- Given the huge acceleration in remote working as a result of the COVID-19 pandemic, office landlords will face challenges in terms of higher vacancy rates and demands for greater environmental quality and more flexibility in lease terms.
- Still, for key office markets globally we do expect recovery to a new normal, most rapidly in key Asia-Pacific cities as well as in the U.S., driven by both economic recovery and, for Asia-Pacific, relatively stronger employee and employer preferences for a return to office.
- These trends are reflected in recovering investor appetite for office-related assets including CMBS and REIT debt and equity, while bank exposure to CRE debt remains broadly manageable.
- A prolonged recovery in office real estate could hurt local government revenues, both directly through lower property-related tax income and more broadly through, for example, lower income from related transportation sector income.
The COVID-19 pandemic has upended office-based working, rapidly accelerating remote working trends. As countries emerge from the pandemic, employers are planning return to office strategies and rethinking the use of office space.
Increased flexibility in remote working will likely depress office space demand, yet the impact will vary across regions based on local market dynamics, industries, and corporate culture. While S&P Global Ratings expects total demand will not return to the pre-COVID level, rated real estate investment trusts' (REITs) prime locations and better asset quality has somewhat offset the uncertainties.
Still, it's clear that offices will not disappear. Factors as varied as the benefits of face-to-face social interaction, the embedding of company culture, and the data security that offices can offer are not always easy or effective to replicate in a fully remote working environment.
We believe the long-term adoption of remote working will vary by country. In that vein, Asia-Pacific's office markets could lead the recovery for the sector, given their higher office utilization and stronger fundamentals. Recovery in the U.S., Europe, and particularly Latin America will take longer.
North America Office landlords in key gateway markets (i.e., New York, San Francisco, and Toronto) could face pressure in the next two years given greater adoption of remote working and downsizing headwinds pushing occupancy and rent lower. Class A space is likely to lead the recovery. Overall U.S. office vacancy increased to 15% at the end of 2020 from about 12% in 2019, according to CBRE.
EMEA Unpaid rents and rent concessions have been modest despite long-lasting inertia on Europe's major office leasing markets. However, we think the actual need for office space in the main European markets could be 15% lower than pre-pandemic levels and constrain leasing activity for the next two years. We therefore assume a flattish performance for European rated office real estate investment trusts (REITs) in 2021-2022, with any rental and valuation declines limited to a maximum of 5% a year. We continue to think that companies with long lease profiles, creditworthy tenants, and grade-A assets that are centrally located in undersupplied European cities will fare much better.
Asia-Pacific Tenants such as multinational financial institutions have swiftly adapted to changes brought about by the pandemic. Meanwhile, the preference for face-to-face contact in Asia gateway cities is likely to remain commonplace and delay any change in office space usage/worker flexibility. We anticipate the vacancy rate to rise from the current levels ranging from 4% to 13% across Asia-Pacific gateway cities. The previous income stability of the office sector, though, will no doubt waver.
Latin America The pandemic and sharp economic contraction pushed vacancy rates to historically high levels in Latin American key markets. Although we expect a gradual and lengthy recovery toward 2022, we believe the office sector is transitioning, with still high uncertainties and downside risks due to the possibility of higher remote working over the medium-to-longer term.
To Zoom Or Not To Zoom? Employers Adopt Hybrid Approach
There is no one-size-fits-all solution to reimagining post-pandemic office space, but most employers will likely adopt a hybrid approach, with the working week split between remote working and office-based working. This greater workplace flexibility allows for limiting the number of staff in premises to comply with social distancing guidelines. A more spread-out workplace could result in a higher square footage per person, for example rising from 150-175 square feet (sq ft) per employee to over 200 sq ft per employee in the U.S. This reverses the trend in office density that has been observed since the global financial crisis.
Still, as the trend for a hybrid mode rises, tenants could downsize their existing footprints, putting some pressure on office real estate demand. A September 2020 CBRE survey suggests that remote working could reduce overall office space demand by 15% in the U.S. over the next few years.
