(Bloomberg) -- There's been a lot of worry over the future of commercial real estate — especially the outlook for office buildings — in light of higher interest rates and the trend towards work from home. But years ago, Wall Street was worried about a different type of CRE: shopping malls. Back in the 2010s, loans backing malls were souring fast, as customers ordered more online and major anchor tenants (like Sears) shuttered their doors. There were sites such as http://Deadmalls.com that tracked closures around the country, complete with apocalyptic-looking photos of empty buildings. But of course, while the overall number of shopping malls in the US has dropped, not all of them disappeared. Some have even thrived. So what can the shopping mall experience tell us about the outlook for offices and the broader commercial real estate market? On this episode we speak with Liza Crawford, a long-time CRE veteran and trader of commercial mortgage-backed bonds, who's now co-head of securitized at asset manager TCW. This transcript has been lightly edited for clarity. 

Key insights from the pod: What makes a good mall a good mall? — 6:46Bifurcation is everywhere across real estate — 9:18Why even Class A offices are under pressure — 13:39What higher rates are doing to office investors — 15:55What makes a trophy office desirable? — 20:06How vacancy rates differ across office categories — 25:32Can office space be upgraded? — 29:54What we can learn from watching an office’s ownership structure — 31:54How to analyze a capital stack — 42:57


Tracy Alloway (00:10):Hello and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal (00:14):And I'm Joe Weisenthal.

Tracy (00:16):Joe, have you ever been to the Highland shopping mall in Austin?

Joe (00:21):Absolutely. Is it still there? That's the one that's not done well, right?

Tracy (00:26):I think it has officially died, yes.

Joe (00:29):I know there's a few and I know exactly which one that is. I have spent time in it multiple times. I was there before it died because I lived there 20 years ago, but when I did, it was pretty quiet overall, it was pretty grim.

Tracy (00:44):This was sort of a classic Texas mall from what I can gather. Opened in 1971 and then closed for good in 2015. Here's another question, have you ever been to the Domain?

Joe (00:55):Yes and that one is much more busy and I'm pretty certain still exists.

Tracy (01:01):So that one opened in 2007 and it is still open. From what I can tell, it's very popular. It's sort of an upscale shopping destination and these two shopping malls, the reason I bring them up is they kind of stick in my mind as the classic example of what happened to malls in the 2010s.

So you had this bifurcation in the market where some of the upscale ones, the ones that had some sort of, I don't know,  specific offering in terms of entertainment, things like that did pretty well. While the old school ones, the ones that maybe had big anchor tenants that were no longer as popular, a lot of those went out of business.

Joe (01:42):Totally and first of all, I just want to say I appreciate and didn't realize that this was going to be an Austin, Texas episode, so thank you for that.

Tracy (01:51):Just for you, Joe.

Joe (01:52):But that crystallizes it perfectly for me, because I know those two malls and I know how different they are, and the Highland Mall was sort of off a highway, not in a great location. It was the kind of place where it probably had some fast food, Chinese in the food court, probably a place that sold hats, maybe a candle store called Wix or something like that.

Tracy (02:16):You are actually vividly bringing to life for me the early 2000s American Mall.

Joe (02:22):And then the Domain probably has a really nice Apple store in it, I don't know for sure and some really nice restaurants. Probably a cool burrito restaurant and stuff like that. I think that's it, that's the story of malls. You nailed it.

Tracy (02:39):The reason I bring up malls in general is because obviously there's been a lot of discussion about the future of commercial real estate and malls fit squarely into that category, but also in the context of concerns about stress in the office market in particular.

I keep reaching back to malls as the analogy here. Clearly there is a structural issue happening in the market, but that said, you can have specific properties that do better, you can have specific properties that go out of business completely like the Highland Mall and so that bifurcation seems really important to me.

Joe (03:17):We've obviously done a handful of office episodes, but it makes sense to think more about this bifurcation because one thing that we've learned, even from talking to various people in the office spaces, they're like, oh, Class A is fine. Not that I know what Class A is definitely, but they're like, oh, Class A the really nice new locations, they're fine. It's just that there's a lot of other space that is not what people think of as the modern office building.

Tracy (03:46):That's right. There are Domains and there's Highlands. So, in this episode, we're going to be digging more into the office sector and commercial real estate more broadly, and I am very pleased to say that we do indeed have the perfect guest. We're going to be speaking with Liza Crawford, she's a portfolio manager and co-head of global securitized over at TCW and a long-time investor in this space. Someone who also covered malls for a while I think in the early 2000s or 2010s. So, we're going to get into all of that with her. Liza, thank you so much for coming on Odd Lots.

