(Bloomberg) -- Pacific Investment Management Co. is facing severe losses on a commercial mortgage-backed security tied to a two-tower office complex in downtown Philadelphia.
The money management giant is the largest holder of a $368 million CMBS backed by the Centre Square buildings, 43- and 36-story high-rises located at 1500 Market St., based on regulatory filings. Appraised for $471 million in 2019, a judge last month approved the sale of the complex for $70 million, clearing the way for the deal to close in the coming weeks and proceeds to be distributed to creditors.
The 85% decline in value means even the bond's safest slices, once rated AAA, will get hit. After accounting for advances, fees and other claims, Wall Street strategists anticipate a recovery of around 44 cents on the dollar, while holders of seven lower-ranking tranches will be wiped out. Pimco holds roughly $58 million in face value across the deal, about half in the top-rated portion. At that recovery, its investment losses would exceed $35 million, based on purchase prices derived from reported changes in its holdings and bond levels at the time.
It's the latest in a string of setbacks for investors in commercial property bonds backed by individual mortgages, known as single-asset, single-borrower transactions, or SASBs. Analysts warn more pain is likely, particularly as older office properties continue to struggle with weak demand, lower valuations and looming refinancing needs.
"In places like Chicago, downtown Los Angeles, Portland, Denver, the values of office real estate have not bounced back," said Alan Todd, Bank of America Corp.'s head of CMBS strategy, who ran his own recovery analysis. "You're definitely going to see more of this. Over the next year or two, more of these loans will come due and borrowers will run out of options."
A representative for Pimco declined to comment.
Occupying an entire block across from City Hall, the Centre Square complex opened in 1974 and is best known for the 45 foot stainless steel clothespin sculpture located in the plaza in front of the buildings.
It was acquired in 2017 by joint venture between Nightingale Properties and InterVest Capital Partners for $328 million in one of the city's largest ever commercial real estate transactions. Three years later the mortgage was refinanced and packaged into a CMBS, closing just weeks before Covid-19 upended the office market.
Back then the property was around 93% leased to 56 tenants, according to KBRA. But the pandemic and the shift to remote work took its toll on occupancy, and demand never recovered. The complex was just 28% leased as of the end of June, according to the most recent servicer commentary, with tenants including the University of Pennsylvania Health System and mortgage insurance company Radian Guaranty.
By mid-2022 the mortgage was transferred to a workout specialist after the borrower said it wouldn't be able to refinance or pay off the loan when it matured later that year. After failing to get a modification or extension, the property was ultimately foreclosed on and put up for sale.
Last month a judge approved the complex's $70 million sale to PMC Property Group and developer Dean Adler, who has said the plan is to convert part of the complex into a 300 room luxury hotel and as many as 500 apartments.
A loss at the AAA level would mark just the third time since the financial crisis that investors in a top-rated CMBS have gotten hit.
Last year, holders of the safest slice of a commercial-property bond backed by New York's Palisades Center mall lost more than $70 million. That followed a roughly $40 million blow for investors in a CMBS tied to the 1740 Broadway building in Manhattan.
All three deals were SASBs which, unlike conventional CMBS that bundle together dozens of property loans, are typically backed by just one mortgage tied to one building or complex.
The financing structure ballooned in popularity over the past decade, but in recent years has been exposed as particularly vulnerable to losses given the lack of diversification, despite deals often receiving AAA credit grades.
SASBs are "a different shape of risk," said Nitin Bhasin, a CMBS analyst at KBRA. "Most other asset classes in structured finance have multiple loans. Some default, some don't. Here, either everything pays off or you default and everything goes into a protracted workout. It's binary."
Industry observers say there's more pain ahead. While markets including New York and San Francisco have benefited from a rebound in leasing demand tied to the artificial-intelligence boom, office demand in other parts of the country is likely to take years to return to pre-pandemic levels, if ever.
That's especially problematic for older properties reliant on one or two anchor tenants. Overall, more than 30 top-rated slices of SASB CMBS deals are now trading below 85 cents on the dollar, according to data compiled by Bloomberg, with tranches below them quoted at much steeper discounts.
Those include deals tied to buildings in Atlanta, Chicago and Denver.
"In this new class that everybody loved, it was easier to fall asleep at the wheel," said Mark Melchiorre, chief investment officer of Forza Investment Group, a $3 billion credit-focused hedge fund. "It was easier to loosen underwriting standards."
--With assistance from Jonathan Randles.
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