We have seen leasing activity drop significantly in 2020 because of low levels of office utilization and uncertain return-to-office plans, particularly for employers in large and densely populated cities in the U.S., Europe, and Latin America. Transactions also paused given limitations on travel, resulting in reduced acquisitions and disposal activity. We also see employers postponing longer-term leasing decisions as they consider the final shape of their strategy for remote working. Those strategic decisions will likely increasingly crystallize in the second half of 2021 and into 2022.
Tenants will demand greater flexibility surrounding their leasing decisions and long-term commitments to leased space. In the U.S., while expiring leases have resulted in higher-than-average retention rates given the pandemic-related uncertainty, tenants are often signing short(er)-term extensions (three-year terms, for example) rather than full-term renewals (eight to 10 years) to maintain flexibility. Rental spreads on lease renewal has contracted modestly, with more weakness exhibited in gateway markets such as New York City. We expect pressure on occupancy and effective rental rates as leases come up for renewal, including higher concessions.
A flight to quality could drive a quicker recovery of higher-quality (class A) office assets relative to the national average. This is because class A assets tend to offer better air quality and layouts, along with greater security and technology embedded within the buildings.
Long Road To Jobs Recovery Despite Improving Economic Forecast
Policy settings remain generally accommodative as economic activity in many countries remains below pre-COVID levels, but labor markets remain soft, and the degree of scarring from the pandemic remains unclear. Central banks are signaling that they will maintain their current accommodative stances until the economic recovery is well entrenched and unemployment falls to pre-pandemic rates. An improving economic landscape is encouraging for real estate demand, but the job recovery in employment could be prolonged, particularly in the U.S.
The global economic recovery from COVID-19 looks set to accelerate in mid-2021, particularly in the U.S. on the back of a massive fiscal stimulus plan (see our Global Economic Outlook Q2 2021). We revised our 2021 global GDP growth forecast by 50 basis points to 5.5%, reflecting bright prospects for North America and China.
The news on the vaccine front has also been encouraging on balance, and the end of the pandemic is now in sight, particularly in the U.K. and U.S.—where vaccination rates are among the highest—as well as better containment in Australia and China, where the pandemic started earlier.
S&P Global Ratings believes there remains high, albeit moderating, uncertainty about the evolution of the coronavirus pandemic and its economic effects. Vaccine production is ramping up and rollouts are gathering pace around the world. Widespread immunization, which will help pave the way for a return to more normal levels of social and economic activity, looks to be achievable by most developed economies by the end of the third quarter. However, some emerging markets may only be able to achieve widespread immunization by year-end or later. We use these assumptions about vaccine timing in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.
Capital Markets Remain Open To Real Estate Deals, And Delinquencies and Valuations Are Holding Up
Capital markets have generally recovered since the depth of the pandemic in mid-2020, with debt markets recovering more quickly than equity markets. U.S. rated REITs issued a record amount of unsecured debt in 2020 ($79 billion in 2020, up from $70 billion in 2019), mostly to refinance debt maturing over the next two to three years and maintain solid liquidity throughout the pandemic. Although equity prices remain below pre-pandemic levels for office REITs, some recovery in recent months has narrowed the share price discount to net asset value (NAV).
Global commercial mortgage-backed securities (CMBS) issuance has declined, but appears to be slowly recovering. In the U.S. (the largest market), 2020 private label issuance—excluding commercial real estate (CRE) collateralized loan obligations (CLOs)—was $53 billion, down from $96 billion in 2019, and $22 billion of that $53 billon (~41%) volume occurred in the first quarter of that year. Indeed, there seems to be a gradual thaw in 2021, with issuance of around $15 billion in the first quarter. EMEA CMBS issuance is likely to exceed total 2020 issuance for the region in Q2 2021. We forecast full year issuance will be $70 billion (excluding CRE CLOs), which is just below the pre-pandemic (2015-2019) annual average of $85 billion.
