The office sector continues to take a beating, as indicated by higher vacancies and flight to quality. Then there is the increase in sublet office space.

According to a recent article published by Moody’s Analytics CRE, that increase in subleased office space, combined with the $8.9 billion of fixed-rate CMBS office loans scheduled to mature in 2023 could add to the current stress in the office sector specifically and CRE in general. Members of Moody’s Analytics CRE Research Team explained to Connect CRE that properties with higher amounts of sublet space could be more vulnerable in a steadily worsening economic situation.

Sublet Space – By the Numbers

First of all, how much sublet space are we looking at? According to Moody’s Analytics research, sublet space nationally has increased by 23.9% on a national basis. Meanwhile, the article said that increasing vacancies are “due to companies re-evaluating their office use amidst the ongoing discussion on the hybridization of the workforce.” Some examples include:

• Google’s addition of 1.4 million square feet of sublet space to the Silicon Valley market

• Verizon’s 190,000 square feet to Boston’s sublease supply

• Tableau’s addition of 200,000 square feet of sublet space to Seattle’s office market

• Other companies giving back large amounts of space include Spotify, Salesforce and Twitter

The Moody’s report also notes that the Northeast is reporting higher levels of sublet space than the Southeast. Moody’s Analytics Data Scientist Ricardo Rosas explained that a reduction in office space utilization (due to work-from-home adaptation) and ease of commute to the office is impacting the Northeast the most. “We found that metros in the Northeast region – such as New York, Boston and Philadelphia tended to have longer commutes than other metros,” Rosas said. Those metros are also proving to have a higher WFH adoption than other regions, he added.

The numbers aren’t likely to improve, either. Moody’s Analytics Economist Nick Villa indicated that the office vacancy rate stood at 18.8% in Q1 2023, which was just below the 19.3% hit during the Savings & Loan Crisis in the late 1980s and early 1990s. “We project the vacancy rate for the top 50 U.S. metros to increase slightly to 19.1% by the end of the year, and remain relatively unchanged, hovering around 19.0% by end-year 2024.”

CMBS – And Beyond

The Moody’s article said that office delinquencies spiked in May 2023, though did allow that the main culprits were single-asset, single-borrow loans like the 375 Park Avenue/Seagram Building in New York City. Still, in examining conduits through two different methods, Moody’s proved a “meaningful jump” in office delinquency rates from January 2020 to May 2023.

Additionally, the situation goes well beyond CMBS loans. CMBS loans simply offer more information and transparency, according to Matt Reidy, Moody’s Analytics director of CRE economics. “That same level of transparency is unavailable for bank and insurance lenders, which are two of the largest lending groups in the commercial real estate market,” he explained. “Due to those transparency differences, we look to the CMBS market as a proxy for what is happening across the commercial real estate debt market.”

The next question is what lenders might do. Villa said that, as lenders might not want to take ownership of these troubled assets, they could extend the maturities. As an example, research into the CMBS market showed that bonds for 375 Park Avenue are signaling potential office extensions. “The servicer has granted the borrower a two-year maturity extension, but the current Class A bond price indicates that investors aren’t expecting a payoff until 2027,” Villa explained. Though just one example, 375 Park Avenue’s pedigree “alludes to an increased likelihood for office extensions across the sector,” Villa noted.

Deliberate Borrower Default

But the borrowers might also not want to keep those properties with high vacancies and a lot of sublet space. Villa pointed to Brookfield Properties’ strategy of strategic default on its Los Angeles office buildings. “These sorts of decisions ultimately come down to each property’s financials, rent roll and whether the projected NOI will be sufficient to offset any marginally higher mortgage rates financed with variable rate loans, for example,” Villa said.

Villa anticipates that landlords are likely to deliberately default on properties as the economy continues its downturn. Still, “while we expect office loan delinquencies and defaults to rise this year, this has also been the case for previous downcycles,” he added.