Coastal Office Landlords Need More Conservative Approaches to Credit

Fitch Ratings says that it’s time for REITs focusing on coastal city offices to spread their attention out to something additional: a more conservative approach to credit.

“US office REITs that focus on coastal gateway markets, such as New York City, must operate with more conservative credit protection metrics to sustain low investment-grade ratings,” the firm noted. “Weak access to attractively priced equity capital will lead office REITs to engage in less credit-friendly asset allocation and funding strategies, including development and share repurchases using proceeds from joint ventures and shorter-term floating rate recourse debt.”

We know how it happened. Public health measures taken at a time when no one was sure what would happen meant millions who would ordinarily be at an office now worked from home. Many of them found they preferred the flexibility and autonomy. Many companies began to wonder whether they needed all that space they owned or had been leasing. And a lot of office building owners and investors found themselves saying, “Uh, what?” What is the value of property when you don’t know who will want to lease it, when, for how long, or under what conditions?

As the ratings agency explained: “Fitch has traditionally set cash flow-based leverage rating sensitivities higher at any given rating level for REITs that own portfolios concentrated in coastal, 24-hour gateway cities, compared to similar REITs with greater portfolio exposure to smaller metro and suburban markets, as well as specialty property types. This is the result of low capitalization rates and superior asset liquidity.”

Which makes sense. With greater concentration comes increased types of risk. How do you get appropriate returns? In this case, better cash flow, which should be both possible and necessary. Lower cap rates should require better operating income through higher cash flow, and asset liquidity backstops the process, because if things on a particular building go badly, it should be readily saleable in the market. But now comes Fitch’s reevaluation given changing conditions.

“However, we expect marginal debt and equity capital available to office owners to weaken, due to reduced office demand from flexible work and outmigration, combined with increased institutional investor interest in US sunbelt markets, as well as nontraditional specialty real estate property types,” the firm wrote. “Tenant sector profiles and lease rollover risk will be increasingly important and potentially gating factors affecting asset-level debt capital access.”

In the case of New York City, for example, Fitch notes that while office jobs are almost “fully recovered,” physical occupancy rates of people in those offices are about 40% in Manhattan, versus 70% pre-pandemic. Its favored explanation is a tight labor market that has employees pushing for what they want, which includes flexibility.

“Long lease durations, strong asset and tenant credit quality, and below-market face rents will continue to support office REIT cash flow, including in more challenging coastal markets,” Fitch wrote. However, at the end of June, they downgraded two NYC office REITs—St. Green and Vornado—from BBB to BBB- with ongoing negative outlooks. “Tenant sector profiles and lease rollover risk will be increasingly important and potentially gating factors affecting asset-level debt capital access,” it wrote more generally.