These trends coincide with an initial spike in delinquency and forbearance rates for loans backing U.S. CMBS deals, which peaked near 9% and 8% in summer 2020. These metrics generally improved from late 2020 and into 2021, standing at 5.8% and 7.6% by the end of the first quarter. Retail and lodging property types account for most of the distress; the delinquency rates for office, multifamily, and industrial are below 2%.
In Europe (including the U.K.), issuance also fell in 2020, to about €2.5 billion compared to around €6 billion in 2019. There are signs of recovery this year, with over €1 billion issuance to date. As in the U.S., for Europe the lodging and retail sectors have comprised most of the distress.
Office remains the dominant property type exposure within U.S. new issuance transactions, accounting for 35% of conduit (multi-borrower) offerings and over 40% of single-borrower deals during Q1. These figures are even higher if we include "mixed-use" (typically office/retail). EMEA deals so far in 2021 have featured office and light industrial sectors. Within U.S. conduit deals, industrial, self-storage, and mixed-use properties' market-shares have grown as retail and lodging exposures have fallen compared with pre-pandemic levels (retailers were already under pressure before the pandemic due to e-commerce and customer shifts).
CRE risk premia have increased due to slower growth prospects but low interest rates continue to hold cap rates at relative steady levels, particularly for highly-leased assets, but the lack of meaningful transaction volume during the pandemic results in limited pricing trend data. Moderate pressure on real estate asset valuation is likely, given slowing cash flow growth despite interest rates remaining low.
Bank Exposure To Commercial Real Estate Debt Is Manageable
We believe exposure to CRE debt is manageable for most U.S. banks as the median exposure to CRE is only 19% of loans, and there does not seem to be a disproportionate exposure to loans backed by office assets. Since the onset of the pandemic, banks have been highly selective in lending. Our 3% base case CRE losses for banks would be manageable and most rated banks should be able to absorb such losses (roughly half the level the Fed projected in the severely adverse scenario of its June 2020 stress test), but this would exceed the roughly 2% that banks charged off in 2009 and 2010, excluding construction loans.
But many factors, including higher CRE concentrations for some banks, structural shifts in the sector that could occur, and the full economic fallout of the pandemic, could mean higher CRE losses than in our base case. Indeed, a portion of the banks that we rate, particularly smaller regional banks and those with specialty CRE product lines, tend to have higher CRE concentrations, with CRE comprising more than 30% of total loans (see "U.S. Banks Face Long-Term Risks To Their Commercial Real Estate Asset Quality"). Notably, in the Fed's December 2020 stress test, aggregate bank CRE losses jumped to 12.6% from June's 6.3% (see "The Fed’s Stress Test Results Open The Door For U.S. Banks To Increase Capital Returns In 2021").
While lending to real estate companies is the largest sectorial exposure of European banks' commercial loan books, as a proportion of overall lending it is less relevant than for their U.S. peers. The median weight of CRE lending for the top 71 European banks that we rate was just 7% of banks' total loan books, based on European Banking Authority data. That is why we think that, in general European banks will be able to deal with any potential headwinds affecting the sector. Only a handful of institutions—mostly Nordic and German banks—reported more sizeable CRE exposures, exceeding 20% of their total loans, although generally only about half of their exposure is backed by commercial properties (with lower risk residential housing accounting for the other half).
Still, we are mindful that CRE lending has historically been a source of outsized credit losses for banks and, although we do not yet see evidence of significant asset quality deterioration to date, we foresee higher delinquencies ahead. This may be particularly in the retail and hospitality subsectors, where activity suffered a massive shock during the pandemic and will take time to recover, though low loan-to-value ratios will help cushion banks credit losses. We consider significantly higher delinquencies for office CRE assets to be less likely, as rent collections and market values have proved fairly resilient during the downturn. While remote working arrangements will become more common, and companies have started to already rethink the work space they need to deploy, the impact of weaker office space demand on lease pricing dynamics, market values, and the future office space supply is likely to take some time to materialize, giving landlords and banks time to adjust.
