PGIM CEO Expects 60% of Office Buildings to Enter Purgatory

Talk about grim. PGIM Chief Executive Officer David Hunt’s take on the future of office properties is dimmer than major east coast metro skylines have been in the face of all the wildfire smoke coming down from Canada, and that’s saying a lot.

“We are going to have a big workout for that purgatory set over the next 24 months,” Hunt said Wednesday at the Bloomberg Invest conference, as Bloomberg reported. “Prices will come down.” And where they will really plunge is in older buildings.

Hunt predicted that 60% of buildings can’t meet tenant or investor expectations in climate (read ESG) or hospitality (as in the ability to woo workers back into the office). They will require serious remediation to be competitive in a market that could well see lower need of office space. Newer properties built since 2016 that are in desirable locations already get good rents and will do find. And the bottom 20% of properties, if financed with non-recourse loans, will probably land back in the lender’s lap.

Conditions have degraded quickly with the combined effects of work-from-home and of inflation, higher interest rates, and leaping costs of interest rate caps making refinancing a challenge in general and not just for office.

A Trepp analysis interest levels from 5.5% to 7.5%, calculating the weighted DSCR at each stage, and put together tables showing effects overall and then by large metropolitan statistical areas, by major property type, and then by property type and MSAs. Overall, 27.9% of properties would have a DSCR under 1.25 times. At 6.5%, more than a third (35.6%) would be in the DSCR danger zone. At 7.5% loan rates, it would be 44%.

Even at a 5.5% rate for office loans that had fixed interest and were backed by a single property, the Denver-Aurora-Lakewood, CO MSA would see 77.2% of office buildings unable to maintain a 1.25 DSCR, putting to doubt their ability to continue throwing off enough cash for debt service along in a refi. Houston-The Woodlands-Sugar Land, TX came in second worst at 61.7%.

Other research suggests a growing wave of so-called Zombie office buildings in gateway cities with a utilization rate of under 50%. A recent report by the Boston Consulting Group found that, on average, vacancy rates have increased from 12% to 17%, and utilization has dropped from 70% to 42%. An Avison Young report last month came to a related conclusion, that as many as a third of office buildings across 14 major North American markets could be candidates for conversion to residential use because of increasing office vacancy.

The situation is deteriorating quickly. In August 2022, less than a year ago, researchers wrote, “We find a 32% decline in office values in 2020 and 28% in the longer-run, the latter representing a $500 billion value destruction. Higher quality office buildings were somewhat buffered against these trends due to a flight to quality, while lower quality office buildings see much more dramatic swings. These valuation changes have repercussions for local public finances and financial sector stability.”