Rising mortgage rates, inflation, and soft demand for office are straining the commercial real estate (CRE) industry, but it’s possible that the office segment may be stronger than headlines would suggest.
Over the next 18 months, a lot of office debt will mature — debt that will have to be paid off, refinanced, extended or written off. Trepp estimates that $310 billion in CRE financing will come due by the end of 2024.
It’s not surprising that so much debt is outstanding; that’s the nature of the real estate business. What’s different this time is that we’re at the intersection of significantly higher interest rates and increased vacancy levels.
Interest rates have quickly increased, largely in response to inflation and Federal Reserve efforts to slow the economy. Between January 2022 and August 2023, the federal funds rate — the rate banks pay for overnight borrowing — went from .08 to 5.33% while the prime lending rate — the rate banks charge for consumer loans — increased from 3.25 to 8.50%.
At the same time, the pandemic spawned a lengthy work-from-home (WFH) movement that has continued longer than many anticipated.
Office Financing Terms
CRE loans vary in term length depending on a multitude of factors — with the loan term varying as well, depending on the capital source. To put this into perspective, bank loans are typically made for shorter terms (e.g., five years or less), while Commercial Mortgage-Backed Securities (CMBS) and life insurance companies traditionally make loans for longer periods (e.g., approximately five years or more).
With a CRE loan, if you borrow $10 million with a fixed rate, the monthly payments might be calculated on a 30-year amortization schedule; however, the loan itself may only have a 10-year term. That means the financing is not self-amortizing; instead, it has a balloon payment at maturity.
In the case of a CRE interest only loan, the payment consists solely of the interest charged by the lender. Companies benefit from interest only loans because it requires less upfront capital costs and increases net operating income (NOI) for the property. Increased NOI allows owners to make needed capital expenditures at properties, from improving tenant lounges, gyms and conference rooms to more functional changes such as fixing water leaks and improved ventilation systems. An interest only loan increases cash-on-cash returns throughout the time that the owner holds the building allowing them to pay higher dividends to investors now rather than waiting to realize gains after the property is sold.
Office Financing and Refinancing
Office loans are typically refinanced with few barriers, which helps owners execute material cash-out refinances that enable them to add value to the property. This can stem from any number (or combination) of reasons, including property owners owing less due to amortization, a likely increase in rental rates, or an increase in NOI.
However, the usual cycle of borrow-and-refinance is not a certainty — even in normal markets. Higher vacancy levels can imply less income and lower property values. A recent paper from the National Bureau of Economic Research estimates that write-downs may still loom ahead.
Today, many office properties are being refinanced with a rate that’s much higher than the original underwritten loan rate. This makes it more difficult for the property owner to cover property expense and other expenditures (e.g., tenant improvements) because any additional cashflow will be directed toward the higher loan payments. If unable to make their payment with the current interest rate — or if occupancy is expected to dip below an unstable percentage — the property owner may elect to walk away from both the property and the loan.
But, in the same way that recession forecasts have been overly pessimistic to this point, could it be that dire office-sector predictions are also overstated?
The idea isn’t that current marketplace realities are imaginary; instead, it’s that the office market is huge, in transition, and that vast segments may be far more stable than the media suggests. In fact, the CBRE Lending Momentum Index, which tracks the pace of CBRE-originated commercial loan closings in the U.S., said recently that borrowing costs appear to have peaked or stablized, even as transactions activity remains subdued.
“I am seeing that companies want office space that caters to their employee base’s needs and desires,” said KBS CEO Marc DeLuca in Forbes. “This means beautifully designed buildings with well-appointed workspaces offering all the bells and whistles workers have come to expect when returning to their workplace are in high demand.”
The reality in most markets is that higher quality, highly amenitized, Class A buildings are faring better than lesser-quality properties, something that can be seen in the CBRE data below.
Office Building Vacancy Rates
No doubt, vacancy levels are generally above what we saw before the pandemic. But a different picture emerges when you look at the specifics.
A majority of U.S. office buildings are now more than 90% leased, according to a 2023 analysis by CBRE. As of Q2 2023, roughly 66% of all U.S. office buildings were more than 90% leased — only 5% lower than the 71% of all office buildings in pre-pandemic Q1 2020.
While the overall U.S. office vacancy rate hit a 30-year-high of 18.2% in Q2, some buildings are doing much better than others. Data shows that only 10% of all U.S. office buildings account for 80% of the occupancy losses between Q1 2020 and Q4 2022.
“These tend to be older buildings in downtown submarkets with relatively high crime rates and few surrounding amenities,” according to CBRE.
Translation: Although reported vacancy levels are up in general, they’re especially high within a small segment of the marketplace. Think of a basketball game when one player gets 38 points and another gets two. As a whole, the players scored an average of 20 points each, but that’s not the entire story.
The same can be true with commercial office space. General vacancy figures may not reflect actual results for individual properties, given submarkets, specific building classes, etc.
The Flight to Quality
Andy Poppink, CEO of JLL EMEA Markets, said in March 2023 that “Most real estate executives — three out of four, according to JLL research — believe the office is key to their future. They want their people back together, collaborating and innovating, so they’re seeking flexible, amenity rich, quality workspaces.”
According to Smart Business, “As many office-based businesses see the return of employees, businesses are reimagining how they handle their real estate. Occupiers are pursuing a ‘flight to quality,’ looking to give their talent better space as a reason to return and address new work dynamics.”
The report goes on to say that tenants and their workers are seeking newer buildouts, modern finishes, upgraded furniture and amenities in upgraded spaces.
“Experts are seeing a ‘flight to quality’ among companies that use offices,” said DeLuca, “and some predict newer Class A office buildings as one of the asset types that will see the highest amount of leasing activity in 2023. With roughly 80% of office leases being signed in buildings that are Class A, I am witnessing companies increasingly seeking fresher, modernized office space to house their teams.”
KBS properties, for instance, are doing well in many markets. Recent occupancy rates at Accenture Tower in Chicago, Illinois, Park Place Village in the Kansas City metro area, and Salt Lake Hardware Building in Salt Lake City, Utah, are nearly 100% occupied.
Next week, catch part two of this report, in which we’ll share how additional factors — including vacancies, absorption, interest rates, and the work-from-home movement — have shaped the office segment’s performance in the market.
Learn more by visiting KBS.com/Insights.