With prudent underwriting, lenders continue to fund office transactions

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A decline in office usage if it lasts beyond the pandemic could pose risks for office asset-backed loans, as it is likely to impact office rents, mortgage rates. occupancy and market values, according to a recent report from Moody’s Investors Service. The report notes that the impact would be greatest in urban markets with the highest average rents. This, in turn, would increase the risk for CMBS office-backed loans, the most important segment of the CMBS market. This would be a particular problem for aggressively underwriting loans that mature in four to seven years, according to Moody’s.

The impact of the coronavirus on loans of all types of property is already evident, as total CMBS loan delinquencies reached 7.77% in October, according to Moody’s CMBS Conduit Loan Delinquency Tracker. However, the lion’s share of loan modifications and the resulting increase in debt has so far fallen on hotel and commercial properties.

While Moody’s doesn’t believe the physical office will be fully abandoned, Blair Coulson, vice president and senior credit manager for new CMBS ratings at Moody’s Investors Service, notes that tenants can return space when leases are renewed. . This would be done gradually, as only about 10% of leases will be renewed per year over the next five years, he says. In the meantime, businesses using offices will continue to need a centralized space for employees to come together, but with many layoffs of large chunks of their staff in a struggling economy, there could still be plenty of redundancy. sublet space to come on the market. This has an impact on the approach of lenders to the financing of office buildings.

“Lenders, or equity investors, fundamentally believe that the physical office is here to stay because businesses need an environment to collaborate, grow culture, develop employees, and foster creativity, which enables their businesses to grow, ”says Keith Largay, Managing Director. director and co-head of the Chicago office of JLL Capital Markets. “They underwrite moderate rental activity over the next 12-24 months, as companies re-integrate their employees into the office and begin planning their workplace strategy for the next 10-15 years. “

Largay adds that with the slower short-term office rental speed expected, stable cash flow is the cornerstone of lender underwriting at this time.

Lenders are more cautious than before the pandemic, says Manhattan-based Richard Katzenstein, senior vice president / national director of Marcus & Millichap Capital Corp. he notes. For example, an entity like WeWork will need to make major changes to its physical space and limit the number of users on its sites to remain viable.

But lenders look at all aspects of a deal, according to Katzenstein, including the terms and structures of tenants’ leases, sustainability of cash flow, tenant credit status, rent collection, security protocols. that have been set up and the location and attractiveness of the building. For example, has an older asset been modernized and is the location convenient for transit and retail?

“Before COVID, if a building had 25 tenants with rental rates at or below the market, there was less credit to collections than today,” Katzenstein said, noting that due to current concerns about the Rent collection, lenders have also reduced debt coverage requirements. from 1.30 percent to 1.40-1.50 percent.

While there is still sufficient debt capital today for further office acquisitions, says Largay, the price and leverage offered will be highly dependent on the sponsor, location, quality of the l asset, stable cash flow and business plan, with conditions varying considerably depending on the combination of these factors. “New acquisitions mean new shares are entering the deal, which lenders like to see where the base and valuation of assets are established,” he adds.

In fact, there is a significant amount of liquidity in today’s market from all lender groups, including banks, life insurance companies, specialty financial groups and investment banks, according to Robert Tonnessen, director of JLL Capital Markets in the New York metropolitan area.

“But due to the uncertain market volatility driven by COVID-19 and the noise around working from home, lenders are more selective and patient in seeking out the opportunities that best suit their capital,” he says. Stable cash flow, current market fundamentals and long-term tenant demand outlook are among their key criteria.

Additionally, loan terms have changed due to the pandemic, especially for urban assets, according to Katzenstein. While interest rates remain low, between 3.50 and 4.25 percent, loan-to-value ratios (LTVs) have fallen by about 10 percent, according to the lender. For example, before the pandemic, LTVs offered by life insurers averaged around 65%. Now that figure is 55 percent. LTVs offered by CMBS lenders are on average 75% before COVID-19, but now range between 60 and 65%.

For the best properties, long-term fixed-rate financing at moderate debt levels will cost between 2.75 and 3.25 percent, Largay says. The more transient, higher leverage and lower properties in the market will be in the higher rate range, depending on the specifics of an asset.

Coulson and Katzenstein both note that large office loans are made in the CBD, as long as they involve good credit tenants and long-term leases. The recent major financing transactions analyzed by Moody’s provide a few examples. There was a $ 410 million COMM2020-CX mortgage trust transaction for a nine-story, 426,869 square foot building. Class A office building located in Cambridge, Mass. and a $ 415 million VLS Commercial Mortgage Trust 2020-LAB transaction secured by a first mortgage on fee interest in two Class A office towers with nearly 711,000 square feet. ft in the South San Francisco Market.

In fact, lenders especially like office assets with lab space, as not only does lab work typically require an on-site presence, there is currently a high demand for this type of space from pharmaceutical companies. and health care, Coulson notes. San Francisco’s assets are 93.4% occupied by 21 tenants with weighted average lease terms remaining of 7.5 years. The main tenant of the Cambridge building is the North American head office of Philips, which has almost 15 years of lease remaining, occupies 80.6% of the building’s net leasable area and represents 78.2 % of its base rent.

In addition, a Manhattan West 2020-1MW Mortgage Trust transaction provided a $ 1.43 billion CMBS loan for One Manhattan, a 70-story, 2.1 million square foot Class A building. office condominium project located one block from Hudson Yards. The asset is 93.8 percent occupied by 10 tenants with weighted average remaining lease terms of 17.5 years.

Despite the industry’s current challenges, Katzenstein says investors are still buying office assets and seeing risk-reward opportunities. “People have learned a lot from before to after COVID and are adapting to today’s lending environment,” he notes.

Looking for opportunities in the current market, Largay says investors continue to be cautious, with careful consideration of their approach to trading. “Opportunistic funds and high net worth investors are able to take advantage of market fragmentation, while institutional investors remain price critical. “

There is certainly financing available for office buildings and some demand from potential investors, Tonnessen adds. “The bigger question today is whether or not there are enough sellers,” he said, noting that given the short-term uncertainty in the market, many buyers are entering into transactions in such a way. very conservative, which leads to valuations that can be significantly lower than the long-term value. As a result, Tonnessen notes that many owners of non-core office assets choose to refinance instead.

Yet “for core office assets with long-term credit and leases, the market is more aggressive than ever before, on both the equity and debt side,” Tonnessen adds. He suggests that investors and lenders are prepared to accept record returns in return for stability and current performance.

According to Katzenstein and Largay, there is also capital available from bridge lenders for capital improvement. “Lenders always look at financing that improves asset value, but they’ll want to make sure the debt structure (coverage) is in good shape,” Katzenstein explains. “It can be a challenge as values ​​have gone down and the price would be a bit higher depending on the value versus the mortgage. “

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