Third Point Real Estate's managing partner said it's 'a foolish debate' to say the office market will fail
Frank Scavone.
- Frank Scavone, managing partner of Third Point Real Estate Strategies, said offices aren't dead.
- Values will have to drop on "secondary and tertiary" buildings, but the process has just begun.
- Scavone oversees the property holdings of Daniel Loeb's family office, and some distressed debt.
The narratives in commercial real estate these days are getting darker, especially for office buildings that have been abandoned by workers embracing remote or hybrid work arrangements.
How that anticipated distress will unfold is up for debate, but as Trepp noted this month, delinquencies in office debt seemed to have hit their tipping point as they spiked higher in May. The largest monthly increase in the percentage of office loans sitting with so-called special servicers — the specialists in handling debt in danger of default — since 2010 seems to confirm that prognosis.
Frank Scavone, the managing partner of Third Point Real Estate Strategies, told Insider he's up for the challenge. In addition to his primary role, he oversees the commercial property assets of Third Point founder Daniel Loeb's family office, and distressed commercial real estate positions held in the Third Point Hedge Fund.
During the last financial crisis and until 2014, he was chief operating officer and president of the debt platform of CBRE's investment management arm, CBRE Global Investors. One of his last roles with CBRE involved selling off some of the riskiest parts of the debt platform's commercial mortgage backed securities.
His management process begins with an analysis of the problems facing the real estate that backs the debt he manages. Offices, for instance, shouldn't be tarred with the same brush, because not every city is plagued with the same plunging occupancy rates, lingering crime, and arduous commutes as the more troubled ones, like San Francisco, he said.
"It's a foolish debate that office is going to become extinct," Scavone told Insider. "That's not going to happen.
The writing is on the wall for the older, less desirable part of the office sector, though. As for how far those values must drop, it'll take time until owners part with their assets, he said. But in places like San Francisco — where one building just sold for 75% less than its value of a few years ago — the depth of losses could be vast.
The following interview with Scavone was lightly edited for length and clarity.
As an investor in commercial real estate debt, what do you think when you see the demise of some large US downtowns, like San Francisco?
I ask what's the driver? Is it that no one feels safe in downtown San Francisco? Is it because the ground level merchants and the amenities associated with being downtown have evaporated because of crime?
Is it because downtown San Francisco is somewhat of a difficult commute from suburbs in Marin County or the East Bay? There's a direct correlation between commute times and the rate at which people are returning to the office.
Collectively these issues set the stage for workers saying "we don't want to be there because we don't feel safe, or it's no longer an enjoyable place to work, or because we feel we're entitled to a different work week design."
Ultimately, employers in San Francisco will acknowledge a declining value proposition to doing business there. Occupancy and rents will decline, and therefore property values will reset.
How bad could it really get for big city offices?
New York tells this story perfectly. Best-in-class buildings in key locations are the winners in terms of occupancy. Secondary and tertiary buildings and locations that rode the wave of the last valuation cycle will have problems.
Overall, we predicted roughly a 15% decrease in office utilization as driven by behavioral shifts. Logically, that's going to be borne disproportionately by the secondary and tertiary properties.
If you have only 40% utilization, employers are going to say "I don't need this much space."
As landlords lose tenants and are burdened with the costs associated with releasing that space, their buildings' values decrease and their equity in excess of any debt on property quickly erodes. In instances where values decrease to somewhere between 60 and 70 cents on the dollar, you will see defaults.
Could there be new uses for these office buildings?
Everyone's saying, "Well, we'll just convert all these buildings to multifamily." But that's not generally practical, economically or physically. These buildings were not necessarily built for residential use, they don't have the proper floor plans for residential use, or the light and window exposure.
Even in strong multifamily markets, the owner's cost basis is often too high to economically facilitate the conversion.
As building values deteriorate to a level that the price is so low, some alternative use will be found or the building will be demolished. If I gave you an obsolete New York City office building in the middle of, let's say, Park Avenue South, for free, you could probably figure something out.
At what point are we in the real estate cycle?
You're now in the second inning of price discovery. Some value adjustments have occurred, but we don't know quite where they are because we haven't seen enough trading to really indicate what people are willing to pay. Also, the unfolding of the macro economy obviously hasn't fully fleshed out yet.
So we are early in the game. But are there opportunities now for investors like Third Point Real Estate Strategies?
It's a foolish debate that office is going to become extinct. That's not going to happen. Employers for the most part want to see their employees working together and in a collaborative culture. Maybe some of them are too politically correct to admit it, but that's what they want — visible energy and productivity.
But this is not a bad thing. People are by nature social explorers. And being isolated through the workday has negative psychological repercussions. People should want to get out. It's healthier and they will better develop as professionals.
We may use less office space in certain instances or certain properties may be preferred over others. But now there is opportunity for investors with the competence and willingness to see beyond the negative headlines, to act. It's difficult, but this is my fourth or fifth real-estate cycle and I'm old enough to know that this is where the money is made.
We're looking for opportunities every day.
What's going to happen with all the commercial real estate debt coming due in this higher interest rate environment?
I think it's somewhere around $1.4 trillion worth of loans that are maturing in coming years, with a significant portion of the 2023 maturities related to either hotels or office buildings. That's a sizable amount, but many of the maturities will be extended. And let's not forget about the more than $300 billion in dry powder aimed at North American commercial real estate investment.
It's a stressful time even if you're a good borrower with a good property in a good market. If your loan is coming due in this environment, this is what we refer to as situational distress."
What do you think about some of the sectors heavily favored by investors these days, like multifamily?
You have to be very careful in multifamily right now, and that you're not underwriting top-of-market rents. You have to make sure that you're in a place that's sustainable from an income stream perspective.
I think the exact same thing holds true for industrial properties. We saw some really aggressive industrial deals moving along and it just felt uncomfortable from a sustainability standpoint.
When everyone in the world is saying this is the thing to do, healthy skepticism and proper due diligence is paramount.
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