Cheap debt fueled a decade-long rise in office values in the United States, offsetting the impact of years of rent increases that failed to keep pace with inflation.
Now that the long period of easy credit has ended, office-building owners are bracing for a drop in the value of their properties.
Prices for some aging office towers in cities like New York and Chicago have already dropped by a quarter as potential buyers struggle to secure financing at a time when interest rates are rising rapidly, according to brokers and lenders. Defaults are gradually rising from low levels.
While rising interest rates and recession fears have weighed on the value of stocks, bonds, and other types of real estate, office owners are particularly vulnerable. They are also dealing with the increasing popularity of remote work, which has reduced demand for office space and increased vacancies. According to brokerage JLL, office leasing volume in the largest U.S. cities was 40% lower in the third quarter than in the preceding quarter.
“I believe we are in the midst of a secular repricing of commercial real estate,” said Ronald Dickerman, president of Madison International Realty, a real-estate investment firm. “It’s a frightening prospect, but that’s what we’re up against.”
Year to date, the S&P 1500 Office REITs Sub-Industry Index is down 37.1%, while the S&P 500 is down 18.2%. Going back to the beginning of the pandemic, the gap is even wider. The S&P 500 is up 20.1% since February 1, 2020. Meanwhile, office REITs are down 43%.
Even so, the office sector had been dealing with a supply glut and soft tenant demand long before Covid-19. Low interest rates masked these issues, brokers say, driving values to record highs even as rents fell. Because of low mortgage rates, buyers of office buildings could afford to pay more. Low yields on Treasury bonds and other securities also made rental income from office towers appear more appealing in comparison, driving up investor demand.
According to Moody’s Analytics, effective office rents in the 50 largest U.S. markets fell by 16% between 1997 and the end of 2021, after accounting for free months of rent and other tenant gifts. Despite this, office-building values increased by 91% during that time period, adjusted for inflation.
“Low interest rates trump fundamentals every time,” said Doug Harmon, chairman of capital markets at Cushman & Wakefield.
Now, as interest rates rise, more building owners are finding it difficult to repay their loans, just as a wave of office mortgages signed during the boom years is set to mature.
According to Trepp LLC, more than $17 billion in mortgage bonds backed by office buildings are due in 2023, up from around $7 billion this year and just $4 billion in 2021. Lenders are becoming more hesitant to issue mortgages against office properties as vacancies rise. As a result, many landlords are forced to borrow smaller sums at higher interest rates, making it more difficult to repay previous loans.
Take, for example, Houston’s three-building Ashford office park. According to Trepp LLC data, Accesso Partners LLC purchased the property in 2012 and financed it with a 10-year, $61 million loan with a fixed interest rate of 4.81% that matured in August.
Accesso defaulted because it was unable to refinance the debt. The buildings were more than 90% occupied at the time of purchase. According to the owner, occupancy is currently at 64%.
Ariel Bentata, managing partner at Accesso, stated that the company is “working closely with the property’s loan servicer to obtain more time to secure financing given the challenging lending market conditions.”
Interest rates on typical office mortgages in Manhattan have risen from around 4% to around 6% since the start of the pandemic, according to Dustin Stolly, co-head of Newmark Group’s debt, equity, and structured-finance group. Many older office buildings are now the most difficult to finance type of real estate.
“There are far fewer lenders than there would have been in the pre-pandemic era,” he says.
The picture isn’t entirely bleak. Some modern, leased-up buildings continue to command high prices. Property owners are less in debt than before the 2008 financial crisis. Brokers report that lenders are also more willing to work with troubled borrowers. That explains why foreclosures have been uncommon. Meanwhile, real-estate investment funds have large cash reserves, which should support building values.
Nonetheless, some property owners have already suffered significant losses. In June 2015, Blackstone Inc. purchased a 50% stake in the Manhattan office tower 1330 Avenue of the Americas, valued at $507 million. According to a person familiar with the matter, the deal’s so-called capitalization rate—a measure of the building’s annual profits divided by its value—was around 4%. A 10-year US Treasury bond yielded around 2% at the time. In comparison, a return of 4% before debt looked reasonable.
On Friday, the 10-year Treasury yield was around 4%. As a result, office cap rates have risen while property values have fallen.
“Why buy a house at 4% when you can buy a Treasury at 4%?” said Ran Eliasaf, managing partner of Northwind Group, a real estate investment firm.
In July, Blackstone and co-owner RXR Realty agreed to sell the building to Empire Capital Holdings for approximately $325 million, which is approximately 35% less than the building’s 2015 value.
“Traditional NYC office represents less than 1% of our portfolio,” a Blackstone spokeswoman said. “However, we continue to see strong tenant demand for new, best-in-class, and highly amenitized properties like One Manhattan West.”