Manhattan's office market, which comprises approximately 500 million square feet (sq. ft.), is crucial for investors because of its high exposure in U.S. single-asset single-borrower (SASB) and conduit commercial mortgage-backed securities (CMBS) transactions. Approximately $125 billion in office SASB and conduit loans have been securitized in the U.S. since 2017 (see chart). Of the 75 U.S. office SASB transactions currently rated by S&P Global Ratings, almost half (excluding defeased loans) are located in Manhattan.

The COVID-19 pandemic's impact on the demand for office space has varied across markets and industries, as well as at the individual building level. However, office loan performance has generally remained stable despite the rise in remote work and the uptick in the overall CMBS delinquency rate since the start of the pandemic, and there have been no rating actions (negative or positive) on the U.S. CMBS transactions we rate. We believe this stable performance primarily reflects the generally long-term leases in place for institutional quality and/or investment-grade (rated 'BBB-' and above) tenants, who have generally remained current on their rents even though their space utilization rates remain low. Still, there is anecdotal evidence suggesting that overall demand is slowing, including recent reports that the General Services Administration is giving back about 5% of its space in California. We also believe properties that have relatively high near-term lease expiries or lack in-demand physical infrastructure for hybrid and remote work face greater risks of tenants rolling over to fill vacancies in higher-class office spaces, many of which are still offering concessions.

Our analysis of office loans focuses on four key areas: the sustainability of in-place occupancy and rent levels, a given property's market appeal, the level of concessions available to tenants (such as free rent or tenant improvement dollars and capital expenditures), and the valuation impact of real estate taxes. We also expect environmental, social, and governance (ESG) credit factors to emerge as an additional concern over time--a move that may be accelerated by New York City's Local Law 97 (LL97), which has a stated goal of reducing greenhouse emissions from New York City real estate.

We believe the evolution of office space demand will remain a hot topic for the foreseeable future. We will continue to evaluate office loan performance and market trends, including tenant rollover, lease expiration timing, and managers' ability to fill vacancies should they arise, as well as assess the likelihood of the rated loans being refinanced by their maturity dates.

Remote Work Trends Drive Demand

We believe Manhattan's class B and C office stock are most at risk from the emerging trends in office utilization. CoStar's one- to three-star classification (which we equate to class B and C) represents 131.0 million sq. ft., or approximately 30.5%, of Manhattan's total office space. These buildings mostly lack the physical infrastructure tenants are seeking in a post-pandemic world (better HVAC, more flexible floor plan arrangements, significant amenity packages, and concierge areas). They are also generally tenanted by companies that haven't made a firm commitment to in-place work, compared with tenants in the class A buildings (investment banks, law firms, investment funds, etc.) in newer areas such as Hudson Yards. While the emergence of the omicron variant slowed the return-to-office trend that began in 2021, many offices are now targeting a February through April 2022 date.

However, not all class A buildings will escape the pressures of hybrid and remote work, which we believe are firmly here to stay for a significant portion of office users. The class A buildings that fall into this category will focus on attracting tenants from challenged class B properties. Existing class B tenants who have elected to remain physical users of space will be eager to trade up to better quality, better located class A properties, spurred by increasingly attractive concession packages and higher vacancies in class B and lesser class A buildings.

Table 1 shows CoStar's breakdown of the Manhattan office market by submarket (for a distribution of S&P Global Ratings' rated office SASBs by submarket, see Appendix I).

Table 1

Concession Levels Remain High

Attracting new tenants and keeping existing ones have become increasingly expensive for office landlords. Many newer class A buildings in New York have been offering unusually high concession packages, which we believe temper any increase in value. While varying from building to building and lease to lease, we estimate that net effective rents across the market are 15%-25% below face rents, considering the amount of free rent given and tenant improvements and leasing commissions paid. We have seen greater discounts as well.

We consider capital expenditures for pre-builds, agreements to pay a tenant's rent in another property as an inducement to relocate, and free rent given mid- or end-of-lease as tenant concession costs, contrary to suggestions by some that those costs should be ignored when determining effective rents. Existing properties that offer more dated amenity packages are having to spend very significant sums on capital expenditures beyond the typical roof replacement or switching out an old elevator system for a new one. Lobbies are being dramatically reconfigured, revenue-generating tenant floors are being turned into amenity and conference space (which usually does not replace the prior income), and available rooftop and balcony areas are being structurally reinforced at great expense to serve as additional tenant offerings.