Liza Crawford (04:23):Thank you so much for having me. I'm so excited to be chatting with you all today.

Tracy (04:27):Well, we're very excited as well and you said y'all, so we're really bringing the Texas theme in this episode. Love it.

Joe (04:35):Are you Texan?

Liza (04:36):I was born in Houston, I went to high school in Dallas, so I've moved around a fair bit though.

Tracy (04:42):So did I get your career summary broadly correct. Longtime player in the securitized space, including in commercial real estate. So, things like commercial mortgage-backed bonds, CMBS, stuff like that. And also, you were looking at malls at one point, right?

Liza (04:59):I've always been in securitized for my career, and I started in 2009, so a pretty exciting time. Interned in 2008, particularly exciting as well. I've focused on various areas of securitize, but when I joined TCW, the firm I work at now, I was a commercial mortgage-backed securities trader, so I dedicated all of my time to commercial real estate research and trading.

And to your comment, Tracy, it involved a number of property tours and years ago malls were the focus, and it was pretty grim out there for a number of tours, but you guys nailed it on the bifurcation. You can really see that when you're visiting these assets and you can see it come through in cash flows and sponsored decision making. And then currently at TCW, I'm co-head of global securitized. So now I have the pleasure of looking across the broader, almost $13 trillion securitized market.

Tracy (05:56):Joe, can I just say when analysts go on the real-life tours of shopping malls or stores in general. That is my all-time favorite research. I love the idea of everyone just hopping in a car and being like we're going to look at footfall at the mall.

Joe (06:12):Same, and actually, that was going to be my question because I remember the Highland Mall that Tracy brought up and I know the Domain. I do remember the Highland Mall is pretty quiet, but I have to imagine that as a professional, you walk through a mall, I walk through the mall, I just sort of notice vaguely this is quiet, this is busy.

What does a professional look at when you're on one of these site tours for a mall and you're looking at it from a sort of due diligence investment standpoint, what are the things that the pro really notices beyond just, oh, this is kind of quiet.

Liza (06:46):With respect to the malls, you're looking to see if the atmosphere is inviting. So, have sponsors spent any effort to try to add natural light to try to add seasonal decor? So that's just the natural ambiance. Then you're also looking at the density. So, is it populated? Are people walking around? What are people holding? Are they holding bags [to show] they're shopping? Or are they just kind of hanging out and they're taking advantage of air conditioning?

You're checking out the parking lot to see if there are a number of cars there. And then you're looking at the tenant mix and you can see the real bifurcation. So, I remember Burlington Coat Factories would always be crushing it. There'd be so many people in there and then there'd be areas where you've got your fourth sneaker store and nobody's in any of these properties, or you'd have another hat store or eyebrow shop that you realize they're probably not paying any rent.

Liza (07:46):They're not really even economic, but they are at least kind of filling space. One of the most egregious things you'll see on these property tours for weaker assets is whole areas that are effectively closed off, or there are very explicitly tenant temporary tenants, army recruiting, for example or polling stations. You can see a landlord perhaps exploring alternative uses, but as a debt investor, some of it looks a little bit of a smoke screen to juice occupancy numbers that frankly don't drive value for the asset.

Joe (08:22):Tracy, the last time, this is a fact, the last time I was in the Highland Mall, I know this, I happened to be with my mother-in-law, and she was voting, it was a polling location at the mall. So, there you go. That was her local place too, and I don't know why we were tagging along, but yes, that is my last memory of the Highland Mall.

Tracy (08:41):I’m so pleased with this anecdote that it worked out so perfectly because we didn't actually talk about this before the podcast, but this is great. So just going back to that analogy of the Highland and the Domain and its sort of application to the broader commercial real estate market and office properties in particular. I mean, I mentioned that the mall is the sort of prism that I'm looking at the office space through but tell us how you're viewing it. How useful is the shopping mall sector as an analogy to stress in the office market right now?

Liza (09:18):It's very helpful as an analogy with respect to bifurcation. I think one of the mistakes folks can make is paint everything with a broad brush. And I'm sure y’all remember plenty of headlines of malls are all dead and there were plenty of malls that were on their way to dying, zombie, ugly, irrelevant, there are too many of them, etc., so of course.

But there's some malls that continue to drive consumer demand, serve a purpose, and are well-managed. That bifurcation trend is very real in the office space now and would love to get into a kind of compare and contrast of what as a debt investor we look for in the different spaces and the different kinds of workouts and evolution of these two property types. But importantly in office, we're really seeing that bifurcation now.

