By the Numbers
Anatomy of an office default
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
The long-predicted default wave in office properties is picking up steam. Owners of an Atlanta office tower are among the latest to turn in the keys, triggering a maturity default on the GSMS 2018-TRW single-asset, single-borrower deal. Despite the startling headline, the four-star property looks like a case study in bad luck: a significant exposure to WeWork as a tenant, colliding with the pandemic. The deterioration in credit metrics was well-tracked and S&P gave investors ample warning. The property may now serve as a case study of the next phase for office real estate as equity and debt try to read the future of occupancy, lease rates and cash flow.
The GSMS 2018-TWR deal was a typical 5-year floating-rate SASB (Exhibit 1). The collateral backing the loan is an office property in the Buckhead region of Atlanta. The appraised value of the property as of June 2018 was $277 million. Other specifics:
- The borrower, an entity of Starwood Capital, got a $212.5 million interest-only mortgage loan with an initial maturity of 3 years, followed by two 1-year extension options.
- The originator was Goldman Sachs Mortgage Company, who also owned the 5% vertical risk retention interest.
- DoubleLine Capital purchased the bottom 45% of the certificates, making it the initial controlling class representative.
Exhibit 1: Deal information and controlling parties at origination
Note: Only principal classes shown. Deal also included three interest only classes with notional amounts. Source: Bloomberg, offering circular for GSMS 2018-TWR, Santander Capital Markets US
The financials and credit metrics were middle of the range at the time of underwriting (Exhibit 2). The building was purchased in 2015 and the property had been renovated in 2017. This was a refinance, which probably followed a bridge loan to pay for the renovations. The borrower and property manager were likely expecting to attract tenants who would pay higher rents as leases began to roll off.
- The loan-to-value (LTV) ratio at origination was 76.7%, occupancy was 87%, the debt service coverage ratio (DSCR) was 1.94 and the debt yield NOI was 7.82%.
- The largest tenant in the building at origination was WeWork, who accounted for 10.7% of the rent exposure and a lease that runs through May 2032.
Exhibit 2: Tower Place financials
Source: Bloomberg
A well telegraphed deterioration
The financials illustrate the impact of the pandemic on a property coming out of a transition period and still trying to build occupancy. The debt service on the loan actually drops nearly in half from 2018 to 2021 as floating rates fall to historic lows. The DSCR rises to 3.4 but the occupancy falls to 72% in 2021 and further to 62% in 2022. None of this went unnoticed by the ratings agencies, who continually monitor deal and loan performance in the deals they rate. S&P has downgraded all classes except the ‘AAA’ A class of the deal twice (Exhibit 3) since origination.
Exhibit 3: Ratings drift of GSMS 2018-TWR deal
Note: Interest only classes not shown. Source: Bloomberg, Santander Capital Markets US
The first downgrade occurred on 5/18/2022. Among the reasons S&P cited in the ratings action (partial excerpt):
- The property’s occupancy level declined to 81.0% in 2020 from 88.0% in 2019 and further decrease to 72.0% in 2021, which is significantly below the assumed 86.0% occupancy rate we derived at issuance.
- The submarket, according to CoStar, has also weakened with vacancy rate increasing to 15.3% in 2020 from 13.7% in 2019 and further worsened to 20.5% in 2021. As of the Dec. 31, 2021, rent roll, the property was 72.1% leased.
- According to media reports, Barnes and Thornburg LLP has recently signed a lease comprising approximately 5.0% of net rentable area (NRA) commencing in mid-2022 at the property. Barnes and Thornburg LLP is expected to fill the space occupied by Catlin Inc., whose lease expired in March 31, 2022. However, lease rollover risk remains a concern at the property, with 17 tenants representing 12.8% of NRA with leases that expire in 2022.
The second downgrade occurred on 4/21/2023. Again, five of the rated principal classes were downgraded while the ‘AAA’ A class was affirmed. Among the reasons S&P cited in the ratings action were (partial excerpt):
- The downgrades on classes B, C, D, E, and F reflect our assessment that the property’s performance continues to lag the expectations we derived in our last review in May 2022.
- The downgrades also consider the property’s exposure to a financially weak tenant, WeWork Inc. (‘CC/Negative’; 10.6% of net rentable area [NRA]), and that the sponsors–SOF-X U.S. Holdings L.P. and Starwood Capital Group Global II L.P.–may have difficulty refinancing the loan by its July 9, 2023, fully extended maturity date, based on the property’s current performance.
- On the other hand, our affirmation on class A considers the relatively low debt of $101 per square foot and its senior position in the payment waterfall.
- Specifically, the downgrade on class F to ‘CCC- (sf)’ reflects our view that the susceptibility to liquidity interruption and risk of default and loss remain elevated based on our expected-case value and current market conditions.
- According to CoStar, the Upper Buckhead office submarket, in which the property is situated, had elevated vacancies prior to the pandemic that continue today, and rents have been relatively flat since 2020. As of April 2023, four- and five-star properties in the office submarket had a gross market rent of $39.96 per square foot, vacancy rate of 24.0%, and availability rate of 33.5%. This compares with a submarket asking rent of $38.04 per square foot and vacancy rate of 15.9% in 2018, when the transaction was issued. CoStar projects average office submarket vacancy rate to remain elevated at 23.4% and asking rent to grow marginally to $40.30 per square foot in 2023.
Though not a perfect storm, the property seemed to be triple witched: positioned in a submarket that was stagnating prior to the pandemic; heavy exposure to the financially weak tenant WeWork; and coming out of a transitional lending period and still in the process of lease up when the pandemic hit.
What happens now
Starwood has turned in the keys and DoubleLine, assuming it has not sold the subordinated debt, which comprises 45% of the certificates, becomes the controlling class. According to the offering circular, the special servicer—subject to the rights of the controlling class and risk retention class—has broad discretion to modify the terms of the loan in connection with a default or expected default. The special servicer may extend the final maturity date of the loan by up to five years.
It’s unclear that the borrower is willing to pursue an extension, based on the watchlist and delinquency commentary (Exhibit 4). The borrower apparently initiated a sale process but was unable to generate an offer that would pay off the loan. Given that the original LTV of the property was 76.7%, this implies a significant haircut may still need to be taken on the eventual sale.
Exhibit 4: Commentary from GSMS 2018-TWR
Source: Intex
The next step will be a full appraisal of the property. That will give the special servicer and the controlling class a view of next steps. Meanwhile the servicer will continue to advance interest payments to the extent they believe the outstanding principal balance is recoverable. That should ensure interest payments are still made to investors for classes at the top of the stack but could potentially stop interest going to investors of the lowest classes.
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