The Cliched Perfect Storm May Be Headed to the Office Market

A new analysis by Trepp and CompStak raises the question of whether the office segment of CRE is facing a now-cliched perfect storm metaphor. The three dangers that could unite are office loan maturities, large lease expirations, and low space demand.

Said another way, it comes down to inflation and the end of easy money, worry about corporate financial performance, and the desire of working people to control more of their lives.

The report says that by the end of 2424, $40.47 billion in loans — that’s 353 loans backed by 583 office properties — and 56% are floating rate with an average remaining term of over 10 months and all with extension options of 29 months.

These are spread across 11 metros: New York-Newark-Jersey City; San Francisco-Oakland-Hayward; Los Angeles-Long Beach-Anaheim; Chicago-Naperville-Elgin; Boston-Cambridge-Newton; Washington, D.C-Arlington-Alexandria; Houston-The Woodlands-Sugarland; Dallas-Fort Worth-Arlington; San Diego-Carlsbad; Atlanta-Sandy Springs-Roswell; and Phoenix-Mesa-Scottsdale.

The list is by current outstanding balance, from $15.72 billion to $420 million. Refinancing means stepping in at much higher rates than a few years ago, which means higher interest and probably lenders who have tightened up on leverage. The process will not only cost more over time, but likely require injections of equity.

Some additional complications are the state of major tenants. The average number of the top five tenants in these buildings with leases that expire within two years ranges from 0.73 in greater Boston to 1.93 in Dallas-Fort Worth. The average square footage expiring among those top five at the low end is 19,182 in Boston. The high end is 49,670 in and around Chicago.

This is already an uncomfortable position. Now add changes in office leasing. Average new lease terms are pretty close to where they were before the pandemic. Renewals in 2022 through Q3 were at 53.5 months, but that’s down almost 12% from 2019 and average renewal transactions are down 28.7% from 2019. The renewal figures have continued to fall since pre-pandemic. For Class B or older space, the situation is even worse, as many are on the way to becoming obsolete.

Put more succinctly, higher refinancing rates hurt debt service coverage ratios and, at a time when hiking rents is pretty difficult, that means tighter finances. Concern over the economy continues to mean companies want shorter renewals and may be looking at cutting space. The last part also means getting replacement tenants isn’t something to count on.

But, against all this is the point that Moody’s Analytics recently made, that utilization rates are improving because even with hybrid, the trend is for people to choose the middle of the week as when to be in the office. And when everyone comes in at the same time, cutting office space may not be viable, because companies must have capacity for peak appearance.