Joe, you mentioned Class A earlier and even Class A is being reviewed and now we have trophy or premiere. What differentiates Class A from the actual trophy premiere?

Well, everything that was a newer build, maybe 15, 20 years ago, was Class A. Anything that maybe had a good view, would be Class A. Now trophy premier means it's either a more recent build best in class or a more recent renovation and it has more than just a good view or location. It has actual amenities to attract tenants, whether that's conference space or an excellent food court or gym, etc.

Joe (10:54):I want to obviously talk more about the office and start getting into this, but I just have one detail going back to the mall question, what stood out to you about the existence of a bustling Burlington Coat Factory? What was it specifically that that told you? Because that was the one brand that you identified as a thing. What was that saying to you?

Liza (11:15):I think when you're, when you're touring malls and it gets really sad, you really get excited about the bright spots and Burlington Coat Factory was really that bright spot. It also signals that there is demand to be identified and leaned into as a landlord or sponsor. So, a lot of these properties needed to be prop right sized from a square footage for the actual retail demand but there's consumer demand in the area, and you need to re-tenant your space to meet that demand.

And what you see in office as well as you saw in retail, is that bifurcation translates into sponsors making a decision. This asset is not core to my portfolio and I'm planning on walking away from it or rolling off of it in the coming years. So, what is the point of investing any energy in leasing it up and making sure our tenants are happy with the location that we are investing in demand drivers that ultimately help the broader kind of ecosystem of tenants.

So instead, you just see the underinvestment so present from walled off areas or these day-to-day tenants, or month to month tenants likely not paying any rent and then the successful, consumer demand moving into some of these retailers that are actually relevant to the local population.

Tracy (12:58):Just going back to what you were saying about trophy properties and some signs of stress, even creeping into trophy office buildings. We heard a lot about how important quality is in the office space and that some of the older offices are probably going to encounter significant troubles in the current cycle, but maybe the Class A would okay and certainly the trophy properties should be doing relatively well, but it is interesting if we're seeing even those start to come under pressure.

So, I guess I'm curious why that's happening and then secondly, how much of it is rents versus interest rates going up?

Liza (13:39):Great question. So, with respect to why we're seeing that Class A come under pressure, there are two main reasons.

One, time. Because something that is Class A doesn't just remain Class A, you can't set it and forget it. You need to continuously invest in that asset and make sure it is designed to meet tenant demands of today. Two, you had Covid. Covid all of a sudden introduced every CEO into the conversation of what do we want our employees to benefit from in shared office space?

I think we all took it for granted before Covid happened. We just showed up to the office and if we had a terrible cubicle, we just went with it. I work on a trade floor so personal space is lacking. I don't use an office, I don't have a cubicle, but I explore other floors of our company and there's just cubicles on cubicles and there's a lot left to the imagination.

It's not as engaging, and you don't always benefit from that shared space, communication, etc., so TCW is actually a great example. We've upgraded our space. We're moving in a couple weeks to a Class A property. We're in what perhaps was once considered Class A now, but it's arguably Class B dropping quickly. But we're moving into a Class A where you have more natural light, you have brighter colors, you have upgraded amenities, you have technological improvements and more shared space.

So, it really is an evolution of meeting tenant demand. And tenant demand is the number one priority as we're in a tough market for office landlords. They are seeing a net reduction in demand, and they need to be proactive to get the best tenants in their space and build out the amenities and whatnot that they need. That really is fundamentally the definition between what is trophy and what is a Class A that just keeps falling further down the quality spectrum.

Tracy (15:40):So, at the same time that they're needing to invest in the properties, I mean, rental income is presumably flat or going down because demand is weakening, but costs are going up in the form of financing.

Liza (15:55):Yes. So excellent point. With the rate move in the last kind of 18 months, the capital markets have created acute stress for landlords that use financing to own and operate their real estate portfolios and it's very common. Commercial real estate is a levered asset class, it is sensitive to interest rates. The sponsors that have locked in lower fixed rate debt in 2020, 2021, they're sitting tight, right?

They might have a 10-year fixed rate, they've got plenty of time, but other sponsors took out shorter floating rate debt so they're acutely vulnerable to their rates resetting five and a half points higher. And it is acting as a catalyst for them to accelerate their decision making of what assets belong in their portfolio, what assets will make sense long-term, what assets are economic to own, and what assets just don't make sense anymore.

