Why office loans are rare and far between – Commercial Property Executive
Lending for new office construction and acquisitions has all but disappeared in recent months. Ongoing financings are often for recently built properties in high growth markets or sub-markets. And those lucky enough to receive financing should expect tighter underwriting and a higher cost of debt.
“The appetite and desire for office finance as a product type has been a 180-degree shift since the second quarter of 2022,” said Brad Zampa, executive vice president of the CBRE San Francisco Capital Markets team specializing in debt and structured finance. “Uncertainty surrounding the return to office, interest rate hikes, lack of tenant demand and massive negative absorption ultimately caused liquidity to almost completely dry up.”
During the first half of the year, CBRE financed value-added and stable office assets and portfolios, but the market is now almost non-existent.
“We marketed a vacant office financing in the third quarter and only received three offers with spreads two to three times higher than similar deals six months prior,” he said.
Lenders are reducing leverage across the board, and rising interest rates have tested underwriting, particularly with respect to exit debt service criteria, which may still reduce leverage, Zampa said: “Lenders are just as focused on funding a lower overall last dollar. basis and reducing interest-only periods, preferring amortization to speed up repayments.
Beyond the economy
All property types are experiencing some liquidity disruption due to the impacts of macroeconomic conditions on financial markets. But the problem for offices is larger and potentially more long-lasting, according to Justin Kennedy, co-founder and managing partner of 3650 REIT.
“We are certainly not dealing with an excess of new supply built in recent years, which has been the fundamental problem of past crises. said Kennedy, whose Miami-based investment firm creates and manages portfolio loans for relationship borrowers. “This is clearly a ‘demand shock’ and it’s one that’s not even close to playing out yet.”
According Newmark National Office Market in Q2 2022 report, there were 10.5 million square feet of new office deliveries in the second quarter, compared to 12 million square feet in the second quarter of 2021. Office space under construction also fell year-over-year , from 87.5 million square feet in the second quarter of 2021 to 75.8 million square feet. feet in Q2 2022.
In times of recession, office and retail tenants are reluctant to make new office rental commitments. But there is another force at play in the office market.
“Today we are seeing a setback because people don’t want to go to the office anymore,” he said.
For the first 12 months post-pandemic through the summer of 2021, decent funding was available for good offices assets, noted Keith Largay, senior managing director, co-head, Midwest Capital Markets at JLL.
“What started to change in the second half of last year, and really came into 2022, is that there’s just huge uncertainty about demand and what the characteristics of the demand in the office sector,” said Largay.
According to Jamie Woodwell, vice president of research at the Mortgage Bankers Association, office building starts in the second quarter were down 11% year over year, compared to a 24% increase for multi-family buildings. and 3% for industrial buildings. Retail and hospitality loans rebounded from low levels, while offices continued to lag.
The MBA updated its baseline forecast at the end of July to reflect an anticipated slowdown in overall lending in the second half of the year. MBA expects total commercial and multifamily borrowing and mortgages to fall to $733 billion in 2022, down 18% from $891 billion in 2021.
Woodwell did not have estimates for office-only loans. If the economy went into recession, however, commercial and multifamily borrowing and lending would likely be even more constrained in 2023, he said.
Close a deal
Despite volatility in debt markets, in late September, DeWitt Carolinas secured a $139 million construction loan from alternative lender ACORE Capital for “1000 Social,” the first office tower of The Exchange Raleigh, a project $1 billion, 40-acre mixed-use property in Raleigh, NC Avison Young arranged the financing. The project will eventually include two 12-story office towers totaling 330,000 square feet of Class A office space.
“While there are fewer lenders willing to fund new projects right now, we have strong relationships and a great balance sheet, which always makes things easier on the financing side,” Soccorso said.
He also cited three other factors in favor of the company: 1000 Social is part of the master-planned mixed-use community The Exchange Raleigh has generated a lot of interest; Raleigh continues to be an incredibly attractive market: and DeWitt Carolinas has a significant equity commitment to the project. Once built, the project will include 790,000 square feet of Class A office space; 1,275 residential units; 300 hotel rooms; and 125,000 square feet of retail and restaurant space.
Mixed-use developments also help mitigate a lender’s exposure with diversified products and diversified revenue streams. For office projects only, the flight to quality is a reality and the more recent the building, the more likely the borrower is to obtain financing for the construction or acquisition.
For the few office construction deals underway, tenant pre-lease credit is the starting point for lenders, Kennedy noted.
“From there, it becomes how special your location and gear story is,” Kennedy said. “Should there be an element of recourse? If we were dealing with a bank, yes. A debt fund? If the story is good enough, I think not. It will all depend on how clearly “specialty” can be defined as the demand for space in that particular area. »
3650 REIT has not provided an office construction loan since last year, when it financed a property in Houston’s River Oaks district, Kennedy said. The company recently bid on an office building contract in Miami, but its pricing wasn’t aggressive enough to secure the deal. Sponsors are always looking for the right deal.
“If someone came up with a building that had a credit tenant, was in a special location, and we had good confidence about a lease for the rest of the space, I think we would still look into it. “Kennedy said. “It would definitely be a lot more expensive than last year, but we would still look at it.”
Sell or keep?
Investors nearing the end of their business plans must decide whether to sell or hold their assets longer. Largay expects a good number to sell because while the cost of capital will hurt their prices, they know that won’t change in the next 12-18 months or 24 months and, if they wait , they will also have a lower average lease term. Meanwhile, closed-end funds can sell if they run out of extensions on their fund.
JLL closed in September the sale of an office property in the Dallas market for a four-year-old Class A building, 80% leased. While the owner of 3400 at CityLine in Richardson, Texas could have held the asset for another year or two, adding more value and selling at a better time in the market, they decided it was the right time from a portfolio perspective to sell.
Largay said the buyer, who used loan funds to finance the acquisition, was willing to accept the risk of continuing to lease the building because it was a high-quality building purchased from a lower cost than replacement with good weighted average lease term in a growing market and good submarket.
He said many debt funds are ready to lend on the desk if there are quality real estate demand fundamentals.
“Where they are challenged is that all these debt funds are self-multiplying,” Largay said. “Historically, the main source of leverage has been money banks. Banks in currency centers have significantly reduced their home lending due to regulatory requirements. »
With banks reducing their leverage on all types of assets, many debt funds have to fund their positions with smaller regional banks. Lower internal leverage drives up their cost of capital, which they pass on to borrowers with higher spreads.
Insurance companies and office
Tony Kaufmann, director of the San Francisco office of Gantry, Inc., the largest independent commercial mortgage bank in the United States, said life insurance companies are still considering office offerings, especially those with high quality properties and strong market fundamentals, but the leverage will be lower and rates will be higher. For Gantry, life insurance companies have provided both the largest loan volume and value so far this year.
“I think one of the things that life insurance companies benefit from and why they continue to view office assets selectively is that they are inherently conservative lenders,” Kaufman said. “They are mostly all non-recourse lenders.”
CMBS is still a good source of cash for office assets, Largay said, but activity has fallen due to pricing, which was 6% in September and could rise depending on how interest rates move. interest. For borrowers willing to pay CMBS rates, the market is functional and the debt is available.
In addition to CMBS lenders and some life insurance companies, experts report that some regional banks, credit unions and some unleveraged debt funds are still active in stabilized office deals, but underwriting will be cautious. due to interest rate increases and continued leverage.
“It’s not entirely predictable where we’re headed,” Largay said. “While there is hopefully some upward momentum in cap rates, there will be a bit more success with deals that are shaping up better.”
Read the November 2022 issue of CPE.