Navigating the ongoing Indianapolis office real estate market meltdown
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In Indianapolis and its surrounding counties, signs of the ongoing struggles in the office real estate market can be seen from the years-old “For Lease,” signs outside the office towers to continuous news of foreclosures and high occupancy rates. It is clear that challenges in the office market will continue for years and even decades to come.
The pandemic kicked off these issues, and the resulting shift to work from home has proven to be the largest challenge any sector of the U.S. real estate market has faced since the 2008 Financial Crisis. The Indianapolis office market’s vacancy rate at the end of 2023 hovered around 24 percent. This marks an increase from vacancy rates in the mid-teens throughout the latter-half of the 2010s. As if vacancy in nearly one-quarter of the office market is not bad enough, 2023’s leasing activity hit a decade low, down 37% from pre-pandemic levels.
All this begs the question: What can individuals and companies who have a stake in this office market – owners and landlords, lenders, tenants, property managers, real estate brokers and asset purchasers – do to navigate these challenging conditions and ensure future success?
GUIDING PRINCIPLES
There are two guiding principles to consider. The first: do not ignore the problem and hide your head in the sand. The second: speed is critical.
Whether you are an owner, lender, tenant, property manager or broker, you should understand the financial and physical condition of your assets in as close to real time as possible. Owners, lenders and property managers must understand their assets’ income, expenses, mortgage terms, reserves, upcoming capital expenditure requirements, key tenant renewal and expiration dates, and payment histories. Tenants must monitor their lease terms, any upcoming opportunities for renegotiation, their premises and the building’s condition, alternatives within the market and their landlord’s relationship with its lender.
Monitoring these conditions lets the parties know if an office building is financially and operationally healthy, or whether a problem (or opportunity) exists. Once a problem is identified, engage all interested parties to negotiate a solution as soon as commercially possible. Understand the underlying facts and legal duties, rights and remedies first, but once a party has that understanding it is necessary to commence negotiations as soon as possible.
Speed is critical because resources, and the flexibility in negotiations those resources represent, are finite. A landlord does not have an unlimited budget to offer new amenities or lease incentives to a tenant. Similarly, a lender does not have unlimited room on its balance sheet to offer forbearance or work outs. A favorable outcome is more likely to occur when a party engages in negotiations as soon as a problem emerges and its scope is understood.
STRATEGIES TO NAVIGATE MARKET MELTDOWN
Potential solutions exist in four areas: 1) operational negotiations; 2) financing negotiations; 3) restructuring; and 4) acquisition, redevelopment and land use opportunities.
Operational Negotiations
Operational remedies are most readily available to landlords and tenants, and the brokers, property managers and legal professionals who advise them. Landlords should seek to engage tenants with expiring leases and secure their future tenancy quickly to establish as much certainty as possible in their revenue stream. From a potential new tenant’s perspective, once the tenant identifies a space, it is useful to understand potential financial and operational challenges within a building. Ideally, an existing tenant would extend or renegotiate its lease 18-to-24 months before expiration for maximum leverage. Given current market conditions, however, that period may be extended to maximize market-based leverage.
Landlords should consider offering, and tenants – whether new to a space or renewing an existing lease – should consider requesting some or all of the following concessions, depending on a building’s occupancy and desirability: 1) reduced rent from prior terms; 2) a term of abated or free rent; 3) fixed operating costs, insurance or tax expenses; 4) early termination rights for all or a portion of the space; 5) unilateral long-term renewal rights at fixed rent; 6) increased signage and visibility; 7) purchase options or rights of first refusal; and 8) other financial and operational incentives based on the building. All parties should understand these incentives allow the landlord to “win” in a limited pool of tenants.
Financing Negotiations
When a lender sees tenant defaults or non-renewal or, worse, its borrower misses a payment, the lender should immediately place that asset under a magnifying glass. The lender must first understand its remedies in such situations, from triggering financial covenants, to commencing the default/foreclosure process, to notifying the property’s tenants of lock-box procedures under which they must pay rent directly to the lender. Then, the lender may engage with its borrower to understand its condition, the operational condition of the leveraged asset, and negotiate potential resolutions. Although a negotiated solution may be preferable, the lender should also consider whether the current asset is salvageable with its current owner and be prepared to impose contractual remedies up to foreclosure.
Conversely, if the asset’s owner knows that either it or its building’s financial or operational condition may violate contractual covenants or result in missed or insufficient payments, the owner should approach its lender with a proposed solution as soon as possible to increase the probability of a negotiated resolution.
Restructuring
The bankruptcy and restructuring process contains advantages for both lenders and their borrowers/property owners. At a minimum, lenders, tenants, property managers and brokers must be able to navigate the process to protect their respective rights if an owner files for applicable protections.
Property owners who are unable to meet their current financial obligations, but understand that their assets may possess underlying value currently or if market conditions improve, may utilize the restructuring process as a negotiating tool and to protect an asset’s existing equity. This process is based on federal law, and all parties should engage legal and financial parties familiar with that law.
Redevelopment and Land Use Opportunities
Asset purchasers, particularly those with a strong financial position through cash holdings or readily available financing, provide a valuable service to a struggling market while also realizing the opportunity for profit. These purchasers negotiate with owners or their lenders to acquire distressed properties at favorable pricing. The purchaser then utilizes its industry knowledge or strong financial position to improve the asset with its current use intact, realizing operating and financial efficiencies the prior owner missed.
Alternatively, an asset purchaser may consider a new use for a current office property. Mixed-use, residential condominium, retail, multi-family residential, and even light or heavy industrial may be available, desirable and financially viable. Government bodies and their land use arms understand the challenges the current office market presents and possess a greater willingness to collaborate with a purchaser who desires to change a property’s use.
CONCLUSION
The commercial office crisis presents challenges to all its stakeholders. While these challenges are likely to persist and even worsen, bright spots both geographically and within certain uses remain. While some of these challenges may prove insurmountable for certain stakeholders, employing the strategies outlined above and collaborating with parties who understand both the market and the building/asset as soon as a problem (or opportunity) arises remains the best method to achieve a favorable outcome.
Andrew Rankin is Of Counsel in Dentons’ Indianapolis office. With more than 20 years of real estate experience, he advises clients in commercial and industrial real estate matters, including in purchase, disposition, financing, construction, leasing and operation.