So, after 10 years of low rates and low growth, the debt markets got very sanguine in both the appraisals they'd accept for office and the lack of differentiation they demanded from these valuations and sponsor quality, etc. in office. Borrowers or the sponsors, the owner operators that borrow in the capital markets got aggressive with the amount of leverage they felt comfortable with, with their assets. So, to your point, Tracy, that's where we're seeing very quick pivots for some very large sponsors to exit entire office properties and Blackstone and Brookfield are great examples there.

Joe (17:40):By the way, just going back to what you were saying about light, there was actually a great New York Times article three days ago on November 26th, “The Envy Office: Can Instagrammable Design Lure Young Workers Back?” backed by Emma Goldberg and Anna Kodé, but it sort of speaks to exactly what you're saying, light and everything. And they have these offices that are featured all millennial pink and all that stuff.

Tracy (18:03):Joe, I don't know why you don't like millennial pink. You always mention it as a negative example.

Joe (18:09):I'm just so tired of it. In 2013 it was like a cool, new color and now it’s 2023 and everyone’s like oh it’s still around. You walk into an office and say this is a trophy asset. What does that look like? What are some other things that you would expect to see?

Liza (18:25):You'd expect to see very high-quality entryways lobbies, lofty ceilings, ideally atriums, you would have separate elevator banks for either different floors or different tenants. A luxury feel, right? You want both your employees to feel really excited and proud and productive when they come to work, but you also want your clients to feel they’re special and that they are working with a really high quality company. And then I mentioned some of those amenities floors.

Other examples include just having outdoor space, just giving your employees the opportunity to step outside and get some fresh air, see some greenery. And then I think everyone, and Bloomberg, you guys are leading the charge on it, but everyone wants the snacks, the coffee upgrade. So, we've seen beyond just maybe shared amenities that multiple tenants can enjoy, you've also got more amenity focused on tenants dedicated floor space because people want to be able to take a break and get a nice coffee.

Joe (19:34):We don't have any Instagram walls here at Bloomberg as far as I know, although actually in the basement, there's a pretty cool art installation that is pretty ‘gramable. But by and large, I do feel like we work in a trophy office here in New York. Can you though, just setting aside the sort of more qualitative differences, can you speak to the quantitative differences that you see right now in this sort of trophy, whether it's vacancy rates or cap rates or anything else versus everything else?

Liza (20:06):Yes, and then I think it's important we also talk about geography and specific city stories. So, as it relates to the quantitative differentiation we're seeing for trophy assets, it's not uncommon to see post-Covid stress translate into a 10% vacancy. There are some assets that only have a 3% vacancy, whereas a [Class] B/C or even a weaker Class A which had 10% going into COID currently has a 20, 25% and then some assets are effectively vacant and that's where you see these distress sales come through. I want to lean into a couple items here.

How do trophy offices best able to maintain higher occupancy? It's because they attract high quality tenants, and they demand high quality leases from those tenants. They have to pay for it in today's market. So, what is a high quality lease?

A high-quality lease is a 10 year term with no contraction options, no termination options. You're trying to avoid volatility in your, in your tenant role. You're trying to avoid your tenants having too much optionality to walk. And then you're also adding high quality tenants, so you're mitigating the risk that they go bankrupt. High quality sponsors are very focused on that.

I think SL Green is a public REIT and they're the largest Manhattan office landlord. They're always highlighting that, and they do an excellent job with that. One Vanderbilt is their trophy asset, and it's very evident in that property. What happens in weaker, kind of B/C offices, is the sponsors are on their back feet. They have to accept what tenants are willing to give them. So that typically translates into shorter lease terms, kind of a two to five year.

And that creates even more vulnerability to the economic cycle to tenants downsizing or rotating into another asset. It also means that you have a weaker tenant base. You are more exposed to bankruptcies and the need to renegotiate rent lower. WeWork's a great example of the tenant that nobody really wanted. They were expanding massively for years, but sophisticated landlords made sure they were 2% or less of their revenues Interesting to mitigate that risk.

WeWork is, from a debt investor perspective, it's a curious story and I don't know how open I can be, but it's very frustrating to see some of their behavior. So on the quantitative side, we should see that bifurcation continue to play out and perhaps one of the most stark ways to evidence this is when we see some of these distress sales, it's still early in distress sales, but from a dollar per square foot valuation perspective, you would usually pre-Covid see a thousand per square foot for a trophy Class A trophy asset in New York City in San Francisco with the rate move, with the stress in the capital markets.

