The U.S. office real estate market has entered an undefined period of turbulence. Declining demand from office users and falling market values for office real estate due to rising interest rates have been squeezing borrowers' ability to secure new and favorable refinancings for maturing loans since the rate increases started in March 2022. To assess the potential funding gap and the impact it could have on commercial mortgage-backed securities (CMBS), S&P Global Ratings undertook a macro-level scenario analysis, using various financing parameters and imputed market values, on a sample comprising the 72 U.S. single-asset, single borrower (SASB) CMBS transactions it currently rates.

We examined the possible range of exposures from the struggling office sector (based on a uniformed set of market-derived assumptions used to input office property values in today's uncertain environment) and lenders' willingness to keep providing capital based on revisited leverage and coverage matrices. The results show that the outstanding volume of secured debt would decline by one-third if overall market value declined by 40% from initial valuation. In other words, unsecured lenders and property (equity) owners would need to refinance about a third of the outstanding secured loan balance.

Even though the market faces serious refinancing risk due to rising loan-to-value (LTV) ratios from declining property values (with an average actual LTV ratio of 94% based on our imputed values), we do not expect existing lenders to experience principal losses across the board. Although our scenario analysis relies on functioning debt and equity capital markets, we expect some assets to change hands in the process if borrowers are unable to reach a consensus on loan modifications and/or extensions with existing lenders. The winners and losers remain to be determined, and will reflect on individual circumstances outside the macro level view.

This report can also be read in conjunction with, "Stressful Conditions For U.S. Commercial Real Estate Are Raising Refinancing Risks," published June 5, 2023.

Office Sector Under Siege

Capital providers (from borrowers to senior lenders) have a lot of variable parameters to consider in the years ahead, and especially during the next 12-24 months. In many ways, the number of "known unknowns" now exceeds those of past cyclical downturns, and office CMBS borrowers are likely facing their greatest challenge since the Great Recession.

Until early 2022, office properties were seen as a "refuge" asset class when compared to other property types such as lodging and retail, whose CMBS delinquency rates spiked to 20% or higher in the earlier part of the COVID-19 pandemic. Times have certainly changed. In the post pandemic era, office tenants are rationalizing their use of space to accommodate their "still evolving" work-from-home/hybrid model. Some tenants are giving back some of their space at lease renewal dates, while others are trying to sublet their space. As a result, office availability rates are creeping up across the U.S. and net effective rents are declining.

Environmentally friendly regulations are also moving forward, creating even more pressure for some class B and C office stock, which now face significant capital expenditure to satisfy the new standards. On the liability side of the spectrum, the cost of money has surged since March 2022 from historical lows, creating more stress in the form of the increased cost of capital and negative repricing effect on property market values. These challenges are also unfolding amid the overall macroeconomic context of an expected recession, inflation concerns, regional bank issues, and tech company layoffs--a stark reminder of the cyclical nature of commercial real estate (CRE).

Redistribution Is Likely

Equity repatriation was very much the norm until interest rates started rising a year ago. Now, the market is trying to figure out how much of the outstanding loan balance secured lenders can carry on their books, and how active mezzanine lenders and supportive property owners could fulfill the funding gap.

Office market values have been declining since their peak in first-quarter 2020, according to Green Street Commercial Property Price Index (CPPI) for office properties, and the cost of debt is becoming more expensive. Nevertheless, we believe that a property's intrinsic core value is still present when the property is of relatively high quality and well located, especially in infilled locations such as New York City where newer class A buildings still command rent premiums.

Our analysis shows that, based on the overall state of the market, a 40% drop in overall market value from initial valuation could cause office-backed loan balance to decline by one-third, in aggregate, due to skyrocketing LTV ratios. That is, borrowers could refinance about 67% of their outstanding secured office-backed loans (by balance, on aggregate) through similar channels--if they, as well as unsecured lenders, can cover the remaining piece (see chart 1).

With a calculated LTV of 94% on average (based on our imputed values), the actual bondholders risk profile is worsening because of obvious refinancing challenges. However, principal losses are not necessarily inevitable. As such, the risk mostly lies with property owners and less so with senior debtholders. Absent property-specific circumstances, we don't expect senior secured mortgage lenders to broadly experience principal losses on their positions, though this depends on functioning debt and equity capital markets. One in which actual and opportunistic borrowers could raise secured and unsecured capital when fresh equity is being deployed in good faith to secure financing (or refinancing, as the case maybe).

