With a backdrop of rising interest rates, economic uncertainty and hybrid work that is keeping office usage well below pre-pandemic levels, financing office assets remains challenging, with the cost of capital increasing and lender appetite diminishing.
The Fed has aggressively risen rates in an attempt to curb inflation. The pace of hikes has begun to slow with the last hike coming in at 50 basis points rather than the 75-point hikes in the previous moves, but no one is quite sure where the Fed funds rate will peak and whether its possible rate cuts may even return by the end of the year.
Amid all of this, lenders and investors in the office sector are struggling to project where and when pricing will level out.
“Both the equity and debt markets are experiencing a great reset in pricing, which I believe will occur at some point in the second or third quarter of 2023,” says Steve Pumper, executive managing partner of Transwestern's Capital Markets and Asset Strategies Group in the firm’s Dallas office.
As of the third quarter of 2022, the MBA originations volume index for office properties stood at 85. (A score of 100 equates to average quarterly volume in 2001). That was the lowest mark of any of the major property types for the quarter and down from readings of 108 and 123 in the first two quarters of 2022. On a year-to-date basis, office originations were down 15 percent compared to 2021 compared with increases of 14 percent for multifamily, 47 percent for retail, 32 percent for industrial and 64 percent for hotel properties.
Investors are increasing their internal rates of return and adjusting their risk tolerance when underwriting, says Aaron Jodka, director of research, U.S. capital markets, at real estate services firm Colliers, noting that strong rent growth and occupancy gains are harder to pencil today.
The U.S. office vacancy rate stood at 16.2 percent at the end of November, according to CommercialEdge, an increase of 110 basis points year-over-year. The national listing rate was $38.06 per sq. ft., down 3.1 percent from November 2021.
This means that investors are targeting their return thresholds through lower acquisition costs, which is putting downward pressure on asset values and upward pressure on cap rates and widening the bid/ask spread in the office market, he says.
According to Russell Ingrum, CBRE vice chairman of capital markets, interest rate hikes are playing a significant role in the slowdown in transaction activity, but so is a reduction in the amount of debt available in the marketplace. Ingrum notes cap rates have risen in response to the increase in the cost of debt, and in general will increase by about 60 percent of the change in whatever index it’s priced off of. He does not expect office investment to pick up until rates stabilize and are predictable for at least six months.
One part of the market that may pick up earlier could be lenders and investors targeting opportunistic and value-add strategies, Pumper says. But with lower loan-to-value (LTV) and higher interest rates, underwriting office acquisitions going forward will be difficult given uncertain tenant demand.
Jodka concurs, noting that office investors with expiring debt are seeking recapitalization partners, but preferred equity investors, mezzanine debt, or other forms of rescue capital also are in play in the overall office finance market.
Another factor changing the equation for lenders is monitoring tenant renewal trends. Many tenants today are willing to renew but for a shorter duration, while taking less space, Pumper notes. In the past, 10-year leases were standard, but “in today’s market, a five-year lease term has become the new 10-year lease,” he says.
This phenomenon, coupled with high tenant improvement costs and commissions, make it difficult for investors and lenders to feel comfortable about placing capital in the office sector, Pumper adds.
“Some lenders are pencils down for the moment,” agrees Jodka, but he notes that others are examining their market level exposure and shifting markets where they can and will lend. While lenders are still willing to finance office assets, they expect higher equity contributions and strong debt coverage ratios and are scrutinizing deals far more closely, he adds. “Tenant credit and location durability are front of mind, and building systems investment, ESG standards, and overall health of the asset matter more today than ever.”
Jodka says, however, that smaller investments are easier to transact in today’s financial environment. Deals that require hundreds of millions, or more than $1 billion of investment (debt and equity) are difficult to execute.
“The best buildings can still transact, as they offer best-in-class amenities, building systems, emission controls, and superior locations,” Jodka continues, noting that these assets have demonstrated strong leasing activity and attract occupiers at premium rents. But while these are the most liquid assets in the office market, they aren’t transacting, because owners are choosing to hold onto them and maintain their market outperformance, he adds.