We as debt investors quickly reset to closer to a 500 per square foot implied mark to market valuation. Now, if you're a sponsor with a 10-year fixed rate mortgage, and you have your tenants in there for 10 years, you're insulated from this period of time. So, you don't need to monetize that implied mark to market valuation. You can hide it with various, even with the JV interest sale, you can finagle a way to really preserve that kind of top tick valuation but for weaker assets, they cannot hide. The sponsors walk away from them, they hand over the keys to the lender, and the lender gets an updated appraisal that's closer to market and or the lender sells the asset into the market and that's where you're seeing valuation declines beyond 70%.

I mentioned Blackstone walking away from an asset in New York City, that's 1740 Broadway, it's basically empty. And the valuation was closer to a thousand per square foot In 2015, they committed over 300 million with that acquisition, and they walked once the largest tenant rolled and the valuation came in around 300 per square foot, just under the updated appraisal. So, it is dire out there but if you are insulated owning and operating a business using prudent leverage, you can navigate economic cycles. If you are over-levered or overextended or going through your portfolio and exiting the losers that's where we see these real prints come through and it adds that quantitative data to really ink how far some of these assets can fall.

Tracy (25:14):So, I definitely want to ask you more about the specific things that go into a decision by a sponsor to walk away from a property or try a workout. But since you mentioned geographies and since a lot of what we're talking about is bifurcation in the market, tell us what you're seeing in different areas.

Liza (25:32):We work in downtown LA here at TCW and the vacancy is 30% and that seems like a number on a good day, but that's the official reported number. So, there is just too much supply for limited demand, and there are no real tangible, massive demand drivers to soak up that incremental supply. So, it's a central business district that suffers from competitors around it.

West Hollywood, or sorry, West LA offers more attractive properties for some office users. Then you've got Century City, which has the trophy assets in the market. So downtown LA really almost fits more of that super regional mall traditional story of the area. The demand in the area just cannot support three competitive assets. So, you're going to have that bifurcation, one's going to win, and one to two are going to lose.

So that's the story in downtown LA, for example. If we move to San Francisco, that area has so many headwinds, but one of the major issues is the amount of tenant concentration. It's healthy to do a compare and contrast San Francisco and New York City. San Francisco and New York City both had full valuations, they had a lot of international investors that really supported high per square foot valuations for office real estate. San Francisco before 2019 had, before Covid, had a sub 5% vacancy, and now it's closer to 30%. It still has headwinds to remote work. I was just reading that around I think 30 plus percent of job postings are remote in San Francisco. Compare that to Manhattan, where you're attracting talent that wants to be there, wants to live there, and there's a large financial presence that is going to demand their tenants or in the office.

In the technology space, you have some larger employers like at Google that have indicated they want some type of office presence, but you also have many smaller firms that would love to continue to save money on office expenses. Their business models work fully remote, and they're going to continue to benefit from that until their venture capital investor demands that they get an office space and go about things that way. So, San Francisco, unfortunately it has way too much tenant concentration. There is a decline in office space demand in that sector and then adding insult to injury, the valuations were so frothy that these owner operators are inevitably particularly over levered with their debt. So, this idea that the catalyst of making a faster decision on what assets you keep, what assets you leave is your debt maturity.

I think there's around 4 billion San Francisco offices in this commercial mortgage-backed securities market that's coming due in, in 2024. So, we'll see how more of this plays out and then unfortunately, San Francisco also has declined in its level of attractiveness for employees. There are plenty of reports, everyone sees them of blights, crime, etc. So, it really continues to suffer and it doesn't take too much to try to improve things, but if we think about the tech bubble, I think that it took around six years for San Francisco to come back. So, it's going to take some time and a concerted effort.

Joe (29:12):You mentioned Century City and that happens to be where Bloomberg has its Los Angeles office, which I've visited, and it is indeed trophy property, exactly how you, I think imagine. The ground floor, there’s Sweetgreen and poke restaurants, etc. We did an episode once on the challenge of converting office to residential, which is very tricky and limited. How much effort is there, or how possible is it to upgrade a, I don't know, Class B to something that resembles Class A or Class A to something that resembles trophy? Is that a thing that some of these owners of underperforming assets are attempting to do?

Liza (29:54):It is a thing but it's not super easy and it's expensive, especially when everyone's cost of financing has shot through the roof. Everyone should have upgraded their lobby and their elevators over the last five to 10 years. And what a fantastic time to do it with respect to Covid and having no tenants in.