For Asia-Pacific, the average proportion of CRE assets in banks' loan books was less than 15% in 2020. For our rated office REITs in 2020, bank loans accounted for 53% of their capital structure, while debt capital market financing (including medium-term notes) accounted for 44%, and other financing for 3% of their capital structure.
In Latin America, lending and exposure to construction (including CRE) in the Mexican and Brazilian banking systems—the two largest economies in the region—have been limited, representing about 8% and 5% of total loans, respectively. We believe traditional commercial banks have been conservative and cautious about expanding their exposure to this sector, considering the historical and relatively high credit losses. In the case of Mexico, almost half of the total construction exposure belongs to infrastructure projects, while CRE exposure is less than 5% of total loans. In Brazil most of these loans are related to large infrastructure projects rather than CRE development, reflecting a historically moderate risk appetite for the sector in both banking systems.
We foresee this conservative approach and modest growth to continue, considering the significant downside risks as partial economic lockdowns continues, coupled with the slow and gradual economic rebound while vaccination programs slowly evolve. We estimate that banks' CRE exposure as a percentage of total loans will stand at less than 5% in both countries. Consequently, we project that banks' balance sheets and capital indicators would be resilient to the ongoing deterioration for this sector over the next 12 months.
Prolonged Decline In Office Real Estate Could Hurt Local Government Revenue Bases
Most local and regional governments (LRGs), which operate in large metropolitan areas, are relatively resilient to a short-term volatility in the office real estate market. We have reviewed the dependence of LRGs in Greater London, Paris, Frankfurt, Sydney, Tokyo, Hong Kong, Toronto, New York, San Francisco, and Mexico City on various property related payments made by office landlords and renters. These LRGs predominantly collect taxes and fees depending on the assessed property value, which is revised once a year and may substantially deviate from the market value. Office-related transaction fees normally represent less than 2% of revenues across the local governments. One notable exception are French departments, which we see as among the most vulnerable French LRGs. After local tax reforms in France, starting from this year the departments of Grand Paris will receive nearly all property-related revenues—in the form of property transaction fees and asset sales—which are directly linked to property market values and demand for new office space. We believe that exposure of the city of Paris and department of Haute-de-Seine to such payments is relatively high.
Still, a longer-term weakening of demand for office space in the post-COVID world could materially affect revenues of a broader group of LRGs, including in particular the Greater London Authority (GLA), City of Sydney, and New York City. Based on our estimates, business rates from offices represent about one-third of GLAs' budget revenues. Although central governments transfer to the GLA the agreed amount of revenues irrespective of the actual collections, a substantial reduction in collections could lead to a reduction in such transfers.
A lower demand for offices can also affect LRGs' finances more broadly than through these falls in revenue from direct property-related taxes and fees. A corresponding reduction in other taxes paid by landlords, smaller tax income from related construction and business services, and lower payments from related transportation, catering and hospitality sectors could all lead to a more substantial decline in LRG budget revenues.
ESG Factors Could Be An Important Differentiator For Office Assets
Post-COVID, the focus on environmental, social, and governance (ESG) factors will only intensify and tenants will gravitate toward real estate assets that are better equipped to provide health and wellness measures. As tenants think about their return to office strategies, factors such as air quality and space density are some considerations in addition to environmental factors such as energy efficiency, carbon emissions, and waste management which had gained relevance pre-COVID.
Tenants are seeking sustainable workspaces in response to employee demand, as well as investor and C-suite buy-in on ESG-related ambitions. This includes, in particular, tenants in the tech sector that are significantly expanding their office footprint. Across real estate property types, office landlords have increased the penetration of green assets in their portfolios, which has differentiated them in their markets
While office landlords could face higher maintenance costs to install higher quality heating, ventilation, and air conditioning (HVAC) filtration systems or more stringent cleaning protocols, higher quality assets can also command higher rents and enhance property value. Although Europe has more green assets in office properties than the U.S., a renewed climate change focus from the Biden administration could also spur greater investment in ESG initiatives across key U.S. office markets.
