Impact of Higher Interest Rates, Tighter Lending Standards, and Work-From-Home on Commercial Real Estate Valuations
By Steen Watson, CEO, Chestnut Funds
Q3 2023 The commercial real estate market, particularly the office sector, has been significantly impacted by the convergence of higher interest rates, tighter lending standards, and the growing trend of remote work. This edition of Viewpoints, a series that Chestnut produces on a periodic basis to share our thoughts on relevant topics for commercial real estate investors, aims to explore how these factors are impacting the commercial real estate markets.
We have observed that recent news articles about the commercial real estate sector generally report on two topics. The first is the work from home trend and its impact on the office sector. We first explored this topic in the June 2021 Viewpoints. The second commonly reported topic is the risks faced from near term loan maturities where asset values have declined and interest rates have increased. We explored increased borrowing rates and the impact on commercial real estate in our June 2022 Viewpoints. In this edition of Viewpoints, we aim to revisit and outline our view of the broader market and managing risk in the face of higher interest rates, work from home (WFH) realities, and tighter lending standards.
Risks related to the current debt market
The rise in the federal funds rate from near 0% in late 2021 to 5.25% has significantly increased borrowing costs. This increase has been most acutely felt by borrowers with floating rate debt that was originated prior to 2021. These borrowers, and in particularly borrowers who own commercial office buildings, face interest expenses well in excess of their underwritten expense and in some cases the interest expense now exceeds a property’s net operating income. This dynamic is particularly acute for properties that were acquired at very low cap rates where the investment strategy was to increase income through capital improvements or for properties where occupancy has significantly decreased.
In instances where an owner’s interest rate expense has increased significantly, so too has the risk of default. This risk is magnified by tighter lending standards and declining valuations, a byproduct of increased vacancy in the office market and higher cap rates across all property types, which make it much more challenging for owners to refinance their existing debt at loan maturity. Lenders are tightening lending standards in response to a challenging operating environment that results from concerns about the value of the assets on their balance sheet, including commercial real estate loans, and an inverted yield curve which turns upside down the model of short-term borrowing at low rates and lending long-term at higher rates. The high profile bank failures of Silicon Valley Bank (SVB), Signature Bank and Silvergate Bank—three out of 4,236 FDIC-insured commercial banking institutions in the U.S – has caused additional regulatory and investor scrutiny of other regional banks, further compounding lender’s caution on new commercial real estate lending activity. To the extent owners are unable to refinance debt with near term maturities, properties will either need to be sold at a loss, foreclosed on by lenders, or loans will need to be extended and/or amended. High profile commercial office “walkaways,” where the asset owner turns over the asset to the lender at a complete loss, have been reported and more are anticipated when refinancing is not possible. Defaults that lead to distressed sales can further depress property values and disrupt market stability, reinforcing a self-perpetuating cycle.
Concerns about WFH’s impact on office occupancy and valuations has caused banks to evaluate their loan portfolios to evaluate risk. Roughly $760 billion of office loans are held by banks while another $400 billion is held through securitized loans and mortgages originated by debt funds. Debt on office properties amounts to about 35% of total commercial real estate debt. Owners need to refinance approximately $137 billion of office mortgages this year and over $400 billion in the following four years. This volume of maturities is higher than for any other commercial real estate sector.
As traditional lenders grapple with their commercial real estate debt portfolios and tighten their lending standards, the void created may be partially addressed by private credit lenders, like Blackstone and others, who choose to further expand into this space. We anticipate that this shift would increase capital availability but also may increase its costs.
Work from home, the challenges and benefits
The widespread adoption of remote work following the COVID-19 pandemic has led to a fundamental shift in the way many businesses operate. Companies have embraced flexible work arrangements, allowing employees to work remotely either full-time or part-time. This shift has reduced office building occupancy and the demand for office space, as businesses require smaller amounts of space to accommodate their workforce. Additionally, many employees with jobs that can be done remotely have expressed a strong preference for WFH or hybrid work arrangements. As a result, office buildings face higher current and anticipated vacancy rates, which negatively impacts their valuations and in turn makes refinancing maturing debt more challenging.
The decline in demand for traditional office spaces has prompted office building owners to consider repurposing or adapting existing office buildings for alternative uses. Repurposing strategies include converting office spaces into residential units, hotels, co-working spaces, or mixed-use developments. Such projects, though, often require significant investments and regulatory approvals. Moreover, the suitability of an office building for repurposing may vary based on its location, configuration, and market dynamics. As a result, the conversion of office buildings may be unlikely to significantly reduce office building inventory.
All that said, we are currently invested in three projects which involve repurposing office buildings that were acquired recently at attractive bases. These include an office to medical outpatient building conversion along with two others slated for conversion to residential.
The impact on valuations
Tighter lending standards, higher rates, and market concerns have also slowed new investment activity by over 70% from last year while concerns about WFH have caused office valuations to decline by over 25% from their peak. Transaction data across property types points to valuations being down approximately 15%. In our experience, owners who valued assets from their (likely) peak valuations in 2021 and early 2022 have generally been unwilling to bring to market or sell assets at lower values, unless they are facing debt challenges they cannot resolve. Thus far, we have become aware of very few sales of distressed assets though some office properties are beginning to transact at very low values, an indication that some office building owners do not have a positive outlook on the probability of the value of their property increasing.
Our perspective in action at Chestnut
It is inarguably a difficult time for commercial real estate, with more uncertainty on the horizon. Although Chestnut has seldom made urban commercial office building investments, we pay close attention to this asset type and the trends affecting it because of the broader implications for the commercial real estate market. Also, the debt climate for commercial real estate is presently a challenge for any new investment, no matter the asset type.
With this context in mind, we continue on our path with discipline, remaining focused on:
Managing existing assets to maximize value and net operating income, with a focus on tenancy, expenses, and disposition timing analysis
Investing in assets that are generally less correlated to macro-economic conditions, like medical outpatient buildings
Identifying opportunistic investments at a lower basis that may result from the current climate, like well-positioned office conversions or land entitlement strategies
Closely monitoring portfolio performance, as well as economic conditions and industry trends, to proactively prepare for challenges and opportunities ahead
As always, we welcome your questions. You can reach Steen Watson at steen@chestnutre.com or 423-708- 2178.
Sources:
Business Insider. Geiger, Daniel. (May 1, 2023) Billions of Dollars of Bad Real-Estate Could Mean Big Bank Losses.
Cushman & Wakefield. Corbet, Abby, Rockey, Rebecca, & Thorpe, Kevin. (March 13, 2023) Bank Failures and Panics: Five Key Thoughts for Commercial Real Estate.
Federal Reserve Bank of St. Louis. FRED Economic Data. (Accessed on July 11, 2023) Federal Funds Effective Rate.
Green Street. (June 15, 2023) Property Insights Report.
Green Street. Webinar. (June 14, 2023) It’s Not All Doom & Gloom: Midyear Sector-Level Takeaways.
Reuters. Mattackal, Lisa Pauline. (May 10, 2023) Private-Credit Firms See Opportunity as Banks Tighten Lending.
The New York Times. Creswell, Julie, Eavis, Peter, & Goldstein, Matthew. (April 27, 2023) Stress Builds as Office Building Owners and Lenders Haggle Over Debt.
The Wall Street Journal. Grant, Peter. (May 16, 2023) Rise in Distressed Sales Signals New Chapter for Beleaguered Office Market.
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