America’s second-largest city is at the forefront of mounting property distress that threatens to bring widespread defaults and deeper pain for landlords. With downtown LA’s office vacancy rate at a record 30%, buildings have plunged in value as workers stay away from the urban core of a sprawling, car-centric region.

It’s a scenario unfolding in downtowns across the US after a pandemic that turned millions of Americans into remote workers, afflicting cities with vacant storefronts, crime concerns and fiscally strained transit systems. Now, rising interest rates are colliding with falling real estate prices, pressuring building owners whose debt burdens are higher than the market value of their properties. That’s in turn spurred warnings of financial instability from bankers, private equity executives and the Federal Reserve, which said in a report this month that “a correction in property values could be sizable.”

More than $900 billion of debt on US commercial real estate is set to mature through 2024, and much of it will need refinancing at interest rates that have more than doubled since early last year. Offices are in a particularly dire situation: Values for top-tier properties have plunged 25% in the last 12 months, while the broader office market is almost 40% below pre-Covid levels, according to Green Street, a real estate analytics provider.

Dense cities like San Francisco and New York face growing gluts of obsolete office space, but they also have histories of rebounding after crises such as the dot-com bust and the Sept. 11 attacks. The outlook is more murky in the downtowns of metro areas that sprawl into freeway-laced suburbs and offer alternatives to the central business districts. Atlanta, Chicago and Houston rank among the downtowns with the highest rates of office vacancies, according to Savills.

The problem is especially acute in Los Angeles, better known for its Hollywood studios and celebrity estates than downtown towers miles from where many residents live and work.

“In terms of distressed borrowers in the market, downtown LA might win the prize,” said Lea Overby, a commercial real estate analyst with Barclays Capital. “The product is old, tenants are downsizing and the area isn’t appealing.”

The top three dozen office buildings in downtown LA are almost all underwater on their loans, according to Colliers International Group Inc., a commercial real estate brokerage. They average more than $230 in debt per square foot, in a market where this year’s only major sale — the Union Bank Plaza — was about $154 a square foot.

It’s not just American money at stake. Foreign pensions and sovereign wealth funds are among the biggest holders of US office real estate, assets considered safe havens until the pandemic upended office norms. Downtown LA, for one, was a center of Asian investment, attracting billions of dollars from developers such as China Oceanwide Holdings Ltd., which has left the shell of mixed-use project sitting stalled for years. Korean Air Lines Co. opened the Wilshire Grand Center, a 73-story hotel and office complex, in 2017. About 20% of the office space is vacant.

Many US office owners will skimp on building improvements, milking revenue as properties slowly decline and tenants turn off the lights. Other landlords will return the keys to lenders, washing their hands of money-losers. In some cases, prices may need to approach the value of raw land in order to attract new investors, Overby said. More broadly, the emptying out of towers threaten the vibrancy of downtowns and the decades-long bet on dense urban landscapes.

“We’re at the point here where the Z Apocalypse has started,” said Fred Cordova, chief executive officer of Santa Monica-based commercial real estate brokerage Corion Enterprises, using a Hollywood-inspired analogy to World War Z, a 2013 Brad Pitt movie about a zombie apocalypse. “If you want to prevent your building from becoming a zombie building, you have to fix the capital stack fast.”

Much of downtown LA’s real estate troubles have roots in its sprawling geography. Los Angeles County is 4,750 square miles (12,300 square kilometers) — almost as big as the state of Connecticut — with a population nearing 10 million. The metropolis has been called “72 suburbs in search of a city,” a comment attributed to Dorothy Parker, Aldous Huxley and HL Mencken among other wits.

No S&P 500 company calls downtown home. The area is the seat of offices for government agencies and legal and accounting firms, with a handful of financial companies, such as Capital Group. The oil and aerospace firms that drove the city’s post-World War II boom are long gone. The entertainment industry is almost everywhere but the city center: Walt Disney Co. is in Burbank; Warner Bros. Discovery Inc. and Comcast Corp. are in the San Fernando Valley; Netflix Inc. and Paramount Global are in Hollywood.

Before the pandemic, downtown LA was in the midst of a renaissance. Early 20th century factories, warehouses and movie theaters found new lives as apartments and hipster hangouts. The population ringed by the freeways that encircle downtown grew to 90,000 in 2020 from 15,000 in the 1990s. Street life teemed with outdoor cafes, bicyclists and dog walkers, appealing to the type of people who wanted Manhattan-like urban living in such a decentralized city.

An Ace Hotel opened in 2014 in a former oil industry office building with an adjacent movie palace built by Mary Pickford and Charlie Chaplin that was restored as a concert venue. A Whole Foods Market opened in 2015, while the old Rialto Theatre was transformed into an Urban Outfitters shop and the Tower Theatre became an Apple store.

Then came Covid-19, with downtown LA suffering the broad fallout seen in cities across the country. Homeless encampments, previously concentrated in downtown’s notorious Skid Row, spread as health officials argued that forcing the unsheltered indoors would transmit the virus. Police enforcement dialed back after the May 2020 murder of George Floyd in Minneapolis, which sparked protests that were followed by looting. Stores and restaurants were boarded up and never reopened.

“It feels like you couldn’t have created a set of worse circumstances,” said Jessica Lall, who headed a downtown business development district before joining CBRE Group Inc. as a managing director in January. “Money’s not the only reason. The reasons are safety, security, amenities.”