North America: Gateway markets' recovery may lag suburban markets
We expect office landlords in key gateway markets across North America (i.e., New York, San Francisco, and Toronto) to face pressure in the next two years given greater adoption of remote working and the potential downsizing of office space, pushing occupancy and rents lower. Suburban markets should remain more insulated with less severe declines in occupancy and rental rates, though these markets are more susceptible to supply risks.
Although office utilization remains low, rent collections for office REITs remained high throughout 2020, in the mid- to high-90% range for office assets, even as most buildings sat virtually vacant since the onset of the pandemic in March 2020. We expect office utilization to remain relatively low in 2021, as the return to office strategies are hampered by logistics complexities due to population density. After several years of steady rent growth and occupancy, these markets have quickly shifted to a renter's market. Weakness in leasing activity and slow jobs recovery have caused vacancies to spike. The U.S. office vacancy rate increased to 15% at end-2020 compared from about 12% in 2019, according to CBRE. The vacancy rate in San Francisco jumped to 16%, with New York at 12% at the end of 2020, several percentage points higher than pre-pandemic levels. Rent pressure has been moderate so far, declining about 5% in the U.S., however, we've also heard examples of landlords offering concessions to keep face rents from declining considerably. Toronto's vacancy is slightly better at 11% and rent has held relatively flat. Given higher supply conditions and accelerating growth of the sublease market in New York and San Francisco, these markets are likely to face a slower recovery than Toronto.
On the other hand, we recently raised our forecast for U.S. GDP growth in 2021 to 6.5% from 4.2% following the massive $1.9 trillion American Rescue Plan. If this growth is realized, it would be the highest reading since 1984. Despite the improved outlook, we see jobs as a lingering weak point in the recovery, with unemployment, adjusted for labor force composition, reaching its pre-crisis rate only by the second half of 2023. Despite expectations that economic growth will be relatively robust over the next two years, we expect office demand to remain relatively muted. Employment recovery in Canada has outperformed the U.S. thanks in part to a policy framework that has helped businesses keep employees and we've seen a strong employment recovery across industries. Eighty percent of jobs lost have been recovered in Canada, a much better outcome than in the U.S., where the comparable metric is 58%. We forecast the Canadian economy to expand by 5.5% in 2021 from the previous 4.5% forecast. In the near term before the economy gets to full-vaccine rollout, risks to spending may be skewed to the downside.
Office utilization should increase as vaccine rollout gains momentum. Based on data from Kastle Systems that tracks keycard, fob, and KastlePresence app security access data, the average utilization was about 24% on its barometer of the top 10 cities from the 2,600 buildings across 136 cities. The return to the office strategy has been much quicker in non-gateway markets such as Dallas with utilization at about 38% at the end of March 2021, compared to New York and San Francisco at just about 14%. We would expect a recovery in office utilization togain momentum in the second half of 2021 as vaccine rollout widens.
The extent of the COVID-19 impact on office usage remains to be seen, but we forecast the impact to be more gradual but prolonged. Office REITs entered the pandemic with relatively good operating metrics, having low vacancy rates and steady rent growth, while long-term leases and staggered lease maturity schedules should help mitigate the impact of a shrinking office footprint.
On the other hand, job growth could help mitigate the impact of remote working, particularly in the tech sector and life science sectors as these companies look to expand their office space to accommodate growth.
We maintain a negative ratings bias for office REITs with over 20% of ratings having negative outlooks. Rating activity for rated REITs with meaningful exposure to the New York City markets has been decidedly negative. We lowered the ratings on Vornado Realty to 'BBB-' from 'BBB' and revised the outlook on SL Green to negative in March.
Unlike retail REITs, tenant quality remains steady as office REITs' tenants are generally well capitalized and diversified across a multitude of industries (technology, health care, financial services, etc.). The top few tenants for office REITs usually account for less than 12% of annualized revenue and have predominantly investment-grade ratings. A larger proportion of tenants is under distress in the retail segment. Public REITs own above-average assets (mostly class A) that should outperform the overall market in a downturn and also recover quicker.
