Moderate Changes to Office Cap Rates and Cash Flows Could Cause Big Problems

Between work-at-home and hybrid models, worries about recession, and the growing recognition of the potential for massive obsolete stock, there is a lot of concern about the office market. As a Morningstar Credit Information & Analytics (MCIA) report recently noted, the combination of factors “has people speculating that aging office properties may replace regional malls as the bane of commercial mortgage-backed securities investors’ existence.”

Cap rates and net cash flows ultimately drive valuations, but the firm notes the amount of uncertainty around them. Cap rates depend on price discovery, but that is currently severely limited with the reduction of transactions.

Vacancies will drive down revenue and also affect ongoing rents for everyone because of increased supply, although GlobeSt.com discussions with many experts does point to the potential for a mitigating factor in at least some property classes. Even if hybrid becomes a dominant model, a bulk of companies are interested in minimizing pure work-from-home, and with hybrid typically having all employees in place at least a few days a week, there’s a need for enough room to fit all of them simultaneously, so it may be that average utilization falls while vacancy might not.

So MCIA has undertaken an analysis of office-backed single-asset/single-borrower (SASB) CMBS transactions as a proxy for what might happen. The firm took 121 outstanding of these “trophy” deals and applied some net cash flow and cap rate stresses for modeling reactions.

About 60% of the deals had trust loan to value ratios of less than 60% to start; only 14.9% showing over 70% LTV. Part of the distribution is timing. Deals from before 2017 had LTVs under 50%. Those from 2021 and 2022 leaned over 60%.

Using most recent cash flows instead, LTVs already started showing problems, with the number at 70% to 100% doubling and a few showing leverage over 100%. MCIA then tried different scenarios, mixing changed most recent net cash flow of 0%, 10%, or 20%, and then cap rate changes of 50 or 100 basis points. The results were bad.

“Even a 10% haircut to current cash flow pushes more than half of the loans above a 70% LTV; a 20% haircut pushes that number above two thirds,” they wrote. “The bigger takeaway is that the majority of deals show significantly weakening metrics in nearly all scenarios. This is not to suggest that losses are going to be prevalent on these deals; only in our two most stressed scenarios do over one fourth of the loans exceed 100.0% LTVs.”

But refinancing would become painful. “Borrowers may be faced with coming out of pocket with fresh equity (at the same time they’re expending capital on renovations or adding amenities) to get to adequate leverage points on the refinance. This naturally leads to the possibility of maturity extensions beyond contractual extensions present in most SASB deals.”

Two-thirds of the group had fixed coupons with an average of 3.75% and one-third had floating-rate. “Assuming the return of functioning capital markets, loans needing to refinance in the near term are facing significant increases in debt service that will likely serve to limit proceeds,” MCIA wrote. “Among the floaters, most loan agreements require a new rate cap as part of exercisable extension options; the price and availability of rate caps in this environment has become an issue further limiting options for borrowers. This has already played a role in at least one transfer to special servicing.”

Again, these are “trophy” properties with owners who probably have the resources to manage. What will happen with other properties? No one knows.