Office Vacancies Are Not Our Only Problem

By Kevin Tatro

Managing Director, Credit Solutions for Trimont

While no one should discount the possibility of positive surprises, the math for US office space looks pretty dismal right now. Almost 20% of all office space is vacant [1],  physical occupancy is still hovering around 50%[2], and despite what the optimists say, all data points to these trends continuing or getting worse. Two billion square feet of this office space is likely obsolete, as 31% of all office buildings were constructed before 1980, with as much as $600B of these buildings no longer housing office tenants[3]. While creative re-uses may lessen some of that impact, many of these buildings will be tear downs, with some demolition costs exceeding the value of the underlying land.

Challenges Beyond Structural Obstacles

The issues extend beyond this, as these figures only highlight the structural obstacles this asset class encounters. There are undoubtedly discrepancies between class A buildings and older class B/C buildings, but all are facing operational challenges including escalating insurance costs, wage hikes, rising utility costs, TI package requirements, and a waning tenant base in an oversupplied market.  Exceptional operators and those with deep pockets will continue to support the best buildings, however, there is insufficient demand to sustain all these projects, and financing costs have basically doubled. Despite varying predictions about the future of interest rates, it’s undeniable that current borrowing rates are considerably higher than a few years ago. The base rates of the past several years, being at 0.5% for floating debt and as low as 0.25% for fixed-rate loans, are unlikely to return.  Fed language and forward market predictions suggest elevated rates will persist for the predictable future. This means that a loan taken two years ago would now refinance at about 50% of that level. Even this level of financing is generally unavailable for challenged office assets, and when it is available, debt yields typically sit in the mid-teens, which implies such refinancings would be at about 35% of the original balance, if you can get it. Given these facts, it is not surprising that the rating agency KBRA indicated just 73% of the office loans in surveyed CLO’s can refinance at current rates[4], or that Trepp reported that less than 66% of maturing commercial mortgage-backed securities (CMBS) loans repaid their obligation at maturity in 2023[5]. For those with fixed rate loans there may be time to amortize their loans, and perhaps rates will come down a bit between now and when their loans mature, but for loans maturing in the near term, the prospects of refinancing look challenging.

The Impact of Rising Interest Rates on Financing Costs

Where interest rates go, cap rates are soon to follow. Right now, there is almost no price at which a buyer is willing to purchase a secondary or tertiary office building and sales are rare as indicated by current sales volumes that are down 66% from the same period last year[6]. As the market comes to terms with levels of pricing, appraisers will begin to develop a sense of ‘market value’, that will be used to determine the worth of all comparable assets.  While clarity in that space is still illusive, most agree that those overall values are currently down by more than 25%, and several high-profile sales have occurred in the range of 70% discounts.

The Looming Debt Maturity in Commercial Real Estate

The future of office buildings is coming to light quickly, but unfortunately this isn’t the full extent of the challenges facing investors and lenders. An estimated USD 2.8 trillion in commercial real estate debt is set to mature in the next four years and more than USD 1 trillion of this is multifamily properties, which could potentially be an even larger issue than office[7]. This is due to these loans making up 42% of all loans made in 2020-2022 when lending standards were most aggressive and real estate values highest[7]. The ‘safe’ nature of these products drove cap rates well below 4% for many properties. Lenders, eager for these supposedly safe assets, were willing to lend at higher loan-to-value (LTV) ratios, lower debt service coverage ratios, and proforma assumptions, in many ways the real estate equivalent of banks committing surplus deposits into securities and treasuries, resulting in the “unrealized loss” mini-crisis of March 2023. These real estate loans on “super-safe” assets are now effectively carrying unrealized losses as values have moved out as risk-free money rates have increased.  

The Trouble with Short-Term Debt and Multifamily Properties

With historically significant year-over-year rental and, therefore, valuation growth in these assets, owners increasingly opted for short-term debt, enabling them to refinance more frequently to realize equity growth. As a consequence, many of those loans are now facing imminent loan maturity. While multifamily properties are not currently subject to the loss of demand that plagues office buildings, the effects of higher borrowing rates and stricter lending standards is much more pronounced when applied to the lower cap rates and favorable terms at which these assets were purchased and financed. Borrowers who financed a purchase at a 3.5% actual cap rate with 75% debt, are finding themselves in a zero-equity position as financing rates have now reached around 7%; with potential valuation losses sometimes exceeding 50% as cap rates adjust to reflect current leverage costs.  The pain will be felt more acutely in inferior buildings, with deferred maintenance issues and with weaker landlords, and those who purchased at higher actual cap rates and at lower debt levels or with longer dated debt will have a better chance of survival. However, the issue extends far beyond the struggling office space sector. With collateralized loan obligations (CLOs) historically averaging 65% multifamily concentrations and providing some of the most aggressive financing terms, these entities and others with similar concentrations are likely to encounter significant multifamily refi risks despite stable Net Operating Incomes (NOIs) in these properties.

The Risks Faced by Lenders and Potential Strategies

This brings us to the lenders. Maturing CMBS and single asset single borrower (SASB) office loans are likely to see impacts beyond the first loss holders. CLO firms with up to 20% invested capital may find their entire positions wiped out. Warehouse lenders are likely to make margin calls, and borrowers are increasingly likely to walk away from assets where they have no real equity. We expect a significant increase in the amount of collateral that is likely to come to market through real estate owned (REO) and note sales, while loan recovery and special servicing firms are likely to be very busy. Rational lenders and investors would be well-advised to form partnerships with robust workout teams, acknowledge and resolve their legacy assets early in the cycle, and preserve capital for the opportunities that are likely to arise as these assets are repriced.

To learn more about how Trimont can assist you, contact Trimont at info@trimont.com.

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