The coronavirus pandemic and the many business closures that have attended it may accelerate ongoing structural changes in the office real estate market, with unknown consequences for landlords and their lenders, industry observers said.
Well before COVID-19 evolved into a crisis, the commercial office space was undergoing rapid change that put stress on landlords. Across the country, office tenants were downsizing and owners moved to redevelop office floor space to better meet contemporary requirements, assigning less square footage per worker and carving out more shared spaces to encourage collaboration. Now, social distancing and remote work may upend the market dynamic again. More workers may request to telecommute, while those that return to offices may require more space as a health precaution.
Joseph McBride, head of commercial real estate finance at data and analytics firm Trepp, said the trend for less space per corporate user may continue in the coming quarters, but the rationale may be different, and the market's transformation may happen much more quickly with many sectors of the economy shut down.
"The immediate-term risk is the same thing with what's happening in multifamily and retail, which is tenants just call their landlords and say, 'I'm not paying this month.' ... What would have happened over the next five years might happen over the next three months," McBride said in an interview.
Because office leases typically have longer terms, office landlords are thought to be more insulated from the economic shutdown than lodging and retail owners — the two real estate segments hardest hit by the pandemic. Office REITs were among the industries deemed least affected by the coronavirus in a market signal model furnished by Credit Analytics, a branch of S&P Global Market Intelligence, that calculated a median one-year probability of default for companies in each industry based on share-price volatility and other country and industry-related risks.
David Rodgers, senior analyst at Robert W. Baird, sounded a note of caution about rising unemployment figures, which he said will shock the office market, but he gave the office REITs overall a relatively clean bill of health as of early April. The group learned its lesson from the 2007-2008 financial crisis and today has lower leverage, carefully staggered debt maturities and better cash flow coverage, he said. Rodgers does not expect many near-term defaults on property-specific loans because there is not a severe liquidity crisis and "the cushion is too great this time."
Rodgers said some property loan defaults are possible but not the largest concern for the sector. "I think the bigger issue is just going to be market weakness in office that stems from coworking [tenants] not making payments. And from new buildings that had been built with 30% or 40% [lease] commitment, but were 60% spec, and now that spec is going to take longer to lease. I think those are the market pressures we see in office, more than the risk of giving back assets, turning keys back to lenders."
Among office REITs, Columbia Property Trust Inc., SL Green Realty Corp., Paramount Group Inc. and Vornado Realty Trust had the highest leverage, as measured by net debt to EBITDA, at the end of 2019, according to S&P Global Market Intelligence data. Columbia Property Trust and Paramount Group declined to comment, and SL Green and Vornado did not return a request for comment. REIT earnings season begins next week.
Trepp's McBride maintains a cautious view of the office space overall. He said the coronavirus and related business closures have created many more unknowns in the office market. Any current probability of default analysis cannot fully account for this. He expects the bulk of distress around rent payments to manifest in May and June data, and then there is the question of how the demand picture changes longer term.
"[C]ompanies that survive and thrive in this time all of a sudden realize that they don't need 200,000 square feet. They only need 50,000 because they only need a couple of fancy conference rooms and a bullpen," he said. "And half of the office can work from home two weeks out of every four."
Among banks, Wells Fargo & Co., Bank of America Corp. and PNC Financial Services Group Inc. had the highest amount of office loans outstanding in their respective commercial real estate portfolios, at $37.11 billion, $17.90 billion and $7.64 billion, respectively, at the end of 2019. Those dollar figures represented a relatively small proportion of the banks' overall lending activity, however. The banking industry's exposure is limited to just office buildings and excludes office/warehouse, health facilities, and medical offices and services when those categories were reported separately.
Bank of America and PNC declined to comment for this story. A Well Fargo spokesperson said in an email that the bank is "well-prepared to support our customers across our lines of business."
CVB Financial Corp., BankUnited Inc. and Cullen/Frost Bankers Inc. were the three banks with the largest proportional exposure to office borrowers as of year-end. A spokesman for Cullen/Frost, whose office loans represent 8.8% of its lending book, said many landlord-borrowers began reaching out to their tenants in early March in anticipation of rental deferments.
"Several owners had tenants complete applications for rent relief and/or developed protocols to systematically address deferments. Those are encouraging things. Landlords recognize that some type of relief is prudent and appropriate for good, well-established tenants," the spokesperson said in an email, noting that Cullen/Frost has been "very active" in the Paycheck Protection Program.
Synovus Financial Corp. saw a 55.4% increase in the dollar value of its office loans in 2019, which a spokesperson attributed to the firm's acquisition of FCB Financial Holdings Inc. As of year-end, the firm had $2.26 billion in office loans on its books, representing 6.1% of its overall lending activity.