Office-to-residential conversions are growing, but are minuscule because not many towers are suitable for conversion.

By Wolf Richter for WOLF STREET.

The delinquency rate of office mortgages that have been securitized into commercial mortgage-backed securities (CMBS) spiked by a full percentage point in November for the second month in a row, to 10.4%, now just a hair below the worst months during the Financial Crisis meltdown, when office CMBS delinquency rates peaked at 10.7%, according to data by Trepp, which tracks and analyzes CMBS.

Over the past two years, the delinquency rate for office CMBS has spiked by 8.8 percentage points, far faster than even the worst two-year period during the Financial Crisis (+6.3 percentage points in the two years through November 2010).

The office sector of commercial real estate has entered a depression, and despite pronouncements earlier this year by big CRE players that office has hit bottom, we get another wakeup call:

Amid historic vacancy rates in office buildings across the country, more and more landlords have stopped making interest payments on their mortgages because they don’t collect enough in rents to pay interest and other costs, and they can’t refinance maturing loans because the building doesn’t generate enough in rents to cover interest and other costs, and they cannot get out from under it because prices of older office towers collapsed by 50%, 60%, 70%, or more, and with some office towers becoming worthless and the property going for just land value.

Mortgages count as delinquent when the landlord fails to make the interest payment after the 30-day grace period. A mortgage doesn’t count as delinquent if the landlord continues to make the interest payment but fails to pay off the mortgage when it matures, which constitutes a repayment default. If repayment defaults by a borrower who is current on interest were included, the delinquency rate would be higher still.

Loans are pulled off the delinquency list when the interest gets paid, or when the loan is resolved through a foreclosure sale, generally involving big losses for the CMBS holders, or if a deal gets worked out between landlord and the special servicer that represents the CMBS holders, such as the mortgage being restructured or modified and extended. And there has been a lot of extend-and-pretend this year, which has the effect of dragging the problem into 2025 and 2026.

Of the major sectors in CRE, office is in the worst shape with a delinquency rate of 10.4%, far ahead of lodging (6.9%), permanently troubled retail (6.6%), and multifamily (4.2%). Industrial, such as warehouses and fulfillment centers, is still in pristine condition (0.3%) due to the continued boom in ecommerce.

The problem with office CRE isn’t a temporary blip caused by a recession or whatever, but a structural problem – a massive glut of useless older office buildings – that won’t easily go away. The glut is a result of years of overbuilding and industry hype about the “office shortage” that led companies to hog office space as soon as it came on the market in order to grow into it later. But during the pandemic, they realized they don’t need this still unused office space, and they put it on the market for sublease, adding to the glut.

The motto in 2024 was “survive till 2025,” driven by hopes that the Fed would unleash massive rate cuts and drive rates to the bottom.

A lot of CRE loans are floating-rate loans whose interest rates adjust with short-term rates, such as x percentage points over SOFR. And pushing interest rates back down to rock bottom might give some of these properties a chance.

The Fed has cut interest rates, but its five short-term policy rates are still between 4.5% and 4.75%, and SOFR was at 4.57% on Friday, amid lots of talk from the Fed about slowing the cuts and stopping them earlier than expected, while long-term rates have risen since the first rate cut on renewed inflation fears.

But whatever rate cuts the Fed will eventually get done cannot address the structural issues that office CRE faces. Owners of nearly empty older office towers won’t be able to make the interest payments even at lower interest rates.

The current “flight to quality” is making the fate of older office towers even worse. High vacancy rates in the latest and greatest buildings allow companies to move from an old office tower to the latest and greatest tower, some downsizing in the process, and they’re doing it, thereby speeding up the demise of the older tower.

Conversions of old office towers to residential are taking place, and the numbers are growing but minuscule because many office towers cannot be converted for a variety of reasons, including their large square floorplates and the costs of conversion to where it would be cheaper to tear them down and start from scratch with a modern building.

In 2019, across the US, 56 office buildings were converted into residential, based on their dates of completion, according to data from CBRE, cited by the WSJ. That pace continued in 2020 and 2021. By 2023, the pace ticked up to 63 conversions. And in 2024, 73 conversions were completed and 30 conversions are under way. In 2025, 94 conversions are expected to get completed with another 185 planned, for a total of 279 conversions.

There are now 71 million square feet of conversions planned or under way. But that’s a drop in the bucket. That would account for just 7.9% of the 902 million square feet of vacant office space in the US, according to estimates by Moody’s.

Thankfully for the US banking system, a big part of office mortgages has been broadly spread across investors around the world and across foreign banks, not just US banks. For years, there was this assumption that you cannot lose money in real estate, especially office CRE in prime US markets, and investors around the globe piled into it.

Office mortgages are held by CMBS and CLO investors, such as bond funds, by insurers, by private or publicly traded office REITs and mortgage REITS, by PE firms, by private credit firms, and other investment vehicles, and by foreign banks. Those mortgages pose no threat to the US banking system.

US banks have some exposure to office mortgages, and there have been some big write-offs already, and lots of extend-and-pretend under the motto “survive till 2025.” Some smaller US banks have concentrations of office mortgages on their books, and so they have to deal with them, take the losses, crush their shareholders, etc., and some might eventually choke to death on their office mortgages. But none have so far.

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