibility of office-to-multifamily conversions remains uncertain due to prohibitive construction costs and market limitations; however, increases in distressed office sales have signaled price corrections that could make conversions economically viable.

RECENT CREDIT ALERTS

Hotel Portfolio Loan Modified and Extended
The King of Prussia Hotel Portfolio loan was modified for a second time during the February 2024 remittance period in conjunction with the approval of the borrower’s final extension option. The new terms include an extended maturity date to June 2025 and the conversion to interest-only debt service for the remainder of the term. The portfolio consists of two hotels and the land underlying a 44,000 sf building occupied by J. Alexander’s restaurant. (CGCMT 2016-GC36).

Microsoft Vacates Washington Office
We identified the Bravern Office Commons loan as a K-LOC based on news that the sole tenant, Microsoft, plans to vacate ahead of its June and August 2025 lease expirations. The news is in line with Microsoft’s plans to vacate all of its space in Bellevue, Washington, and concentrate its workforce at the company’s office campus in Redman, Washington. The loan was actively cash managed with a cash sweep in effect, with reserves totaling $17.5 million as of February 2024. (BAMLL 2020-BOC).

Refinancing for $252 Million Houston Office CLO Loan
The borrower of the specially serviced 700 Louisiana and 600 Prairie Street obtained refinancing for the $252 million loan in March 2024, according to news reports. As part of the refinancing, M-M Properties reportedly bought out the other sponsor, General Electric Pension Trust, and obtained an additional $30 million to renovate and lease up the property, which was 65% occupied as of December 2023. The loan, which we identified as a K-LOC in May 2023, failed to pay off at its fully extended maturity date in September 2023. (STWD 2019-FL1, STWD 2021-FL2 and STWD 2022-FL3).

Industrial and Office User in Phoenix Lists Entire Space for Lease
We identified the Curtiss-Wright Building loan as a K-LOC after the sole tenant listed the entire space as available starting September 1, 2024, according to KCP research. Curtiss-Wright leased the property through August 2024. The loan is collateralized by an 88,065 sf industrial flex building in Gilbert, Arizona, approximately 15 miles southeast of downtown Phoenix. (WFCM 2015-NXS4).