ARE RENTAL RATES FINALLY READY TO START DROPPING?

As pointed out in a previous Rental Rate Update Article, a weak or weakening real estate market does not automatically result in a drop in rental rates.  The markets have typically responded to tough times by aggressively increasing market concessions, generally in the form of free rent and higher allowances for tenant improvements.  The primary reason face rental rates have been so sacred is the desire on the part of owners and lenders to preserve future cash flow levels, and thus property valuation.  In the long run, it can cost a lot less to offer up-front incentives than sacrificing long term property values by lowering rental rates.

The duration of the weakened office market in the wake of the COVID pandemic, combined with the much higher interest rates at a time when so much commercial real estate debt is coming due, have brought us to what appears to be a lowering of face rental rates in some asset classes.  To be clear, there’s no evidence of an across-the-board precipitous drop, but rather some hints of a real shake-up at some levels.

What Types of Buildings are Affected?

So far, what we are seeing is a trend toward lowering rental rates in select Class B office buildings, both in the CBD and in the suburban markets.  Class A and Trophy assets have, for the most part, held firm on their quoted rates and continue to offer larger up-front concessions to preserve those face rental rates.  While there have been no noticeable increases in rates, trophy buildings have maintained their face rates and continue to focus on higher concessions to attract and retain tenants.

What has Changed?

Comparing the current environment with that of the past few years, the primary altered factors that define today’s market can be described as follows:

1. Duration of the downturn and slow recovery of the office environment, especially in Class B.

2. Changing long term outlook of lenders and owners alike due to softened demand and high refinance rates.

3. Change in ownership of select Class B properties to opportunistic bargain hunters.

SLOW RECOVERY

The hope in many circles after the depth of the pandemic was that office utilization would return to close to pre-pandemic levels after a year or two.  Although the dire characterizations of the long-term market are likely overstated, the hoped for return clearly has not happened.  Office utilization continues to climb very slowly, but a full return to five day per week occupancy by most employees is unlikely in the foreseeable future.

The often cited “flight to quality” has left many older Class B buildings unable to retain their existing tenants or to attract new tenants to help fill vacancies.  Tenants who in times past were content to remain in their existing spaces and to pay somewhat lower rents have been aggressively pursued by higher quality buildings with significant up-front concessions.  These concessions allow the Class B office user to upgrade their space and building for effective rents (i.e., taking into account the concessions like free rent periods) that are not substantially higher than what they had been paying in their existing buildings.

CHANGING OUTLOOK

A substantial portion of commercial mortgage loans are and have been funded via Commercial Mortgage-Backed Securities (CMBS).  These loans typically have a term and anticipated payback of ten years from the date of issuance.  For those loans issued in the 2012 to 2016 time period, most have either already matured or are about to.  In the current interest rate environment, refinancing many of these maturing loans has been extremely difficult, if not impossible.  One of the oft-employed tactics to deal with this issue for traditional lenders and CMBS sponsors/servicers alike has been to “extend and pretend.”  The loan is extended by two years or more in the hope that both the real estate markets and the interest rate environment will improve dramatically, thus avoiding significant losses for the lender.

For CMBS servicers, the ability to extend maturities is limited by the expectations of bondholders.  These investors purchased the securities with an expectation of payback in a set time period.  Servicers are thus confronted with pressures from bondholders to return their investments.

As the period of high interest rates continues with very little optimism for a quick return to much lower rates, lenders are less likely to extend maturities.  They seem to be more and more likely to accept losses and proceed to foreclosure.

Likewise, many property owners are becoming loathe to throw good money after bad.  There are numerous examples of owners “handing over the keys” rather than continuing to fund losses in such a down market.  This is true even with some of the largest institutional owners in major cities. 

BARGAIN HUNTERS

In down markets, whether in real estate or other investments, there are always contrarian investors trying to time the bottom and realize extreme returns on the hoped for turnaround.  As lenders have reclaimed properties through foreclosure or deeds in lieu of foreclosure, there are bargain hunters willing to buy the properties at a significant discount to the previous loan amount.

The resulting lower investment basis these investors have allows them to offer aggressive concessions (i.e., tenant improvements and rent abatements) that compete with properties that are not currently in the same financial straits, while at the same time offering rental rates that are materially less than the quoted rates throughout the market.

By way of example, a recent Class B acquisition in downtown Chicago by just such a bargain hunter resulted in a purchase price that was 37% of the prior owner’s purchase price nine years prior and only about 50% of the outstanding debt on the property.  A recent lease proposal from the new owner included full market rent abatement and tenant improvement allowance with a rental rate that is fully $5.00 / square foot lower than comparable buildings.

Start of a Trend or Temporary Exceptions?

As noted above, the primary building groups showing a drop in rental rates have been older Class B and lower.  There is no substantial evidence, either statistically or anecdotally, that Class A and Trophy type assets have been affected.

It’s interesting to note that average office rental rates were relatively flat in the Great Recession years and the five or six years thereafter.  Instead, rents were flat to slightly increasing during this period in spite of the overall economic downturn.  The interest rate environment was not an issue during this time, but demand clearly was.

It is likely that the demand part of the equation has bottomed out.  What remains uncertain is how long the high interest rate levels will endure and the willingness and ability of lenders and institutional owners to wait for more friendly financial markets to return.