US lenders, which have already been demonstrating tepid interest in financing office deals, are pulling back even further from lending on so-called commodity offices.
The thinking is that commodity offices – the older-vintage, mid-block or suburban siblings of newly built or amenity-rich properties – are less likely to see demand from companies that are trying to woo employees back to work. And as a result, debt capital that is being allocated to the office sector is a narrow segment of the market.
“While trophy-oriented inventory is getting absorbed at eye-popping rents, there seems to be a cohort of tenancy that is price-sensitive and decided to vote with their feet”
Michael Lavipour, a managing director at New York-based Square Mile Capital, says the real estate private equity firm has done very little office lending since the start of the pandemic. And when it has, Square Mile has focused on a very specific type of asset.
“We have focused on newly developed assets in markets that are very tight, including a speculative office development in Silicon Valley,” Lavipour says. “We think tenants who come back to work full time will want to be in the highest-quality office. We haven’t done the deals that we traditionally might have done on a class B office in a class A location because we are less certain on valuations and tenant retention.”
Lenders will consider new uses for older assets, with Lavipour noting that Square Mile will consider life sciences conversions for the right kind of office properties in markets like Cambridge, the San Francisco Bay Area, San Diego, New York and Washington, DC.
“The interesting thing is that not all office properties are made equal and not every existing building in one of those markets can handle the transition to life sciences,” Lavipour says. “If we do consider a deal like that, we have to make sure the plans make sense, that the building meets the physical requirements that are needed.”
ING Real Estate Finance has been shifting away from the office sector since the start of the pandemic. Craig Bender, managing director, says the sector – which once made up about 75 percent of its portfolio – is a fraction of what it was.
“We are very selective on office deals,” Bender says. “We haven’t done one since the pandemic started, apart from refinancing a couple of existing transactions. We aren’t closed to office, but we are also taking a wait-and-see approach on transitional office assets.”
Part of this concern about office properties is the economics of how leases are structured, especially when compared with multifamily. Office lease terms are five to 10 years and acquisition costs tend to be very high in terms of tenant inducements and commissions – so owners are faced with a large cash outlay and in return receive an unattractive rental rate that is locked in for a long period of time, Bender says.
“It may be too low to pay expenses or debt service, plus you may have to give tenants about $120 [per square foot] in tenant improvement costs and 12 months of free rent,” Bender notes. “In a bad market, you can sign a lease, spend significant money and not cover your expenses, or you can sit with an empty building.”
Tenants tilt toward quality
One of the problems with commodity offices is that lenders don’t have the certainty that there will be the same kind of tenant demand for these assets as is being seen for newer, class A properties. As a result, more debt capital has flowed toward higher-quality office properties as well as into other sectors, like multifamily and industrial, says Jay Neveloff, a partner and chair of the real estate practice at Kramer Levin.
Michael Cohen, president of the New York tri-state region at advisory firm Colliers and an office leasing specialist, is also tracking a clear tenant preference for newer-vintage properties. These tenants often sign longer-term leases at higher rates, a key factor for a lender that is underwriting an acquisition or redevelopment loan. Shorter-term leases are a concern for lenders, which want more certainty of cashflow.
“A building is usually like a bond portfolio with leases of different lengths,” Cohen says. “We aren’t yet seeing buildings overwhelmed by one- to three-year leases, such that they become a different product. But over the last few years, as you’ve had to make short-term deals with a handful of tenants, then you had to address these issues in the financing market, including the building’s cashflow, loan-to-value ratio and coverage levels.”
At the higher end of the market, there is more absorption. This is not the case for more commodity-type properties, Cohen adds. While Colliers is seeing strong demand for the highest-quality space, there is also a group of tenants that sees now as the time to lock in low rents at less prominent properties.
“While trophy-oriented inventory is getting absorbed at eye-popping rents, there seems to be a cohort of tenancy that is price-sensitive and decided to vote with their feet,” Cohen says. “This group thinks that today is the time to buy low and get these deals done.”
There are a few bright spots on the horizon for the office market in general, including an increase in overall transaction activity.
According to an October report from Real Capital Analytics, there were more than $450 billion of investment sales in the first three quarters of 2021. The office sector comprised about $34.8 billion of the activity seen in Q3, which represented a 137 percent year-over-year increase for that period. Year-to-date, the office sector saw about $84.9 billion of transactions, which is a year-over-year rise of 43 percent.
New York stands alone Commodity offices in Manhattan’s roughly 420 million-square-foot office market have different challenges than properties in other markets where the average age of properties is higher. The average age of an office building in New York is about 75 years and this means there are multiple problems with commodity assets that include ceiling height, the amount of light, air quality and amenities, market participants told affiliate title Real Estate Capital Europe.
Lender and borrower interest could also be defined by elevated pricing for industrial and multifamily properties, with borrowers and lenders looking at the sector as an alternative to paying higher prices.
“We’re getting that call now,” said Will Silverman, a managing director at Eastdil Secured, speaking on a Real Estate Capital USA roundtable in October. “We closed on a portfolio of workforce housing in New Jersey at a cap rate of 4 percent and are seeing sub-3 percent cap rates in the Sunbelt. That sort of activity has people saying, ‘Tell me more about New York office!’”