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 , physical occupancy is still hovering around 50%, 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. 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.
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. 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. 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. 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 firstname.lastname@example.org.
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About Trimont LLC
Trimont (www.trimont.com) is a specialized global commercial real estate loan services provider and partner for lenders seeking the infrastructure and capabilities needed to help them scale their business and make informed, effective decisions related to the deployment, management and administration of commercial real estate secured credit.
Data-driven, collaborative, and focused on commercial real estate, Trimont brings a distinctive mix of intelligent loan analysis, responsive communications, and unmatched administrative capabilities to clients seeking cost-effective solutions at scale.
Founded in 1988 and headquartered in Atlanta, Trimont’s team of 400+ employees serves a global client base from offices in Atlanta, Dallas, Kansas City, London, New York and Sydney. The firm currently has USD 236B in loans under management and serves clients with assets in 72 countries.