 Office properties are expected to continue to face headwinds, though there is still a market for quality office space. Source: Thomas Barwick/DigitalVision via Getty Images |
The US office real estate sector faces a higher risk of loan defaults and delinquencies as increasing vacancies, declining property valuations and tougher refinancing hound office landlords.
Negative fundamentals including tenant space rationalization, rental pressure and increased vacancies are expected over the next 18 months, real estate investor Hines said.
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"From a capital markets perspective, we expect office values to keep declining, driven by higher cap rates resulting from rising interest rates and deteriorating operating fundamentals," Alfonso Munk, Hines' chief investment officer for the Americas, told S&P Global Market Intelligence in a written response.
A further interest rate rise, which the US Federal Reserve could announce at its September meeting, would put further pressure on commercial real estate. Many traders expect July's 25-basis-point hike to be the last in the current cycle, but inflation remains well above the central bank's 2% target.
Delinquencies and distress are expected to rise, particularly in the office sector, as property valuations decline and the cost of financing remains high, investment manager Cohen & Steers Inc. said.
"Loans originated during the last few years at peak valuations (regardless of property type) carry refinancing risk, especially if they were short term or variable rate," Rich Hill, head of real estate strategy and research at Cohen & Steers, wrote in an email, "There will be restructurings and foreclosures; however, it will likely play out over several years."
The US office market was described as "the problem child of global commercial real estate," by real estate service company Savills PLC. In a report, Savills said it has seen a number of high-profile defaults with several major institutions preferring to surrender the keys to their buildings rather than continue to service outstanding debt.
Debt markets for the issuance of commercial mortgage-backed securities have dried up, and nonbank lenders are largely avoiding anything using an office as collateral.
"While some owners in higher risk sectors (notably office, multifamily, and retail) may be able [to] restructure their debt, there is also a strong likelihood that high cost and limited debt availability will pose a recapitalization challenge for a good portion of the industry," Munk said.
The lender ecosystem is preparing for defaults, workout procedures and refinancings, Munk said, adding that as "rising rates collide with maturing loans, we expect more choppy waters ahead."
Estimating commercial real estate risk
US office real estate investment trusts had a median RiskGauge score of 44.5 as of Aug. 9, according to S&P Global Market Intelligence data. The score is below the 49.0 median score of all US REITs.
A RiskGauge score assesses a company's creditworthiness, comprising elements of a company's fundamental credit risk and market-based signals. A lower score signifies higher risk.
So far in 2023, S&P Global Ratings has downgraded five US REITs, of which three are in the office sector.
Office Properties Income Trust was downgraded to BB from BBB- on March 31 due to ongoing secular headwinds, material lease expirations and refinancing at significantly higher interest rates.
Hudson Pacific Properties Inc. was downgraded to BB+ from BBB- on the back of deteriorating macroeconomic conditions and office headwinds.
Brandywine Realty Trust's credit rating was also downgraded to BB+ from BBB-. Brandywine's fixed-charge coverage ratio is expected to deteriorate over the next year as it refinances upcoming debt maturities, which are higher relative to peers, Ratings said.
'Not homogeneous'
While office properties face challenges in valuations and vacancies, a market remains for quality office spaces.
"The market is not homogeneous. Not all buildings work for all people, and we have a huge glut of buildings that tenants just aren't that interested in," Savills North America President David Lipson told Market Intelligence. "There are parts of the market in all cities that are doing well. Tenants continue to want high-quality space that their employees want to work in."
Office REITs Boston Properties Inc. and Vornado Realty Trust said on their recent earnings calls that there is increasing demand for modern offices rich in amenities and in easily commutable locations.
Technology companies have seen an increase in vacancy as they prioritize remote and hybrid work, but the financial services and legal sectors are expected to continue returning to offices.
"Bifurcation we have been seeing for several years between well-located quality assets and older properties is also likely to continue," Hines' Munk said, noting that occupancy is higher in buildings that are up to 10 years old, and rent growth is much higher in newer buildings compared with older ones.
This report may contain information about credit ratings issued by S&P Global Ratings. Descriptions in this report were not prepared by S&P Global Ratings.