Office Landlords Use Cash Gifts, Loans to Inflate Building Values

News of the deal boosted SL Green’s share price about 20% that day, and it is up more than 20% over the past year. The sale also helped buoy sentiment across the beleaguered New York office market.

But the sale came with an important caveat. SL Green and other investment firms agreed to sell the buyer, Mori Trust, more than $500 million worth of the building’s debt at a roughly 6% discount, according to people familiar with the sale. SL Green didn’t disclose these transactions in its earnings report, earnings call or in the press release announcing the deal.

That sale and that discount, while a modest amount, were important in getting Mori to agree to invest in the building at a $2 billion valuation, despite the property’s debt load, these people said.

Analysts said the sale is a success for SL Green, one of New York’s largest office owners, even with the discount, because the company got $174 million in cash in a tough market. Firms also have some leeway over what to disclose, analysts said.

Yet some also said complex deals like this mean valuations now often come with an asterisk.

“You see the headline number that everybody cares about, and then there’s the story behind it," said John Kim, a real-estate stock analyst at BMO Capital Markets. “And in this case 90% of the people who heard about this deal just focus on the number."

SL Green’s chief executive, Marc Holliday, said: “Skepticism about valuations of top buildings is stuck in the past and misses the reality on the ground—the worst is behind us and first-movers have already spoken with investments in extraordinary assets like 245 Park."

While SL Green didn’t disclose the debt sale to the general investment public through its earnings report, an SL Green spokesman said the company’s chief financial officer talked to investors and analysts about the debt sale at various points after the deal was announced.

A spokesman for Mori Trust declined to comment.

Office landlords increasingly rely on cash gifts, veiled discounts and other financial engineering to prop up property values as the sector faces its deepest crisis in decades. While the maneuvers are legal and often make business sense, they raise questions from analysts over whether publicly available property valuations are inflated.

Dylan Burzinski, head of the office sector team at real-estate analytics firm Green Street, said the discount potentially inflated the valuation of the SL Green building, known as 245 Park. As property sales become more complex, he added, analysts have a harder time figuring out the true state of the office market.

Vacancies have surged and the share prices of public office landlords are down since 2019, but actual building sales prices have in many cases budged little—partly because they are inflated through side agreements, real-estate brokers say.

When Green Street estimates property values, it not only counts sales prices but also tries to account for side deals and other factors like changes in interest rates. The company estimates that high-end office building values are down around 35% since the start of the pandemic.

Other types of financial engineering proliferate. Landlords increasingly hand out cash or no-rent periods to tenants in return for higher rent. In a recent report, real-estate brokerage CBRE found that free-rent periods on leases at high-end office buildings in a dozen major U.S. cities averaged 10.1 months in 2023, up from 6.8 months in 2019.

Cash payments to tenants for construction work on their offices increased by 37% during the period. That helped high-end office rents rise slightly in 2023, but the number is misleading. Real, so-called net-effective rents that account for concessions fell slightly.

Making these concessions to tenants often pays off because it keeps annual rents and building profits high, and these are used to calculate building values, brokers say. That means any dollar paid to a tenant upfront can return many more dollars when the building is sold or mortgaged.

“You want to protect the face rents," said Alan Pontius, national director of the office and industrial divisions at brokerage Marcus & Millichap.

Office landlord Boston Properties, for example, handed out more than twice as many days of free rent per month of lease term in the first three quarters of 2023 as it did in the same period in 2014, when the company’s public filings began to disclose the data.

SL Green has also been offering more incentives to tenants. It is among the more active in using creative deals to get higher valuations, lenders and brokers say. “They figure out how to have one and one equal three," said William Shanahan, chairman of New York capital markets at real-estate brokerage CBRE.

In another deal last year, SL Green said it agreed to sell a Manhattan office tower for $632.5 million, or a lofty $1,123 a square foot. The company was able to reach a deal at that price by effectively lending the buyer part of the purchase price.

SL Green and its partners agreed to make a $234.5 million preferred equity investment—a type of equity that typically pays interest and resembles debt—in the building as part of the sale, the company said in a press release at the time.

This practice, dubbed seller financing, is becoming more common, brokers say. High interest rates and stingy banks mean investment firms struggle to get loans to pay for office purchases. That means if landlords want to sell, they would have to accept much lower prices. By lending buyers the money to pay for the building, sellers can keep prices somewhat high.

“To make the deal happen, you have to do seller financing," said John Guinee, a former real-estate stock analyst.

Financial engineering in the office sector isn’t new. The practice became more common over the past decade as private-equity companies became a bigger part of the market. These firms helped popularize upfront concessions to tenants that, along with low interest rates, juiced the market even as underlying demand remained weak.

“Net-effective rents were flat 2010 to 2019, yet values went through the roof due to a significant increase in concession offerings," said David Lipson, chief executive of brokerage Savills North America.

Write to Konrad Putzier at konrad.putzier@wsj.com