EMEA: gateway markets may see a two-speed recovery
COVID-19 lockdowns sent many workers home to work remotely and its economic impact stressed most companies' capacity to pay their rents. We believe that demand for office space in Europe will weaken as companies may revisit their needs in the next two years. With remote working becoming more routine, cost cutting and the search for productivity gains should gather steam in response to the pandemic's economic fallout. The actual need for office space in the main European markets could be 15% lower than pre-pandemic levels and constrain leasing activity for the next two years. In 2020 leasing demand fell well below the five-year average in all major markets—Paris, London, Berlin, Madrid, and Barcelona, due to the pandemic direct effects (see chart 7), and we think market recovery could be only gradual and linger toward 2022.
Deliveries of new office buildings could push up vacancies in some markets. We believe office buildings to be delivered vacant in 2021 and 2022 could be hard to lease, given the slow recovery of the leasing market. Moreover, large deliveries of vacant spaces for let could threaten the absorption of existing supply in the main European cities. In our view, Paris, Stockholm, Frankfurt, and the West End of London are less exposed to that risk. But Bucharest, the City of London, and Warsaw could see higher vacancy levels, which were already high as of Dec. 31, 2020, because of the large numbers of deliveries due this year and next (see chart 8).
However, the solid performance of European office REITs last year dispelled some of the concern about the landlords' capacity to maintain rents and asset values. REITs we rate reported flat revenue growth on average and still rising office property values in 2020 (1%) despite some rise in vacancy rate (two percentage points). The few declines in rental income were all contained in the 0% to -5% range. Collection rates remained high (97% on average), with tenants showing limited financial stress, even at the peak of the lockdown, because of the companies' sound and diversified tenant bases. Unpaid rents and rent concessions have been very moderate despite long-lasting inertia on the leasing market. We do not yet observe a shortening of lease standards (between six to nine years) nor a large subleasing trend, rather modestly rising rent incentives and a slightly shorter remaining lease duration for REITs that we rate (2.4 months less on average) due to longer negotiations with tenants in 2020. We believe decreasing demand should only moderately pressure revenues for the companies that we rate, as less than 5% of their rental income in 2021 on average is not yet secured (extended or replaced). We do not expect any further rent concessions ahead of lease maturities.
Valuation growth remained slightly positive on average, at about 1% in 2020, supported by few benchmark transactions that further reduced capitalization rates and some positive rental value expectations. However, we still believe valuations could erode, by 0%-5% on average in the next two years, assuming that lower rent indexation rate and a higher vacancy rate than previously anticipated would reduce appraisers' revenue expectations. Moreover, investments are relatively subdued currently and we believe that prolonged market inertia or the emergence of potential distressed asset sales could weigh on future valuations of office assets.
While we don't think offices will disappear as remote working expands, we believe the long-term adoption of working from home could vary by country. Several reasons could underpin uneven adoption such as commuting time, share of international tenants (generally applying widespread and more stringent health and safety policies), office density and verticality, trade unions (which may require more protection and compensation for remote workers), and possibly other sociocultural factors.
Tenant inquiries in our view will increasingly target service-oriented grade-A assets, with a higher proportion of collaborative spaces and green credentials. New ways of working are likely to dictate the configuration of future offices, requiring more attention from landlords. Costs consciousness and growing environmental awareness are also pushing occupiers toward more energy-efficient buildings.
Assets in the centers of large cities, where 70%-80% of the assets of companies we rate are located, outperform those in decentralized areas. For example Gecina's assets in Central Paris gained 2.2% value in 2020 while those in La Defense and other areas declined by 7.6% in the same year. Rental reversions are also opposite. Although rent affordability and cost of living remain major issues in central business districts, these areas remain the best for attracting talents, access via public transportations, and maintain a proximity to business partners. Office leasing conditions may ease in most European capital cities as landlords' bargaining power weakens somewhat and we have seen rent incentives slightly growing this year, but central business districts should see less of an impact on rent than secondary locations. Besides, the supply-demand imbalance is more pronounced in most central locations given the scarcity of good quality assets, the barriers to entry (such as building rights on protected buildings), and the lack of available land. We therefore see stronger potential for vacancy absorption in central areas.
