How Distress Will Play Out in Office

Investment sales are way down in the offie sector as cap rates push up, price discovery continues and a widening bid-ask spread slows deal velocity. The public markets suggest average office cap rates in the mid-to-high 7% range, to north of 8%, but institutional owners have yet to take such markdowns, according to a new analysis from Colliers.  And the lull in sales could continue for several quarters until interest rates stabilize and the cost of capital becomes more palatable.

“The Fed remains hawkish, suggesting more rate hikes are in the offing. BBB bond rates were higher than transactional cap rates — a historically uncommon trend that is not sustainable over long periods,” Colliers researchers note in a report breaking down the future of the sector. “For this spread to remain negative (lower cap rates than BBB bonds), investors should be pricing in solid NOI gains, which in today’s market are difficult to underwrite outside of the best assets. This suggests that cap rates need to rise, as the historical spread between cap rates and bonds is 2.4 percentage points (bonds above cap rates).”

As occupiers seek shorter lease terms, office valuations will be impacted and underwriting will become more challenging, according to Colliers. Capital costs will also be higher due to tenant turnover, they say.

In short, ”owners cannot rely on a return to a 4% cap rate environment,” the report notes. “Interest rates are likely to stay relatively higher, at least when compared to the past few years. Distress will emerge. Foreclosures and short sales are coming. The market is on the forefront on this. Cap rates are interest rate sensitive.”

A “wave of debt maturities” will pressure office assets, according to Colliers, because values don’t support current terms. This will force owners to pay out of pocket to bridge equity gaps or else find different forms of capital like mezzanine debt.

“As some assets go back to the bank, they’ll create opportunity for the vast sums of value-add and opportunistic capital waiting on the sidelines,” the report notes. “Rescue capital is being raised and will look to be deployed. This capital will have assets to pick over, and challenged loans will be moved off banks’ books, even if they remain viable investment targets.”

Colliers predicts the most challenged assets will be liquidated first as owners hold onto their best product, and notes that even those owners looking to hold onto properties must prepare for liquidity events.