Would-be buyers of distressed office properties can see the troubled buildings just waiting to be marketed. They can see them on the balance sheets of banks and in the reports of rising defaults on CMBS loans. They can see them in the form of deals like the $31-million sale last year of an Orange County, CA asset called 3 MacArthur that sold for $83 million only two years before, and in the sale this year of another Orange County property, Griffin Towers, that went for $90 million compared with the $200 million that refinanced it two years ago.
Those opportunities are just the kind of bargains that investors expected to see when the capital markets crashed and it became evident that scores if not hundreds of office buildings across the country would be in distress. Yet such deals have proven to be the exception rather than the rule, according to Kevin Shannon, a vice chairman with CB Richard Ellis in Los Angeles and a broker on both the 3 MacArthur and Griffin Towers sales.
"The volume of distressed office sales has been disappointing." Shannon says. He explains that although the Griffin Towers sale is the largest office deal to close thus far this year in Orange County (a couple of larger deals are pending), distressed sales have not played the big role that was almost universally expected. "Most of the sales over $25 million that have occurred this year have not involved distressed sellers." In fact, Shannon continues, throughout the West Coast, most of the office building sales this year represent "normal selling by institutional and private sellers." The relatively few distress sales are exceptions, he says, and a number of those have to do with the effort by MPG Office Trust, formerly Maguire Partners, to get out from under the huge debt that it took on when it acquired its Orange County office properties at the top of the market.
Nationally, the story's the same. In its latest report on distress in the office market, New York City-based Real Capital Analytics says: "Other than in Phoenix, sales of distressed office assets were minimal over the past 12 months." Distressed sales accounted for only 10% of transactions in the distress saturated markets of Detroit, Las Vegas and Tampa, which combined closed just 30 transactions over the past 12 months, RCA points out. Distress "was a negligible factor" behind sales in New York and Los Angeles over the past year, it says.
The slow pace of distressed office sales is not surprising to anyone who is familiar with the extend-andpretend strategy that lenders have been employing to cope with their troubled assets in all classes. That strategy has paid off for lenders who have sold this year, Shannon points out. "If they didn't sell last year, they're looking real smart this year because prices have clearly appreciated substantially, ' he says. Lenders "are being patient and waiting for a better time to sell, and their patience is being rewarded."
The dearth of sales has produced a number of unusual consequences, according to Shannon and Robert Bach, senior vice president and chief economist at Grubb & Ellis Co. Bach tells of a recent meeting between Grubb executives and a group of institutional investors who complained about not being able to find either the quantity or the quality of deals they were looking for. "There is frustration on the part of institutional investors because they can't find the properties that fit their criteria, ' he says.
Investor frustrations are one of the signs that this downturn "is playing out much differently than people thought it would" and differs in many respects from the early 1990s recession, Bach observes. "Everybody thought, a year or 18 months ago, that this was going to be a replay of the early '90s, and they were all going to be mini -Sam Zells," The expectation was that investors with cash would be able to buy at a bargain price and then sell at a hefty profit in a few years. "That may still happen, but most certainly not at the pace that it did in the days of the RTC."
Bach cites another unexpected development that has occurred in this downturn that contrasts with the previous cycle, when distressed properties sold at deep discounts. "There are actually bidding wars for the best properties today, ' he says. As counter-intuitive as that might sound, he points to an analogy in the housing market, which, "is still severely distressed, but for the right properties in the right markets, bidding wars have arisen, ' he says. "The same dynamic is at work on the commercial side."
In those bidding wars, according to Shannon, the label "distressed" has, paradoxically, proven to benefit those who are selling. "When you put the 'distressed' label on a property, it seems to get anywhere from 50% to 100% more registration agreements from interest and competition and pushes prices higher than for non-distressed product, he adds.
Despite the relatively slow pace of distressed office sales, the velocity of deals is expected to pick up because the number of troubled properties on the market is increasing. Some $3.2 billion of newly troubled office properties entered into distress in the US in March, the latest month for which data is available, according to RCA. That raised the amount of outstanding office distress to $32 billion, 225% higher than the outstanding amount one year earlier.
The RCA figures reflect distress that is easily measured in that it can be tallied from foreclosure statistics and reports of properties in default. Harder to measure are the future effects of office shadow space and the impact of zombie buildings. The amount of shadow space is one of the unknown numbers that will playa key role in determining when and how quickly the US office market recovers, Bach and other researchers say. "I look upon shadow space as delayed or latent distress on the leasing side, and zombie buildings as latent distress on the investment side, ' Bach says, explaining that in many cases it is only a matter of time until the zombie buildings go back to their lenders and add to the inventory of REO.
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