We may make a valuation deduction for properties that haven't taken those measures--similar to what we do in the lodging space for hotels without funded property improvement plans (for more details about our approach to valuation, see our criteria "CMBS Global Property Evaluation Methodology," published Sept. 5, 2012). Valuing new construction is more complicated because it can be difficult to parse what is a construction cost and what is a build-out for a specific tenant. However, we generally account for these considerations in our valuations by increasing (often significantly) our tenant improvements/leasing commission cash flow deduction using shorter lease terms or by applying a higher vacancy factor. In specific cases, we may make other significant adjustments.

Lower Tax Assessments: A Temporary Reprieve

The role taxes play in valuation has become a secondary concern, eclipsed by questions and concerns about the impact of remote work on future office demand. However, we believe it is important to not lose sight of the moderating effect taxes have had on office valuations in recent years. We believe the recent pandemic-related tax reprieve will be short-lived, and taxes will continue to grind ever higher, with greater direct impact now that shifting tenant demand is putting pressure on rents and occupancies.

In 2020, at the height of the COVID-19 pandemic, commercial real estate owners in New York City saw their taxable assessments, and ensuing real estate tax bills, decline sharply, falling approximately 16% on average for office buildings, according to data provided by the City of New York, and as high as 25%, based on recent loan collateral data we have evaluated. While there is some disagreement about the speed of the recovery in real estate taxes among the larger appraisal firms, the consensus is that tax bills will return to pre-COVID-19 levels within the next four to five years, driven by increases in assessed value and real estate tax rates. We generally agree, largely due to the city's reliance on commercial real estate tax revenue to fund its annual budget of approximately $100 billion. In fiscal year 2021, the office sector provided an estimated $6.9 billion in direct revenue from property, real estate transaction, mortgage, and commercial rent taxes, according to the New York State Comptroller.

We also believe the temporary savings will accrue primarily to the equity holders' benefit, and these savings will almost certainly be gone when recent loans are due to refinance. As a result, we have generally excluded the present value of these temporary tax savings in our valuations. Further, if significant swathes of office (or retail) assets become obsolete, as some market participants expect, the tax burden may also increasingly fall to the remaining viable commercial properties, leading to accelerating increases.

ESG Moving To The Forefront

Our rating analyses for office loans consider a transaction's potential exposure to ESG credit factors. For CMBS, we view the exposure to environmental credit factors as above average, to social credit factors as average, and to governance credit factors as average (see "ESG Industry Report Card: Commercial Mortgage-Backed Securities," published March 31, 2021).

Our reviews concluded that environmental credit factors are not yet key rating drivers for the CMBS transactions we rate, and these factors were adequately addressed through means such as property insurance, environmental guarantees, or specific upfront reserves for certain transactions. While the progressive decarbonization of the real estate sector by 2050 is expected to influence market values over time, we believe our current approach to evaluating stressed long-term recovery values indirectly accounts for the potential materialization of that pricing differentiation over the expected life of a transaction.

In addition, our analyses have not given credit to any future actions that landlords and tenants may take to reduce their carbon footprint to support a healthier environment and preserve property value. As a result, we have not separately identified this as a material ESG credit factor in our analyses. In our view, the CMBS transactions we rate have exposures to social and governance credit factors that are in line with our sector benchmark.

However, New York City's LL97 is helping to bring ESG concerns to the forefront of CMBS. The law, which became effective in November 2019, has the goal of achieving a 40% reduction in aggregate greenhouse gas emissions in "covered buildings" by 2030, and an 80% reduction in citywide emissions by 2050. Covered buildings include those that exceed 25,000 gross sq. ft., two or more buildings on the same tax lot that together exceed 50,000 gross sq. ft., and two or more buildings held in the condominium form of ownership that are governed by the same board of managers that together exceed 50,000 gross sq. ft.

Beginning in May 2025, owners of these buildings must file an annual report showing that, for the previous calendar year, the building was either in compliance with the applicable building greenhouse gas emissions limit or, if not, by what extent. Industry participants have criticized the methodology of the law, arguing that it does not take sufficient account of density as calculations are a function of generalized use and gross building area. And, as a result, two buildings with similarly efficient systems (e.g., a moderately used office building and a trading floor) could perform quite differently under the city's metrics. Real estate owners had until June 2021 to apply for adjustments to the 2024 to 2029 limits.

The implementation of the law remains uncertain because the emissions targets partly depends on the state getting an appropriate balance of uses in the underlying grid--in addition to any capital improvements building owners make to their properties. Further, New York State could enact additional policies, such as carbon auctioning or trading, which could allow property owners to exchange emission credits and avoid fines under the law. At this stage, these developments remain uncertain, but we will continue to monitor them because they could have a lasting impact on long-term sustainable valuations.

