Alternative lenders are eyeing office property loans amid interest rate hikes
Pressure of bank lending tightening is transmitted to the liability side of office properties.
Although the current economic situation is still far different from that of the 2008 financial crisis: Firstly, the collapse of small banks can be attributed to the investor withdrawals, which were caused by the devaluation of bonds they hold in the context of interest rate hikes, not because of the poison assets. Besides, the impact of commercial office loans on the overall banking industry is also relatively limited, according to UBS data, office loans constitute less than 5% of total bank loans in the United States. Furthermore, since the 2008 financial crisis, banks have adopted stricter loan standards and diversified their customer base, which has bolstered their ability to withstand risks.
It seems the probability of a systemic financial crisis in the banking sector is not yet a serious concern, but the bankruptcy of small and medium-sized banks can lead to more conservative lending standards and higher credit spreads, aggregating the debt-funding gap in the real estate industry. According to data from Trepp Inc., approximately $80 billion of commercial real estate loans for office properties held by banks in the United States will mature in 2023, and the financing gap for the United States office sector is estimated to reach $52.9 billion during the period of 2023-2025 by CBRE. The situation in Europe is not much better either, as stated in the report by AEW research, which estimates a debt-funding gap of approximately €51 billion in the UK, Germany, and France during the years 2023 to 2025. Besides, the declining property value forces office investors to refinance at lower loan-to-value (LTV) ratios, further challenging the financial conditions of the office sector. Recent data already indicates the decline in commercial mortgage activities in the United States.
Figure 1:Debt-funding gap in UK, Germany and France will reach 51 billion during 2023 and 2025, Unit: billion euro， Source：AEW Research &Strategy.
Figure 2: Debt-funding gap in the U.S. will reach 52.9 billion during 2023 and 2025, Unit: billion dollars，Source：CBRE Econometric Advisors.
High-interest rates accompany the high returns of real estate debt, and the contraction of bank lending to the real estate sector presents an opportunity for alternative lenders
Is it necessary to fill the financing gap in the office sector? Let's start by considering the importance of office buildings. From the user’s perspective, firstly, people always require space for face-to-face collaboration. Moreover, the demand for office space is not solely dependent on the average or the lowest vacancy rate per week but instead on peak demand, such as the vacancy of those work-intensive days like Tuesdays and Thursdays, which show us a less pessimistic picture of the office market, these facts may indicate a long-term existence of office demand. From the investor's standpoint, office buildings are still an important asset class for portfolio diversification, besides, even if the assets are underperforming, it's unlikely for institutional investors to sell those immediately, but may seek to recover losses by transforming/restructuring spaces to meet trending demands, such as creating flexible and sustainable office environments, which will also boost the office properties continue to be a long-term participant in the market.
But how to fill the financing gap for office spaces? Due to the Basel IV regulations, banks are not allowed to extend or pretend their commercial mortgage loans, which will increase the demand for mezzanine debt and provides investment opportunities for fast lenders. A recent report by LaSalle highlights that alternative lenders in the European market view office property debt investment as a huge opportunity for counter-cyclical investment: Europe not only represents a trillion-euro market, but also has substantial risk-return potential, which benefits from the rise in benchmark interest rates and widened credit spreads. CBRE indicates that the decline in the issuance of subordinated debt could also be an indicator that debt investors in Europe are holding back and waiting for opportunities. Investor Intentions Survey in the U.S. by CBRE also shows the U.S. investors’ consensus on this issue.
Sustainable properties receiving growing attention from lenders, but the shift in preference is not created by the pandemic, rather just accelerated
The demand for sustainability in economic activities and the decarbonization of buildings is a prevailing trend. But wanting to attract employees back to the office from their comfortable homes in the post-covid era, does make the company and investors have a more evident preference for high-quality and sustainable office properties than before. Borrowers also notice these phenomena and consider the sustainability of properties when selecting lending projects. This is not only just driven by borrowers' commitment to social responsibility, but also betting on the future winners of the office market: Although they know in the short term, the additional facilities in green buildings may incur a higher operating expense and higher initial investment costs, lenders believe that these office buildings will be the survivor in the future. "Lenders are avoiding lending money to buildings that will be outdated in 10 or 20 years,". says Natalie Howard, Head of Real Estate Debt at Schroders Capital.
Under the dual impact of remote work and borrower preferences, the divergence of office performance between high-quality and those inferior ones may be further exacerbated.