Some distressed office properties and related loans are in a state of limbo, frozen without any investors who in the past would have scooped them up at discount prices.

High interest rates and declining occupancy and cash flow are creating dark clouds over an increasing number of owners’ properties, real estate lending professionals say. Buyers are not buying, and lenders are reluctant to refinance.

Another option, returning the property to the lender to cancel the debt, exists as a last resort for owners who feel their situation is more trouble than it’s worth.

The issue is prevalent in the commercial mortgage-backed securities market where $44.6 billion of U.S. office loans come due by the end of next year, according to Morningstar data. Of that total, up to $12.6 billion of office loans are already in special servicing, where troubled borrowers work out plans for repayment but sometimes end up returning a property to the lender.

National office deals have sputtered to the lowest point since the third quarter of 2010, with only $9.1 billion in sales in the first quarter, according to CoStar data. From Jan. 1 through June 10 last year, $1.5 billion of office buildings were sold in advance of their impending CMBS loan maturity date, CoStar data shows, a figure that fell to $165 million over the same time this year.

Volume is down for foreclosed property sales as well. Over the past five years through May, special servicers have arranged only $1.9 billion of resales of these properties, according to CoStar data.

It may take longer than 18 months for office buyers and financing to reemerge, according to executives at brokerage firm Sperry Commercial Global Affiliates, which added a commercial property loan resolution team to its services this spring.

“If there is going to be a recession, that’s going to have to happen first because there is a disconnect still between buyers and sellers,” David Baird, national director of institutional investments at SperryCGA, told CoStar News. A recession will “bring the buyers and sellers back to reality. And we could be as much as two years away before that lender capital comes back on the market.”

With a lack of price clarity, selling is the next-to-last thing an owner would want to do in this market, according to Baird. In some cases, office landlords are just trying to hang on to their properties with existing loans until they can boost cash flow and, at least, get valuations back to break even.

Ann Hambly, founder and CEO of 1st Service Solutions, a full-service CMBS advisory company, said owners could seek a short sale, where a determined price is less than what’s owned on a loan.

“If I’m an owner right now my options are, one, I can fund the shortfall [in the loan] and pretend there’s not an issue,” Hambly said. “The other is I could sell the property and potentially do a short sale. So, if I owe $10 million on a property valued at $7 million, and I can find someone to buy it for $7 million, a short sale might be an option.”

And even if an owner wants to sell a property, there are “a whole bunch of challenges” for a willing buyer to be able to obtain financing, according to Baird. Lenders are reluctant to finance office purchases because of the uncertainty around where the sector is headed in terms of future leasing demand and property values.

The U.S. office market is increasingly vulnerable as tenants have shrunk their space requirements in response to remote work habits and technology advancements, according to Chad Littell, national director of capital markets analytics for CoStar Group.

In May, the vacancy rate for offices reached a record high of 13%, surpassing previous peaks during the Great Recession of 2007-09 and around the turn of the most recent century. Moreover, this rate could climb even higher in the coming years as the 3.5% of sublease availability converts to landlord-controlled availabilities, according to Littell.

The fundamentals present particularly elevated risks in markets such as Chicago, Houston, Los Angeles, New York, San Francisco, and Washington, D.C., which all exceed the national average office vacancy rate.

National office rent growth for the past three years has hovered around 1%, according to CoStar data. The U.S. inflation rate by comparison averaged 4.7% in 2021 and 8% in 2022.

Faced with that backdrop, owners are expected to be more likely to hand a property back to the lender to wipe out loan debt.

The weakening office market is adding to doubts about the viability of lower-quality assets, S&P Global Ratings noted in a report last month. The bond-rating firm expects to see more borrowers giving back keys for properties that are underwater.

“Even if a few banks ... were going to own all of these offices, well that is horrible for our market, the industry, and the economy in general,” Hambly said.

About a third of the outstanding volume of U.S. office CMBS loans would face refinancing risks if the overall market value declined 40%, according to S&P.

“Although we don’t expect existing lenders to face principal losses across the board, some assets will likely change hands if borrowers and lenders are unable to reach a consensus on loan modifications and/or extensions,” S&P said.

The special servicers themselves can sometimes end up as property owners in distressed loan situations. They can opt to foreclose on a property if the value has declined significantly. A foreclosure allows the special servicer to sell the property and recoup some of the investors’ losses.

Borrowers, too, may be willing turn a property over to the special servicer through a deed-in-lieu foreclosure, saving time, costs, and potential additional court-ordered settlements.

CMBS special servicers already hold more than 13.1 million square feet of foreclosed properties with a total current outstanding loan balance of $1.4 billion and a vacancy rate of 36%, according to CoStar and Morningstar loan data.

Getting those properties off their books has taken a long time. Moreover, the sale of those properties are generating far less than market value.

The average price per square foot of those sales equated to $74 versus the average going market rate of $162, CoStar data shows. The average market price has been ticking up, while the sale of foreclosed property has bounced along the bottom.

Among loan workout options, borrowers can negotiate reduced payoff amounts or extensions. The preference, according to Baird and Hambly, is to extend the loan and hope for falling interest rates and renewed sales and leasing activity. In either case, the borrower must come up with cash.

“There’s almost always new capital required to bring in to keep the property stable or stabilize it to bring in new tenants and take care of tenants that are going to probably downsize or renegotiate their lease,” Hambly said.

“Office owners are worried, and they are panicked about what they’re going to do,” she added.