Steady Performance

Of the 35 SASB transactions we rate that are collateralized by Manhattan office loans, all but two are secured by institutional quality, class A office buildings. The class A assets are located primarily in the Grand Central, Plaza District, and Columbus Circle submarkets, as defined by CoStar (see Appendix I for more details). The two exceptions are 75 Broad Street (loan collateral for NCMS 2017-75B), a class a B+ office building located in the Financial District submarket, and One Park Avenue (loan collateral for ONE 2021-PARK), a class B office building located in Murray Hill submarket.

Watchlist loans

Six loans of the 35 loans we rate are on servicer watchlists, but generally for issues we identified or considered at securitization (see table 2 and Appendix II).

The most immediately pressing is 1740 Broadway (loan collateral for BWAY 2015-1740), where 70% of the net rentable area (NRA) is due to expire in March 2022 and another tenant that represented approximately 15% of NRA vacated its space when its lease expired. The anchor tenant's decision to leave was expected, and the sponsor, Blackstone, has been working to increase the building's attractiveness to prospective tenants by reworking the building's lobby and second floor to create a new entryway with a lounge, cafe, restaurant, and a private club for the building's tenants. The building offers two large blocks of contiguous space: approximately 157,000 sq. ft. on floors 16-26 and approximately 379,000 sq. ft. on floors two to 13. Blackstone acquired the property in late 2014 for a reported $605 million, and the 10-year CMBS loan matures in 2025. In 2020, real estate taxes for the property were approximately $12.5 million and annual debt service is an additional $12.0 million, bringing basic annual carrying costs to an estimated $24.5 million. We continue to monitor the master servicer's dialog with the sponsor regarding leasing updates, and our last review did not result in a rating action.

Table 2

SASB loans

Manhattan SASB office loans that matured in recent months have found ready access to refinance capital, although take-out lenders are increasingly turning to innovative structures to get the deals done. These structures include full property cash flow sweeps (large upfront reserve deposits to fund known or expected tenant leasing concessions or significant borrower guarantees for the same), which remain elevated in the market. Table 3 lists SASB transactions we rate that have near-term maturities, based on the fully extended maturity dates.

Table 3

We currently rate seven SASB office transactions for which more than 30% of the leases are scheduled to rollover by 2024 (see table 4). Of these loans, the loans collateralizing JPMCC 2012-HSBC and Natixis Commercial Mortgage Securities Trust 2018-285M are maturing in 2022 (see below for more details).

JPMCC 2012-HSBC, which matures in July 2022, is collateralized by 452 Fifth Avenue, a class A office building in the Penn Plaza/Garment District submarket of Manhattan. The property, which is also known as the "HSBC tower," has been predominately occupied by HSBC Bank PLC since 1999 and serves as the company's North America corporate headquarters. According to media reports, the sponsor (Property and Building Corp. Ltd.) found a potential buyer (Innovo Property Group), which agreed in December 2021 to purchase the trophy asset for $855.0 million. The transaction's current balance was $277.6 million as of January 2022. HSBC leased 547,963 sq. ft. (63.3% of total NRA) at the property, and it recently renewed its lease through April 2025 at $77.00 per sq. ft. net rent. Only one other tenant occupies more than 10.0% of the property, Baker & McKenzie LLP, which occupies about 105,800 sq. ft. (12.2% of NRA) with leases expiring in January 2028. The property was 99% occupied as of June 2021 and reported a debt-service coverage ratio (net cash flow) of 1.75x.

Natixis Commercial Mortgage Securities Trust 2018-285M, which matures in November 2022, is collateralized by 285 Madison Avenue, a class A office building owned by RFR Holdings LLC. The property, which is located in the Grand Central submarket, was 96.7% occupied as of the September 2021 rent roll, compared to the market vacancy rate of 12.1%, according to CoStar. PVH Corp. occupies 43.0% of the NRA with a lease that matures in October 2033. The property has little rollover until 2025. At securitization, the appraised loan-to-value (LTV) ratio was 44.3% and the S&P Global Ratings LTV was 89.3%. We currently expect this loan to be able to refinance, based on the moderate leverage level.

Table 4

New York City Office Exposure In Conduit Transactions

U.S. conduit CMBS also has significant exposure to New York City office loans and properties. Of the 150 U.S. public conduit transactions we rate (excluding Freddie Mac transactions), 25.8% have more than 10% exposure to New York City office properties (all boroughs, including Manhattan) (see table 5). While conduit and SASB transactions face similar market risks, we believe conduits' exposure to a single submarket or property type are lower because of the diversity they offer.

Table 5

Appendices

Appendix II

Editor: Georgia Jones