That said, value growth is more difficult to achieve in today's office market and will likely remain that way for some time, given the lower demand from office users and the negative pricing effect from higher interest rates. Therefore, it may be challenging for "new equity" to find suitable returns. This could lead to more assets changing hands if borrowers are unable to find consensus on loan modifications and/or extensions with existing lenders, such as when property owners are unable or unwilling to inject further equity when warranted.

Chart 1

Hypothetical Refinancing Risk Scenario

To determine the impact the CRE funding gap could have on U.S. CMBS transactions, we conducted a hypothetical refinancing scenario analysis using the 72 SASB transactions currently rated by S&P Global Ratings as a sample of the broader U.S. office-backed commercial mortgage market. Our analysis first focused on approximating the potential market values of the underlying collateral backing these loans using non-asset-specific public information. We did this by imputing property market value declines to the initially reported appraised property values, based on a combination of factors such as price indexation, cash flow performance, and estimated market cap rates (see table 1). We then applied a uniformed debt structure factoring leverage and coverage (see table 2).

Because our scenario analysis was not designed to be property or loan specific, it does not factor in individual property characteristics, their relative position in their respective markets, their singular strengths and weaknesses, the various loan maturity profiles, any eventual borrower support, or any actions that could be taken by the servicer (or special servicer) to protect bondholders' interest. We instead focused on a macro-level approach to estimate potential market direction and, therefore, purposely decided not to comment on any particular case from the sample.

Results

Under the parameters outlined in table 1, office values would contract approximately 40% on average from initial valuation. To give some context, the average implied net yield would increase to 7.2% (based on most recent full-year net cash flows [NCFs]) from 4.4% (based on the issuer's initial underwritten NCF at closing). This compares with Green Street's weighted average market cap rate of 8.7% for first-quarter 2023 for the 50 largest office markets in the U.S.

Using the uniformed lending matrix outlined in table 2, the scenario results show the following:

• 67.0% of existing office-backed mortgages could be refinanced via new mortgage loans, reflecting an average LTV of 58.9% and an average debt yield of 12.3%;
• 13.0% of existing office-backed mortgages could be refinanced via new mezzanine loans, reflecting an average LTV of 71.8% and an average debt yield of 10.1%; and
• These assumptions imply an equity effort of at least 20.0% to pay out the portion of the outstanding secured loan balance that cannot be refinanced by the mortgage or the mezzanine lenders with fresh equity injections.

Chart 2 illustrates the results of our analysis for entire sample pool, with some additional details on the three-largest exposures by state. For example, in New York, which has the largest exposure by number of loans, the aggregated outstanding mortgage loan balance would decrease by about 29% to $13.1 billion if national office values contract approximately 40% on average from initial valuation. This would translate into an average LTV of 59.2%, based on our imputed values and new financing structure, compared to the original average of 49.2%, which was mostly based on initial valuations (i.e., before the imputed value declines). From a cash flow standpoint, the average debt yield for New York would reset at a comfortable 12.2% from 8.6%.

Chart 2

We also examined the outstanding secured loans' sensitivity to change in market value (declines) and loan coupons (increases) (see table 3). We noted that, for example, if the loans were refinanced with a 8% coupon in a 50% market value decline environment, the outstanding secured loan balance could decline by about 44% on average, and thus likely need more equity support from the property owners.

Chart 3

Limitations

This analysis is meant to help market participants broadly assess the state of the office CMBS sector under various scenarios. The data presented are not deal specific but instead reflect the overall state of the market, which is based on a host of CRE-specific and macroeconomic factors. Therefore, any future rating actions would represent the outcome of a rating committee's assessment of individual office loan performance and market trends, including tenant rollover, lease expiration timing, and a borrower's ability to fill vacancies should they arise. Our ratings address timely payment of interest and ultimate repayment of principal by no later than the transactions' legal final maturity dates. The committee would also assess the likelihood of the rated loans being refinanced by their maturity dates.

Appendix: Recent Rating Actions

Below is a list of the recent rating actions S&P Global Ratings has taken on the SASB transactions secured by office properties as part of our surveillance process. Since 2022, we have taken rating actions on 32 of the 72 transactions in our sample, which resulted in 58 downgrades and 107 affirmations. There were no upgrades or withdrawals.