Impossible Math

Imagine you invested in an office building in San Francisco in 2015.  At the time, the building was 95% occupied.  You paid $750/sf for the building and secured a loan on 50% of the value at the rate of 3.5%.  50% of the building’s tenant leases rolled in 2023/2024, a fact you underwrote as opportunity, opportunity to increase net operating income by achieving higher rents.  Then the pandemic hit.

By early 2021, the daytime population in the building was down by 90%.  By 2022, it was clear the 50% of the tenant leases expiring in 2023 and 2024 would not renew, leaving a large vacancy to fill.  Instead of increasing, net operating income has substantially decreased.  Adding to this downward spiral, the loan matures in 2025 and the lender won’t extend.  Your only option for alternative debt is at 50% of the current valuation of building, which is $350/sf, at an interest rate of 7%.  You will need to invest large amounts of fresh capital to maintain ownership of the asset (e.g., to pay off the maturing debt and to release the vacant space).  You would be investing new capital at a significant loss, against the backdrop of a market that by any rationale assessment, offers no chance of a positive return on your investment at any point in the foreseeable future.

Of course, faced with this reality, you will hand the keys back to the lender and run, not walk, from your equity, thus capping your loss.  This is the impossible math some owners of San Francisco office buildings now face.  The outcome for the lenders isn’t much better, as they, too, will take a loss when they sell the asset.

As we write, a surprisingly large number of investors and lenders are approaching this very outcome.  For the past few years, lenders often provided short-term loan extensions while the capital partners hoped beyond hope for the market to snap back.  It didn’t.  We believe we’re near the bottom of the trough, but the recovery will be slow.  Only those investors having a cost basis which is in proper relation to underlying leasing fundamentals will prosper.