Banks Try to Salvage Empty Office Buildings

MANY banks and other lending institutions face a hard question - what should they do with empty office buildings?

They acquired these structures, mostly launched in the real estate boom years of the 1980s, after many developers went under. They were unable to make payments on construction loans because of the lack of tenants in an overbuilt market.

Though the Federal Reserve has cut interest rates to their lowest level in more than a decade in an attempt to restore faster economic growth, real estate experts predict that in some parts of the country it could be years before there is sufficient demand for office space to occupy the surplus buildings.

"Unlike Detroit, which can shut off a manufacturing line, you can't turn off the supply of office buildings. Once they are up, they won't go away, and they have to be filled" says G. Daniel Prigmore, of Prigmore Associates, counselors in real estate.

It is possible for a lender to walk away from a hole in the ground, Mr. Prigmore says, but "once you put the steel up, you have to finish the project." He defines a building as empty when it is less than one-third rented.

In most cases the question is not what the owner or developer wants to do, but what the lender wants to do, says Arthur Nelson, of Nelson Properties which specializes in executive office space in the suburbs.

There are three typical options for lenders with a vacant or "see through" building.

* Sell the building.

The lender decides that commercial real estate is "not my business" and dumps it. This approach works in isolated, individual cases. During a recession it is often not an option except at bankruptcy prices. The glut of empty, unsold, and unrented buildings in all regions of the country is the single greatest cause of bank failures.

* Continue preparing the new building (or renovating an old one) with the hopes of securing a major tenant.

When the shell of the building is complete, if tenants are found, developers seek new loans for tenant improvements or "fit up" costs. The builder tailors the commercial space - such as walls, carpeting, doors, electrical outlets - to the specifications of tenants. These costs also include marketing, promotion, and brokerage fees and can run $20 to $30 a square foot. But when paying tenants cannot be found, as is the case with thousands of foreclosed office buildings, lenders face the dilemma of throwing

good money after bad. "Nothing is less valuable than a half-finished building," Mr. Nelson says.

* Retain ownership of a property but take it off the market. This is called mothballing the building.

The bank or developer cuts back on every conceivable cost and waits until the market turns up again. Insurance companies and pension funds are the ones most likely to take this route in a weak market. Some very strong developers, those with a number of successful, fully occupied buildings, may decide to mothball a property and offset losses from the mothballed property with profits from other properties.

William McCall of McCall-Almy, real estate advisors, helps banks figure out what to do with buildings they did not want to manage. "You look for a tenant to fill the low-rise end [ground level] of a building, since you can't put the CEO or partners of a law firm there. Seek a major tenant to set the tone for a building," he advises.

In New England, which is in a deep economic slump, the most optimistic predictions for a turnaround in commercial real estate stretch out three to five years, says Mr. McCall, who is decidedly bearish on commercial real estate. Banks have written off 20 to 30 percent of the value of building loans on their books, he says. But until the economy picks up and creates new jobs and a demand for office space, "the question is how big a hit ... does the lender want to take?"

"Every tenant out there is thrashing about, saying m paying more than I should be, Prigmore says. They know that once a lease comes up hard bargains can be driven.

There is a flip side though, says Prigmore. Since it takes three to five years in the production cycle of a building, when there finally is rising demand for commercial real estate, "you just can't turn the spigot on and have a building."

Historically, supply and demand eventually get in balance and then rental prices, come in at a higher level per square foot than the last cycle due to unmet office space demand. This partially offsets the losses of a new building held during a down cycle, Prigmore says.