S&P Global Ratings continues to assume that rent and valuations for rated companies will remain in the 0% to -5% range in 2021 and 2022 after a modest increase in 2020. Under our base-case assumptions, we conservatively assume that rents that are due to expire in 2021 and 2022, and which have not yet been secured, would be renegotiated or replaced at a 20% discount to the previous level. This assumption could also depict a situation where 20% of the leases maturing would not be renewed and become vacant, with the remainder 80% being renewed at the same rent level. With these assumptions, most European office REITs that we rate are able to maintain ratios that are commensurate with their current rating levels.
Asia-Pacific will likely be the first to reach a new normal
The secular change to a new way of working could be less painful for landlords. The availability of funding, quality of tenants, and preference for in-person contact in the region, are all likely to ease the inevitable pressure change will usher in. While COVID-19 is more contained in the region, negative impacts for office landlords such as cash collection rates and valuation losses are more protected in gateway cities. Prime asset location also supports Asia-Pacific's position as leading the recovery.
Tenants such as multinational financial institutions have swiftly adapted to changes brought about by the pandemic. Meanwhile, the preference for face-to-face contact in Asia gateway cities is likely to remain commonplace and delay total change. The previous income stability of the office sector, though, will no doubt waver.
Compared to the U.S. and EMEA where the average lease term is eight to 10 years, the average lease term for office REITs is three to five years. Gateway cities with shorter weighted-average lease expiry (WALE) profiles such as Tokyo, Hong Kong, and Singapore (at about three to four years) will be more harmed by shorter dated leases than Sydney and Melbourne, where WALE profiles exceed five years. Reductions in WALE profiles will increase rental income volatility, which could increase business risk, in our view. Shorter WALE profiles will likely prove to be a double-edged sword. If the post-pandemic rental rebound is stronger than expected, shorter WALE profiles could bode well for earnings growth. For example, Hong Kong's rental rate skyrocketed by 56% one year after the global financial crisis: Shorter WALE profiles allowed operators to capitalize on the uptrend. Hurdles to achieving this could include the upcoming supply in these gateway cities, which is quite substantial particularly for Tokyo after 2023.
The capital structures of office landlords and REITs tend to be quite simple, because of their large fixed-asset bases. We believe that the well-banked status of these players will continue, because operations have been relatively unaffected and appear to be on the mend. Compared to the U.S., the general absence of CMBS also makes valuation adjustments less likely to hamper access to debt funding or to have strong ripple effects in financial markets.
Latin America: A slow and fragile recovery with relatively greater downside risks
Latin America's two largest economies, Mexico, and Brazil contracted sharply in 2020, with GDP rates falling by 8.5% and 4.4%, respectively. Although we expect a gradual and lengthy economic recovery in those countries, starting in 2021 and supported by improved global growth prospects and higher export activities, we believe the recovery path remains exposed to the slow vaccine rollout, the high number of active COVID-19 cases, lack of government stimulus, low private investments, and slow recovery of formal employment which could still weigh on consumption, population mobility, and overall market dynamics.
Like in other regions, the pandemic has disrupted ways of working and therefore the office market in Latin America's key gateway markets (Mexico and Sao Paulo). Latin American companies have rapidly adopted work from home policies to ensure employee health and safety. This significantly reduced office utilization, space needs, occupancy rates, and rent prices in 2020. Remote work is likely to prevail through most of 2021 in most of Latin America's key markets.
