The flight to debt-free landlords

While the rock climbing wall, zen garden or virtual reality fitness studio of a class A building may be most enticing for some, an increasing amount of companies are simply looking for which landlords have the least amount of debt right now.

As the U.S. office market grapples with the structural shift to hybrid work, there’s a lot of chatter about the ‘flight to quality,’ or movement toward state-of-the-art spaces with competitive amenities. But the notion that companies, eager to encourage workers back to the office, are simply choosing the most wildly equipped and tech-enhanced class A buildings doesn’t tell the whole story.

In Los Angeles, San Francisco, Washington, DC, and other major cities, tenants are also ‘fleeing’ to institutional landlords with either no debt or manageable debt levels–whether or not their building is brand new or has a rock climbing wall, zen garden, or virtual reality fitness studio.

Financial losses and opportunities facing today’s office market

As the industry faces higher for longer interest rates that increase the cost of refinancing amid a so-called ‘wall of maturities,’ the $2.2 trillion of commercial real estate debt that will become due between now and the end of 2027, tenants and their brokers are increasingly scrutinizing landlords’ capital stacks. They are putting debt status high up in their RFPs as one of the first line items. These tenants and their advisors are savvy to the fact that landlords with manageable debt are more likely to provide tenant allowances above $50 per square foot and keep the building in good shape, proving advantageous in the debt landscape shown in the stats below.

The result? Some owners of the newly built class A properties that would typically attract the flight to quality are struggling under the weight of loans that cost more than their buildings’ current value. Overleveraged owners deter companies unless they escrow tenant improvement funds.

Tenant improvement allowances are especially important to companies in the financial services and law sectors because these firms tend to prefer to custom-build their own space, which costs $150 to $250 a square foot in Los Angeles. These tenants often seek sizable tenant improvement allowances of up to $150 to offset their costs in return for a longer lease term. If they can’t find a new construction building that adequately meets this criteria, they are likely to stay put or even move to an older property.

When the right demand meets supply: the market-shaping impact of LA’s City National Plaza

Consider City National Plaza in Downtown Los Angeles: twin towers built in the early ‘70s. In April 2024, City National had an average occupancy of 90%, while the rest of the downtown office market averaged around 72%. Its success is due mainly to the fact that the building’s owner, the California State Teachers’ Retirement System (CalSTRS), has very little debt and almost owns the property outright.

The stability of the owner and the relative lack of leverage, paired with a good location across the street from the two leading downtown business clubs and large, rectangular floor plates that suit the needs of law and finance firms, have made it a building of choice for larger tenants in those sectors. Law and finance firms have also meaningfully returned to office, which has strengthened City National's position in the market.

Last year, the asset management firm TCW Group signed a lease for 160,000 square feet of space to move into the building. In the past quarter, the Bank of Tokyo-Mitsubishi UFJ signed a 60,000-square-foot lease, and multiple AM Law 100 firms entered the building. Law firms, especially, love to cluster near each other.

In essence, City National, unencumbered by debt, hasn’t aged out of its prime. Instead, it has virtually created its own market.

What should office occupiers looking for their next move take from this?

The best fit for you might not be what makes headlines. Think first through the needs and desires of your unique workforce, and work with an advisor to consider every option.

Could the new, flashy, amenity-rich downtown high-rise be your firm’s perfect fit? Maybe. Or could it be the decades old, tried-and-true space where there are other companies in your industry to synergize with? Also, maybe. Let the needs of your specific business and employees lead the way.