Not everyone did that, but that's a great example of a Class B effort to maintain relevance. And then also if you're looking at some of these smaller office spaces that are a lot of your kind of Class B and C, the focus is less to make them all of a sudden, a trophy and more to design around what the tenant demand is. So hopefully you still have doctors, dentists or lawyers or somebody that is comfortable with a smaller office footprint.

There's a geographic attraction, they want a lower per square foot valuation, but they're also going to need better natural light. They're also going to need a better floor plan and that costs money from the sponsor. So, I'd say we're likely to see the Bs and the A minuses make upgrades to make themselves more attractive to tenants and make economic decisions that way, rather than see too many assets go from an A-, B to we're going to just go for broke with trophy. There are some assets that we're having fun watching. I'll give you an example, but 245 Park is in New York City. It's large, I think it's fair to call it a trophy office. It was owned by H&A back in 2017 with some very aggressive financing up to 80% loan to cost.

Tracy (31:47):Oh, sorry, you just reminded me. H&A had a really weird portfolio of properties from what I remember.

Liza (31:54):

There was an influx of international buying, but particularly some of these Chinese conglomerates that had insurance, but also pharmaceutical companies and H&A and Ping An are examples and their portfolios included things like airlines. Then they really leaned into the New York City office and New York City office, as well as some San Francisco office.

The benefit of those kinds of investments is you're putting a slug of money to work at once, right? These are expensive, they're large, we have excellent property rights here, you do have kind of an established tenant role and can feel good about underwriting the cash flow. At the time, financing was really cheap, so you could buy, you could go on a buying spree with pretty attractive financing. So, for this 245 Park property, ultimately SL Green moved from being the most subordinate lender to the owner and operator, using their lender rights, when H&A defaulted.

And 245 Park, I was able to visit by leveraging the fact that I'm a client to one of their tenants and it was really fun to see. That's a space where you're not going to compete. You're in an area with JP Morgan's new build and you're in an area with SL Green's one Vanderbilt, you're not going to suddenly become them, but what you can do is upgrade what you have and benefit from your excellent location right by Grand Central. So, I got to see their executive floor. You lean into things like that, your tenants want a really fancy floor to bring their clients in, the entryway was great, everything that I saw had more of a luxury feeling. So, I think that's probably a great example of an older asset that's making strategic upgrades to really hold its own, even though it can't suddenly become a 2020 delivered new build.

Tracy (33:53):So, setting upgrades aside, can you talk a little bit more about the options that sponsors actually have? So, let's say I'm sitting on a property that no longer makes economic sense, what are the options that I have? I guess they span a range from trying to raise additional capital to maybe just handing back the keys or something like that.

Liza (34:20):That's a key part of our investment analysis on the debt side so it is very easy in the commercial mortgage-backed securities market to just hand back your keys. CMBS isn't a relationship lender like banks or insurance companies. What do I mean by relationship lender? That there's no recourse in a CMBS loan. It just asks for adverse selection for sponsors, and you see that translate into their financing. So, sponsors, at the end of the day, they're obligated to pay their debt on an asset.

If they don't, they're in default and lender rights kick in. They can either negotiate with the lender to get a modification, a modification can include some type of relief for a temporary period of time, forbearance is what it's called on their loan. Or it can include more structured solutions, an extension for two to three years at some sort of adjusted rate with a lower rate, with an incremental kind of equity investment, good faith investment from the sponsor.

And we're seeing that play out. If you took out a fixed rate loan five years ago, you're incentivized to extend that fixed rate maturity rather than go into today's market and accept lower valuations on your asset, lower leverage on your asset, higher cost of financing, and come out of pocket. So, we'll continue to see those maturity defaults and modification extension solutions. And that's actually encouraging to see in a number of circumstances because it at least signals that the sponsor cares about this asset. We're always going to look for evidence of them continuing to invest in the asset and ensure its relevant and generating income and whatnot. But the fact that they're not immediately walking away is encouraging. Whereas on the other side, just to give you some examples of sponsors walking away, we talked about 1740 Broadway for Blackstone in New York City, you also have Gas Company Tower as an example in downtown LA and the EY building where Brookfield walked away. It is as simple as no longer paying your debt and basically not answering the call when servicers are looking to find you and not being available for a solution.

Tracy (36:45):Are there repercussions for doing that? Does Brookfield's reputation take a knock when it just walks away from a property like that or is it just business?

Liza (36:56):Unfortunately, there aren't enough repercussions. That's kind of part of the fun with CMBS, I suppose.

