Friday, July 10, 2009

Debacle at 250 Montgomery Street: Now is a Great Time to Be a Major Tenant has a story about the debacle at 250 Montgomery Street in San Francisco:

Realty Finance Corp. of Connecticut has sold its original $47-million loan on a class A office building here for approximately $25 million or $200 per square foot, according to a source familiar with the transaction. The building is 250 Montgomery St., a 15-story, 126,736-square-foot office building completed in 1989 at a cost of about $41 million.

The borrower, Lincoln Property Co., paid approximately $47 million or $405 per square foot for the building in late 2006 and defaulted on the loan in late 2008. Prior to the note sale Lincoln agreed to hand over the property to its new creditor in lieu of foreclosure…

Chris Seyfarth, a partner in Ernst & Young’s transaction real estate group tells the pricing of the 250 Montgomery note sale--50 cents on the dollar, just like the Hancock Tower sale in Boston--suggests that San Francisco is no different than any other major metro in that real estate values have plummeted. That having been said, he adds that 250 Montgomery is only 55% leased so it’s hard to suggest that the new price point is definitely 50% of what it was at the peak.

The 57,000 square feet of vacant space represents a great opportunity for a major tenant. Here are the numbers:


In 2006 Lincoln would need to lease the building at rents which would result in net income of $22.25/sf in order to get a 6% return on its purchase price. Based on its 2009 purchase price (47% lower than Lincoln’s), the new owner can get a 33% higher return than Lincoln, and still drop the rents 29%. This is what Jeff Bernstein was talking about in his post on Urban Digs, “Holes in the Dike”:

This is the transmission mechanism whereby lower rents are enabled in a market due to distressed properties being turned over at a much lower prices. It just doesn't take a lot of this kind of activity in a soft market with high vacancy rates to crush rents.

The beneficiaries of this debacle are the new owner, the building tenants, and the tenants in the market who see the new leases at the lower level and push for reductions in their own rent. The losers are Lincoln’s lenders and the owners of other buildings in the market who will be pressured to reduce rents. Lincoln itself appears to walk away unscathed since it looks like they had no money of their own in the deal (read about that here).

Up to now, income declines have been primarily a result of lack of demand. Income declines are likely to get much, much worse as more transactions like 250 Montgomery occur and rents adjust to the new market.