Epic commutes and clogged freeways also are a deterrent for office workers. The alternatives to driving aren’t appealing. Daily rail and bus ridership on the Los Angeles County Metropolitan Transportation Authority is down 30% since the pandemic.

Through March of this year, 22 people were found dead on the Metro system, many suspected of drug overdoses, Mayor Karen Bass said in a briefing last month. That amounts to the total for all of 2022.

Bass, who took office in December, presented a budget that appropriates $1.3 billion to help rehouse the city’s 42,000 homeless and $1.9 billion for the LA Police Department, which will help hire more officers. This month, the city council approved a plan to add housing for 125,000 more downtown residents.

“The success of downtown is essential to the success of our entire city,” Bass said in a statement to Bloomberg. “Thriving commercial districts do not happen by accident.”

Christopher Rising, a second-generation LA developer, said he recently stepped out of the California Club, a downtown bastion of the city’s elite since 1887, and saw a man with his pants down defecating in the street. Rising still owns four downtown office buildings, having sold several properties to invest the proceeds in industrial real estate, which has more demand.

One of his complaints is that the workers for city, county, state and federal agencies who make up about a third of the downtown workforce aren’t reporting to their desks. The same goes for lawyers, accountants and other professionals who have become accustomed to working remotely.

“It’s all solvable,” Rising said. “Government has to keep people safe” from crime.

Rising has borne particular witness to the effects on real estate: The PacMutual complex, a landmark that he sold for $200 million in 2015, hit the market in January and is likely to sell for half that price, he said.

Similarly troubled situations have unfolded at properties within blocks of each other downtown. Late last year, Starwood Property Trust Inc. foreclosed on the century-old Broadway Trade Center. Manulife Financial Corp. wrote down the value of a building by 33% to $211 million after the anchor tenant, asset manager TCW Group Inc., ended its lease.

Oaktree Capital Management in January seized 444 S. Flower St., the tower that shot to fame as the exterior offices for the firm in the television series L.A. Law. Oaktree said Wednesday that it closed on a loan extension for the 48-story building, providing capital to upgrade the space and “more aggressively secure new tenants.”

Brookfield may also default on another one of its buildings, Bank of America Plaza, which has a $400 million mortgage, Barclays Plc said in a May 16 report.

Brookfield’s troubled offices represent “a very small percentage of our portfolio,” Kerrie McHugh, a spokesperson for the Toronto-based firm, said in a statement. The company is still committed to downtown LA, she said, and is putting the finishing touches on the Beaudry, a new 785-unit apartment tower. Online pre-leasing began in April and there has been a “strong uptick” in demand with the recent start of physical tours, McHugh said.

But the company’s decision to stop paying debt on some office properties — and walk away from the Gas Company Tower — shows the challenges facing landlords across the US, with institutional investors at the forefront of deciding to cut their losses. Blackstone Inc. halted payments on offices in Manhattan and Las Vegas. Columbia Property Trust, a landlord owned by Pacific Investment Management Co., defaulted on $1.7 billion of mortgages backed by properties in the New York area, Boston, San Francisco and Washington.

The situation may only worsen: About 1.5 billion square feet (139 million square meters) of offices – or almost a quarter of US space – are at risk of becoming “zombie buildings” with low occupancy and diminishing financial viability, resulting in as much as $450 billion in lost value by 2030, according to a report this month by Boston Consulting Group. Office values are expected to drop from pre-pandemic levels by as much as 60% in San Francisco, 55% in LA and 50% in New York, Philadelphia and Washington, the firm said. Without new investment, more stores, restaurants and other downtown tenants will close.

“If people don’t act to bring other uses in, you’re going to have a cycle of less and less activity,” Santiago Ferrer, a BCG managing director and co-author of the report, said in an interview from his downtown Los Angeles office. “This is a call to action, that cities need to use their convening power to address.”

One of the biggest downtown LA real estate boosters is New York-based Silverstein Properties, known for rebuilding the World Trade Center area after Sept. 11, 2001. Silverstein paid $430 million in September 2020 for LA’s US Bank Tower and spent $60 million more to revamp the skyscraper, turning the 54th floor into a concierge-staffed conference center and redoing the ground-floor lobby with a plant wall, blond-wood paneling and a juice bar. The goal: to create a hotel-like comfort experience that will lure in workers from home offices.

At a March ribbon cutting, Silverstein CEO Marty Burger likened downtown LA to lower Manhattan after the terrorist attacks, and touted his company’s contribution to the revitalization and transformation of New York’s Financial District into a round-the-clock live-work community.

“The naysayers said that downtown Manhattan was finished as a business district, that nobody would work in tall office buildings ever again,” Burger said. “I can tell you that in New York 20 years ago, we didn’t hesitate for a minute. We recognize the wonderful history and great potential in the downtown neighborhood” of LA.

Rudy Medina, US Bank’s Southern California market president, cheered the new owners. “Our name’s at the top,” he said. “But I’m more excited to have Silverstein at the base of this building.”

Medina said the tower’s underground parking lot has been filling up as more people return to their desks since the renovations. He knows because he drives to work, even though he lives in an apartment a few blocks away. He feels uncomfortable walking.

“It’s not very pleasant on the street,” he said.

Related tickers:
BN US Equity: (Brookfield Corp)
166226Z:US (Silverstein Properties Inc)

Corrects month Aon Center went on the market in photo caption.
Updates with Oaktree loan extension in paragraph before downtown map.