We do focus on sponsors and they're capitalization. So, it's a great example. Brookfield is well capitalized, but you have to also check on the assets’ performance and the assets relevance in their portfolio to really determine if this is going to be something they focus on and they keep. And I mentioned earlier that CMBS in particular is a non-recourse lender and it's not really a relationship lender, so it lends itself to adverse selection. And you saw that both on the retail side as well as in today's office market.

To give you examples, Simon Property Group and excellent owner operator of malls would strategically finance their non-core malls in CMBS. They would get pretty creative. You could see there was zero incremental investment in the assets. But somehow, the valuation has increased off of no incremental cash flow growth, really just a capital markets arbitrage benefiting from lower rates, lower cap rates.

You'd also see them take three properties and combine them with one that's pretty good and then two that are weaker and juice the overall metrics to see if the debt investors would feel more comfortable with owning that security. On the office side, you also see some strategic adverse financing. I use the example of the gas company Tower for Brookfield and there they use shorter floating rate debt and that's where it's tough to underwrite the asset for 10 years.

You really can't afford to support a 10-year fixed rate because your tenant role is heavy, your current occupancy is weak and then they levered it with additional debt beneath the mortgage, so mezzanine debt. And so really that can be viewed, not to be too cynical, but debt investors, we have to be cynical as trying to reduce your basis in the asset as much as possible and set yourself up to even more conveniently walk away and that's exactly what happened. You just hold the asset while you're still collecting cash flow from it, as soon as rates reset and you have to come out of pocket to cover cash flow, you're walking, as simple as that.

Joe (39:20):I have just two questions and one is very short. The next time you're in New York for work, could you take me and Tracy on an office field trip. Just bring us along.

Liza (39:31):I would love to.

Joe (39:32):

We'll make that happen. So, I guess the other question, going back to the malls, as you mentioned, I remember the zombie mall discourse and as you pointed out, it was just way too simplistic because not all malls were the same. What happened to those zombies, the ones that really were dead. Did they become Topgolf locations? Did they get totally torn down? Are there any lessons to be learned about what ultimately happened to physical spaces that just were nowhere close to being economical in the new era?

Liza (40:03):It's still playing out, so you are seeing a transfer of ownership. We talked earlier about the Simon example. Simon has excellent malls, Class A malls now, or you can find Class A plus malls that are over a thousand per square foot sales versus 600 years ago that seemed more attractive, 650. So, they exited non-core assets in their portfolio. There are some owner operators where that's their niche.

They're going to find the unloved mall that has been held by a really big player and there's been no leasing activity or focus on tenant composition for the last 10 years and try to rehabilitate it. And there's probably some reduction overall of square footage. And then there's also that kind of upgrade into whatever the demand looks like for the local population. Topgolf, you mentioned Joe, that's fantastic. I love Topgolf.

So that's a great example. There should be more Top Golfs everywhere, bowling alleys, Dave & Busters, seeing that is actually happening and continues to. And then there's some where it's just going to be an empty parking lot and a dilapidated building that's just going to be blighted effectively for years. There was frankly over building, there are areas where you really don't need it.

There are some efforts to redevelop into multifamily, for example, and that takes time and good developers and owner operators and coordination with local governments. And you'll probably remember when there was so much buzz about all these spaces becoming industrial facilities and that's maybe a great example to talk about bifurcation as well. In theory, if you have a mall that's typically located at a highway intersection, it could be a good location for some type of warehouse distribution, but in practice, new build is relatively efficient and is what tenants like at Amazon typically want. And you can also find cheaper to access or easier to own and operate space away from just absorbing a 2 million square foot structure. So, it was kind of theory versus practice, we're not going to save all malls through industrial the same way we're not going to save all office properties through multifamily conversion.

Tracy (42:29):So, I am conscious of the time and I realize we could go on for hours with you talking about individual properties. But since we are on the theme of bifurcation, I feel like I have to ask you about differences in the capital stack as well, like junior versus senior loans for commercial properties. Are we seeing that bifurcation story there as well?

Liza (42:57):We are, you guys are aware, there's plenty of stress in the CRE market, but under the hood there's also risk transfer in subordinate notes. So, mezzanine for example you've got some players that are going to take advantage of that as an access point to take over assets. You've got other players that bought a 5% fixed rate mezz thinking it was an attractive return three years ago in a relatively safe asset that no longer once you have that exposure, it's defaulted. They don't know what to do. They weren't trying to access a property through that. So, from our perspective, we have as debt investors, we're trying to make thoughtful investments where we're not having to take over an asset that would mean that it defaulted. There are some examples where maybe that's a play we could consider, but we're typically reviewing or we're always reviewing the quality of the asset.

