Unstable markets make for safe investments, so hearing that the state of the refinancing market resembles a kaleidoscope isn’t too reassuring.
Still, as Brad Zampa, executive vice president and senior partner in CBRE’s Northern California capital markets team, explains, the environment for commercial refinancing, especially for less desirable office properties, has shed the current uncertainty.
“The office market is a knife falling right now,” Zampa said, adding that the situation is dire nationally, but especially in the West Coast markets it covers, including San Francisco, Los Angeles and Seattle. “The top 10 to 20 percent of buildings in each central business district will capture the market share of returning office workers. And we are left with a large swath of buildings where nobody knows.”
The unknown has as much to do with present data as it does with future activity. Evaluating buildings and financing for them is incredibly challenging because rents are constantly changing and creating offsets is challenging. Buildings can be rented out and remain significantly unoccupied or underutilized, creating significant hurdles for lenders and landlords.
“Lenders are saying, ‘There’s no one here, how do I underwrite this?’ Zampa said. “They’re just taking over the buildings with good tenants, and that’s a big problem.”
Many expected the post-Labor Day period to mark a large-scale return to the office. That hasn’t happened yet, with prominent companies like Apple and KPMG announcing in advance a hybrid approach to the workplace in which workers come in a few days a week at most. Security firm Kastle Systems, which tracks office gate passes, pegged national office occupancy in major markets at 43 percent for most of August.
The pain is also not evenly distributed across markets. Some have seen more signs of life and real estate activity than others. But with many businesses reducing their footprints and the anticipation of a recession rising, owners and operators are facing increasing challenges, including refinancing. And lenders have pulled back, with the Mortgage Bankers Association (MBA) forecasting a slowdown in commercial mortgage issuance in the second half of the year.
“The market is very fluid, and every trade is underwritten differently based on risk,” said Susan Hill, senior managing director of capital markets at JLL. “The market is liquid with increased scrutiny on underwriting assumptions and real-time market data points.”
That risk, Zampa said, has kept significant sectors of the capital market, especially the big banks and the CMBS world, on the sidelines of all but the safest deals. Some regional banks are trying to step in and grab market share they would normally lose to the bigger players, but they’re not making up the difference. Hill added that smaller local or regional banks or credit companies are handling much of the refinancing of Class B and C buildings. These companies are being “inundated” with loan applications.
Challenging conditions for financing will hit Class B and C office buildings hard, Hill adds, especially those that will struggle to add services and more common space, or reside in locations that are not walkable. Offices with strong tenants and good business plans are likely to still be able to do business. A $128 million refinancing for 77 Water Street in Manhattan overcame bank reluctance in August thanks to strong tenants, including a law firm and engineering firm Arup.
“There’s still a big unknown about how the office will change in the future,” Hill said.
Commercial property refinancing across the board has soared in recent quarters, recovering significantly after falling during the early months of the pandemic. An overall 23 percent increase in commercial property values last year, according to MBA research, offered plenty of reasons to refinance. In the first quarter of 2020, commercial refinance counts stood at 31,383, according to ATTOM Data. That number declined for the rest of the year before rising in the fourth quarter of 2020 and peaking at 46,434 in the second quarter of 2022 (the highest total since the second quarter of 2008).
“Last year, we were in a tear,” Zampa said. “A lot of my competitors were having a great year, if not the best.”
Those statistics can mask the challenges facing older office properties in particular. Zampa said the apartment market remains the most liquid in terms of financing, followed by industrials, then life sciences, segments that have been growing in demand and investment at substantial rates.
The ATTOM data also does not highlight the bifurcation that is taking place in the office sector. Newer tier-one Class A shares may find the refinancing necessary to maintain and upgrade, and to add the kind of post-pandemic amenities (enhanced common and collaborative space, indoor and outdoor space, and technology) that make them even more desirable (and justify higher rents to pay today’s higher borrowing costs). The rest of the market, especially significantly older buildings, face the impact of rising interest rates with lower occupancy.
Adam Gibbons, managing director of investments at CIM Group, a large investor, told Commercial Property Executive in March that CIM is “very, very cautious about lending in older class B commodities where there is no clear path on how to and when those buildings will be leased.”
Zampa says homeowners in those situations can’t get extensions on their loans, so he suggests they ask their lenders for a payment and an extension. Otherwise, financing to go simply doesn’t exist, and your payments could triple in the current interest rate environment.
“Extend to 2023 and live to fight another day,” he said. “Taking 7, 8 or 9 percent to save your building, that’s cheating.”
Many office owners may not have enough money to float their loans for another year. “Cracks” are forming, Zampa said. Without enough liquidity to obtain new loans, there can be a very difficult 12 to 18 months for less desirable office owners who are losing or unable to attract tenants and have little or no income. Prices would have to fall substantially for developers to make a large-scale push for costly office-to-residence conversions, or for investors to see a value play in struggling assets.
“It feels a bit like 2010, 2009, but there is a fundamental change in the way we use the office,” Zampa said.
Jamie Woodwell, vice president of commercial real estate research at the MBA, agrees. Unlike previous recessions, in which businesses went bankrupt and then defaulted on their lease obligations, immediately hurting landlords, renters aren’t disappearing unexpectedly. So it takes a lot longer to understand where companies are and how much of their footprint they will eventually give up, and lending continues to do well.
Zampa said his team even discussed what cities can do to help stabilize the situation, such as corporate tax incentives triggered by office occupancy and utilization, to help encourage corporations to bring employees back to offices. There is a need to revive certain city centers or risk a significant reduction in tax revenues and resulting municipal budget crises.
Analysts expect the office market to bottom out so they can get compensation to underwrite and get data to triangulate value.
“We really need to get our cities back, and I’m not sure when that will happen,” Zampa said. “The market is completely frozen. This is a moment where you hug your banker.”