The wave of interest rate increases from the Federal Reserve to combat inflation, combined with record high vacancy rates in the office sector, is causing the markets to reevaluate the market value of office product. Banks that previously chose to foreclose and seize assets in default are now faced with debts in excess of valuations, and having to accept steep losses because there does not appear to be an immediately clear solution and there are no buyers in sight.
There is approximately $10.8 billion of fixed rate CMBS office loans maturing in 2023 alone, according to Moody’s Analytics. Between January and April of this year, 55% of these maturing loans were renegotiated or extended. Two risk measures, debt yield and lease rollover, shed light on loans least able to pay off. $348 million of office debt with significant lease rollover (+25%) and with a debt yield ratio below 8% defaulted 100% of the time, according to a report by Moody’s. About $451 million of office debt, of which 61% had a DY above 8% and significant lease turnover, also saw high default rates. These data points should be driving investor negotiation strategy, but many lenders do not want to negotiate sooner rather than later.
Berkadia broker Mackinley Robinson says that “depending on your lender, the how and if you can negotiate with the debt holder are very diverse.” Specifically in reference to CMBS loans, he states that often you can’t renegotiate or even get lenders’ attention unless you default, which has led to deliberate delinquencies on behalf of institutional investors such as BlackRock. Life insurance companies will take a more preemptive and aggressive role with debt negotiations and start conversations more quickly. They typically hold loans on their balance sheet, in contrast to CMBS loans, which exposes them to significant downside risk and often leaves them with no recourse. Their early negotiation strategy allows them to mitigate any large value loss and ideally regain the initial valuation with an upturn in the market cycle.
Not only do lenders need to act early, but asset managers need to consistently track their tenants’ leases and mitigate large lease turnovers because leasing turnover is critical. With a lease rollover rate of over 25% being a key risk threshold, adding a wider diversity of tenants could be one possible risk mitigation strategy. Having a building where any one office tenant occupies over 20% of the footprint creates a risk that one tenant could undermine the whole building. This situation requires a higher level of management and creativity. For example, a company like IWG which does flex office is posting record revenue, and owners can turn towards a change in tenant base by seeking out flex office companies or providing flex space themselves.
As an asset manager of Class B or C office space in a core market, how would you assess the current real estate market and what risk mitigation strategies would you take for tenants with over 20% of a property’s square footage?
Leave a Reply