Well-leased towers hold two-fifths of sub-breakeven office CMBS

Trepp's latest screen of the performing office CMBS book finds $12.1 billion of loans whose buildings do not generate enough cash to make their payments. More than two-fifths of that balance sits in well-leased buildings. Those properties are at least 80 percent occupied. The vacancy story, the one the market has leaned on, does not explain this distress.

The screen covers $97.2 billion of seasoned securitized office loans with recent financials, all current on payments and none marked delinquent. A debt service coverage ratio below 1.00x defines the group. Annual net cash flow after operating costs falls short of annual loan payments, so the owner funds the gap. These are performing loans in the technical sense. The shortfall lives in the owner's checkbook, not the delinquency report.

The well-occupied slice runs to $5.17 billion. Servicer commentary names free rent — the lease concession that lets a tenant occupy without paying for a period — as the cause for part of it, with a single loan accounting for a majority of that explanation. For most of the balance, no cause is identified. Floating-rate debt and elevated operating expenses are the two most likely drivers, Trepp says, though the data don't confirm.

Free rent is mechanical and finite; when the concession lapses, cash flow steps back up. A building that has lost tenants, or carries a floating-rate loan, or costs more to run than its rents support, improves on no schedule. The loans are current today. They won't all be current at maturity.

PWD reported this week that office CMBS delinquencies hit 8.89 percent, above the 2012 record. July brought $2.82 billion of new distress, driven by term defaults. Trepp's screen catches loans that are still current but already cash-flow-negative, most without a named cause. Maturity will force the question.

The composition should worry lenders most. Occupancy no longer tells a lender whether a building pays for itself. The market's current trades point the same way. Thor Equities agreed this week to pay $218 million for ESRT's 1359 Broadway. That Midtown tower is 95 percent occupied. Finmarc paid $168 per square foot for a Tysons pair that is 70 percent leased. Both prices discount something beyond vacancy — the gap between what the leases produce and what the debt requires.

The free-rent concentration has a catch: one loan accounts for most of that explanation, and the aggregate hides it. What remains — the bulk of the well-occupied shortfall with no servicer commentary attached — is the real risk for office lenders. These loans will come due in a refinancing market that prices this gap. Free rent ends on a schedule. A building with a floating-rate loan and rising operating costs does not.