Good News for the Office Sector: Corporate Defaults Are Down

The combination of pandemic issues still at hand, the potential for worse Covid-19 variants in the wings, changes in attitudes toward how and where work should happen, but also improving conditions makes predicting the office real estate market tricky.

Even so, there have been multiple indications that things are improving, and that the office market may be turning a corner. For example, office leasing is up 50% from the pandemic trough and more tenants are expanding rather than contracting their footprints. Although, year-over-year estimates pit 2021 against 2020, which is like having an Olympic high jump competition in which the task involves leaping over one side of a railroad track. Pretty hard to not to clear the bar.

Moody’s Analytics has a new report that offers some additional good news, although one the firm tempers as grounds for “cautious optimism.” A natural influence on the office market is corporate default rates, because if many companies go insolvent, there’s likely no immediate replacement for property owners and operators to secure.

As the company notes, “the corporate default rate dropped to its lowest in a decade at 1.2%, compared to the peak of 9% in the summer of 2020.” The number of defaults saw 18 in the fourth quarter of 2021, compared to 121 during the same period in 2020. That was a seven-year low.

Backstopping default rates was the enormous steps in US fiscal and monetary policy to keep companies afloat. Even energy, retail, and hospitality, which suffered enormously with the pandemic’s onset, have largely recovered. Also, none of the Q4 defaults were in either retail or hospitality, which could have made CRE a much uglier scene.

Moody’s also points to default rates of speculative-grade corporate bonds as a leading indicator of office space vacancy. “Over the past 17 years, when corporate default rates rose above roughly 5%, a rise in office vacancy rate generally follows, with the reverse also true,” the report said. One counterexample is 2008, which rattled both CRE and corporate finance.

Moody’s baseline projection expects the default rate to rise slightly to 2.6% by 2022’s end. During the same period, the company estimates office vacancies of slightly above 18% to remain just over average.

The reason for the “cautious” part of optimism is that there are multiple factors that could stir the pot and leave more corporations trying to keep their heads above water. New variants, inflation fears, trade tensions, or China’s actions on its financial regulatory front to potentially drive default rates to 10.7% by the end of the year. And that, indeed, would encourage pessimism.