Office loans hold up well to the pandemic
When the COVID-19 pandemic forced businesses across the country to send workers home in the spring of 2020, some market watchers began to worry about the long-term impact on the office sector, particularly after “a few weeks to flatten the curve”. turned into months then a year and the media have been posting articles claiming the office is dead forever and everyone wants to work remotely. Many casual observers predicted that companies would abandon their headquarters in large cities and either be completely isolated or move to smaller centers in the suburbs. This would lead to vast amounts of empty office space across the country and to defaults on loans secured by these buildings.
In reality, a combination of long-term office leases, many reluctance of companies to make permanent real estate decisions based on an abnormal situation and willingness of lenders to exercise with borrowers had led to a fairly stable situation for many existing credit bureaus.
A mid-October report from Moody’s Investors Service found that even under the most severe projected economic pressure, the value of office buildings in the loan portfolios of non-bank lenders would decline by 11% between now and the end. of the year 2023. By comparison, office building values declined by 24% during the last real estate recession, between 2007 and 2011. The performance of office loans from non-bank lenders is an important indicator as these Lenders have disproportionate exposure to the sector, at 35% of their total ownership of loan portfolios.
Moody’s estimates that from August 2021, the default rate on CMBS loans office buildings averaged 2.60%, well below CMBS’s overall default rate of 6.22%. And the company’s researchers predict that with plenty of capital and reserves to deal with potential losses, the office portfolios of non-bank lenders are expected to continue to show stable performance over the next 12-18 months.
Likewise, September data from research firm Trepp LLC shows that the office loan default rate is currently on average 0.9%, up 10 basis points from before the pandemic. Loans hardest hit by COVID-19 have been those backed by hotel and commercial properties, which reached delinquency rates of 11.9% and 4.9% respectively.
The office loans most likely to withstand housing downturn cycles and unexpected crises like the COVID-19 pandemic are asset-backed with stable cash flows, diversified rental listings, long-term leases term and sponsors with pockets deep enough to take on debt during tough economic times, notes James Millon, New York-based vice president of U.S. structured finance with commercial real estate services firm CBRE. This roughly describes the type of office product that supports the loan portfolios of non-bank lenders.
Moody’s researchers note that most of these loans are senior mortgages on Class A properties in major markets held by institutional investors with large pockets, and have low (average) loan-to-value (LTV) ratios. 60% on average) and short tenors of three to four years. Conservative LTVs create a buffer for lenders to deal with potential declines in value, even in a severe downturn, while owners’ sizable equity reserves allow them to avoid having to pull out of their assets.
According to James Dunbar, senior managing director of the mortgage team at global alternative investment adviser Varde Partners, the pandemic has had minimal impact on the company’s office loan portfolio, which he attributes to underwriting standards and criteria for granting loans from Varde.
Additionally, Class A properties continue to be the most attractive to tenants and typically require less investment in capital improvements to compete for new leases as the recovery takes hold.
Ready to work on it
The willingness of non-bank lenders to restructure loans has also helped reduce delinquencies on their office loans and avoid bankruptcy losses. Another Moody’s report noted: “Forbearance and loan modification appears to be a dominant practice in dealing with distressed loans related to COVID-19 in the CRE industry … This has helped reduce default rates as many borrowers are no longer behind on mortgage payments under the amended loan terms. “
The expected increase in debt foreclosures and sales simply did not happen, according to CBRE’s Millon – no one has completely sold a loan portfolio. “The pandemic was nobody’s fault and the banks restructured the loans,” he notes, adding that some lenders have raised interest rates to recoup losses and others have recapitalized loans.
Non-bank lenders have also taken steps to address repayment issues related to the pandemic, says Millon. Debt Fund, for example, extending upcoming fund maturity dates to create longer loan periods or require additional equity.
And the long-term lease terms inherent in office transactions contributed to a more moderate effect on office fundamentals than expected, he notes.
The pandemic has lasted longer than expected, and Millon admits the office sector still has some way to go before it returns to where it was before COVID-19. “Leasing is picking up, giving us a sense of where the market is going,” he says, noting that while there has been no “backlighting” back to the office, tenants occupancy at New York and other cities eastern gateway tick tock every week.
Dunbar also remains bullish on a long-term return to power. He notes that improving underlying market fundamentals have resulted in better loan performance, including repayments of renegotiated amounts ahead of schedule. He concedes, however, that “we expect tenants to have an almost universal need to reassess their space needs over the next several years as leases expire.” This has led to questions about the future of the office industry that have yet to be answered.
As a result, some non-bank lenders have reduced their exposure to office loans over the past year and a half. For example, Starwood Property Trust and Blackstone Mortgage Trust, which have the highest concentration of non-bank office loans at 53%, have both reduced their exposure to the office sector by 16% and 8% respectively since January start of pandemic, Moody’s reports. “The pandemic has created uncertainty and lenders are constantly focused on downside risk,” Million said.
At the same time, Apollo Commercial Real Estate Finance, Claros Mortgage and KKE Real Estate Finance increased their exposure to office loans by 41%, 30% and 26%, respectively. Office buildings with life science components have been an important factor in the growth of these portfolios.