Three things to know about underwriting risk as property conversions rise 

Commercial real estate lenders are increasingly working with borrowers that see a new life in obsolete properties in the office sector and beyond. But Brad Tisdahl, a managing principal at New York consultancy Tenant Risk Assessment, cautions there is more than meets the eye from lenders who are underwriting these loans.

Part of assessing risk today is understanding the intersection between the commercial real estate market and the substantial steps the US Federal Reserve has taken over the past two or three years to support commercial real estate – and commercial real estate tenants.

“The Fed is already increasing rates and selling off their bond portfolio, two factors that could both have an impact on the cap rates in many commercial real estate asset classes. And as we know, there has been a lot of discussion around recession and there has been a lot of discussion around inflation,” Tisdahl said. “But I am less interested in that and more interested in what the fundamentals of the economy are right now and what is driving it because that is going to have an impact on different components of commercial real estate.”

Here are three things for lenders to consider when looking at conversion opportunities.

1. Office to life sciences conversions are rising steeply 

The numbers of conversions are rising steadily, with office to life sciences and retail to healthcare or industrial making up a significant portion of this activity. A report from CBRE found that at the end of 2021, there were 9.9 million square feet of office to life sciences conversions underway in the 12 largest US life sciences markets – a 49 percent year-on-year increase. At the same time, there was also a 42 percent rise in ground-up lab construction to 18.8 million square feet during the same period.

This activity stems from an extremely supply-constrained market. “There has been a rush to build more life science properties to accommodate this demand,” Tisdahl said. “But one thing that can’t be overlooked is the tenants. You are not always going to see a Merck or a Pfizer in that space – you are sometimes going to find a startup that has raised quite a bit of money but has risks associated with, for example, raising additional capital to fund R&D or getting approval from the Food & Drug Administration for a treatment.”

One more thing to take into account: the cost of a build out could be as much as $250 per square foot, double a traditional office build out. “That can be more of an outsize risk for lenders that are financing the conversion of these properties,” Tisdahl added.

2. Another day, another doctor 

As an aging US population increases the need for accessible medical services, malls and other retail properties have been a common destination for doctor practices and other healthcare services. According to data from CoStar, tenants that fit this profile now take up 20 percent of space in malls, compared to about 16 percent in 2010.

“Medical office is a unique asset class and, over the past 10 or 15 years, we have seen private equity come into this sector and consolidate a lot of the back-office processes for physicians,” Tisdahl said. “The flip side to that is that more doctors have become real estate investors as a way to diversify their income streams in that they will buy a building and operate out of a portion of it and lease the rest to other users.”

The risk, however, comes from the difference in skill sets. “Some of these physician groups might not be quite as good at managing their real estate and might not necessarily see as much of a return on investment,” Tisdahl said.

3. Office does still matter 

Despite nearly daily headlines about the decline of the office sector, Tisdahl believes there is a strong future for these properties, either as traditional offices or as different types of properties.

“I still think tenants will be paying their rent and owners will continue to operate their buildings. But what is interesting to me is that over the past couple of years, we have been in an era where there has been a lot of conversations about how offices are going to be used and companies are talking about the different ways in which they want to handle leasing going forward.”

There will be a divide between borrowers, with some finding financing easy to line up.

“The less well-capitalized or the smaller owners are potentially in for some pain and will have a harder time getting affordable financing with rates going up,” Tisdahl said. “There could be some forced issues around liquidity for some of those owners of those types of buildings.”

Looking ahead 

One question to consider is the level of risk property owners are taking to attract and retain tenants.

“In some markets, like within life sciences, we see owners taking on a lot of risk because they are doing big build outs. And in the office sectors, owners are taking risks for build outs for the big tenants, the law firms and the accounting firms, which are still considered pretty good credit tenants. I think you are actually seeing bigger risks in the life sciences sector than in the office sector right now,” Tisdahl said.

On the other hand, there is much less risk tolerance in the traditional office sector, which means that activity has been much slower.

“In a typical world, you might see owners or lenders might get more aggressive, but we are not seeing that right now,” Tisdahl said. “It is a bit of a contradiction, but also makes sense in the context of what is happening in that market.”