According to CBRE, vacancy rates in Mexico City's class A spaces (90% of the Mexico City market) reached closed to 22.4% in Q1 2021, from 20%, 14%, and 10% in 2020, 2016, and 2010, respectively. Asking rent prices at $23.08 (per sqm/month) in Q1 2021 remained below pre-pandemic levels, and well below the $27.86 prices at the beginning of 2015 when rent prices spiked. While office space vacancy rates have recently peaked, we believe the sector is transitioning. The recovery toward 2022 will be slow and fragile with several downside risks still looming given upcoming lease term expirations and the uncertain equilibrium between home office and new hybrid operating models, while rent prices will likely remain weak, following market demand. We also continue to see negative net absorptions in Mexico City given the depressed demand for new space incorporation in the market. On the other hand, office portfolio developments have been delayed and current conditions do not provide any near-term visibility on when they could be reactivated. Thus, we anticipate developers to proceed more cautiously on greenfield projects, reducing financing needs.
São Paulo has similar work from home policies and higher vacancy rates (20% by the end of 2020 from 16% in January 2020). However, net absorption remained positive at about 60,000 square meters (sqm), although at a lower level than 2019 (100,000 sqm) and 2018 (200,000 sqm) due to the pandemic impact and the delivery of 150,000 sqm on a new inventory. This absorption happened in specific areas of the city such as Berrini and Santo Amaro, driven by a small number of large companies. With tenants looking for more premium areas such as the Faria Lima, Itaim, and Vila Olimpia regions, the average asking rent increased by 17% year-on-year in the city. We anticipate these trends to prevail in 2021 with vacancy rates likely increasing, mainly for lower value properties, as tenants move to premium areas and sustain the asking rent prices at current or slightly higher levels. Net absorption may be affected by the significant inventory of 200,000 sqm to be delivered in 2021 and the continuous pandemic impact.
Although office space per capita in Latin America remains well below that in U.S. or European markets, office spaces may need to be rethought in 2021 and beyond—considering safe distance requirements—while flexible working policies will continue to expand. In this sense, it's highly likely that in the medium to long term, companies in those markets will switch to new hybrid operating models (a mix of working from home and physical office presence). Consequently, we believe the office market in key Latin American cities will continue to face downward pressure over the medium term. Companies will likely renegotiate their lease agreements with office landlords to get shorter contracts, as seen in Mexico where some contracts where renegotiated to two to three year contracts in 2020. Although the magnitude of such renegotiation is still uncertain, companies could downsize their space needs which will ultimately continue to pressure vacancy and rent prices, forcing office landlords to adapt their product offerings to retain and attract new tenants.
Our rated Latin America office real estate portfolio has been broadly stable so far, mostly because rated entities predominantly focus on premium assets where most tenants have shown resilience to the COVID-19 crisis.
- European Office REITs Should Prove Resilient To A Gradual Decline In Tenant Demand, April 29, 2021
- Property In Transition: Remote Working Not Lights Out For Asia-Pacific Office Players, April 8, 2021
- REITrends: North American REITs Are Reaching An Inflection Point On Path To Recovery, March 18, 2021
- Remote Working Is Testing U.S. Office Landlords' Credit Quality, Feb. 11, 2021
- REITrends: Recovery In The U.S. REIT Sector Will Likely Be Choppy, Dec. 7, 2020
- U.S. Banks Face Long-Term Risks To Their Commercial Real Estate Asset Quality, Nov. 16, 2020
- European Office Real Estate Companies: After A Resilient First Half, Upcoming Lease Maturities Should Test The Market, Sept. 18, 2020
Digital Design: Tom Lowenstein
This report does not constitute a rating action.
|Primary Credit Analyst:||Ana Lai, CFA, New York + 1 (212) 438 6895;|
|Secondary Contacts:||James M Manzi, CFA, Washington D.C. + 1 (202) 383 2028;|
|Franck Delage, Paris + 33 14 420 6778;|
|Esther Liu, Hong Kong + 852 2533 3556;|
|Alexandre P Michel, Mexico City + 52 55 5081 4520;|
|Felix Ejgel, London + 44 20 7176 6780;|
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