Most investors are going to focus on things that avoid default. And then where you play in the capital structure is going to be determined by relative value and kind of sourcing. So, we're more commonly in the mortgage portion, the CMBS portion that gets kind of tranched out. So, you can play with seniors, you can play across the cap stack. As you'd expect if you like the mortgage, so let's say it's a $1 billion mortgage, you typically like the billion-dollar CMBS deal that's terming out that mortgage, that's reframing it into more marketable securities. And then your decision making really comes down to relative value with respect to reviewing the capital structure. You always want to be mindful of how much leverage is on the asset and the reason the sponsor took out so much leverage, it typically is a negative signal if there's too much complexity in the capital structure.

If you've got three mezz notes, that's an easy red flag. That means you couldn't find one slug of mezz, you couldn't find a buyer for one slug of mezz. Instead, you're kind of just trying to slice and dice and find the best buyer for specific portions and their levels where the return they need to see to take that risk. And then also you always want to see who those buyers are because they are first in line to navigate distress in the asset. We talked earlier about 245 Park, when we see H&A as a non-traditional owner operator of a New York City office acquire that asset at an uneconomic capitalization rate. That's a head scratcher and 80% loan to cost is a head scratcher. But when you see SL green position themselves in that mezz, you know how that's going to work out.

You know they're strategically investing in that most subordinate mezz to be in position to step in and ultimately take control of that asset. So those are all things, we're always analyzing who the players are looking at relative value across the capital structure. And then for most of our client portfolios we’re really focused on the debt side and I don't want to surprise y'all, but plenty of people that are focused on the debt side that underwrite to fine credits that should avoid defaults are probably scratching their heads at the amount of loans that have default risk in their portfolios. I think that fits into some of the regional banks and we'll see that kind of play out over time as well.

Tracy (46:12):Oh man. I feel bad ending the interview right there because I would love to talk about bank exposure to CRE, although I think we did do an episode earlier in the year. So, we are sort of covered but our producers are giving us the time signal. But Liza, that was so good, thank you so much for joining Odd Lots. Really appreciate it.

Liza (46:30):This was so much fun. I appreciate y'all letting me join and I'm completely happy to take y'all on property tours.

Joe (46:37):We are serious. We are for real going to take you up on that next time or next time we're in LA. Maybe we'll do both.

Liza (46:46):Excellent. Sounds great.

Tracy (47:00):Joe, just to bring it full circle, one of the loans financing Highland did actually end up in a CMBS deal, it was put together by JP Morgan. I think that the only reason I remember it is because I wrote about it back in 2013. The reason I wrote about it was because that particular CMBS deal had a reported loss of 120%, which was the highest ever recorded for a CMBS deal at the time, according to Moody's. I'm not even sure how you can get loss above 100%,

Joe (47:35):That's crazy.

Tracy (47:36):I'd have to go back and look at it, but yeah, crazy statistics. So, there was so much to pull out of that conversation. One thing that kind of surprised me, but it makes intuitive sense is this idea that if you have a property, you kind of have to keep putting money into it. Liza was talking about how with regional malls, if you're walking around and you see seasonal Christmas decorations, that's a good sign. It means someone cares about the property. So, I guess B class office buildings should be putting up decorations around.

Joe (48:08):At least put up a wreath in the lobby. 

Tracy (48:11):That'll fix it.

Joe (48:11):I said that our office here didn't have any Instagram walls and then our producer Dash immediately messaged me, and he said, we do have a very grammable office. I have grammed from here. Fish tanks, the curved escalators, we do have plenty of visual delights in our office. But to the conversation, I thought that was amazing.

I loved that Liza was able to mention so many specific addresses and I could hear, once again, both of us typing at the same time looking up those addresses. 1740 Broadway, the MONY building is an interesting Wikipedia page. And then also I liked some of the things, especially at the end, the clues you can get from looking at who's who in the capital stack in response to your questions. You have this sort of untraditional main sponsor, then this sort of savvy player at the mezz level.

They might be positioning themselves to take it over at some point. I really enjoyed the way she was able to bridge both this sort of the highly technical financial stuff as well as just, you know, does the building of good light and stuff. 

Tracy (49:14):We'll have to have Liza on again next year and talk some more because there's so many more questions that I want to ask her. But for now, shall we leave it there?

Joe (49:23):Let’s leave it there.

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