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As Demand for Office Space Moderates, Some CBD Markets May Experience Outsized Loan Losses

A new report from Moody’s warns that about 23 percent of CBD office collateral included in CMBS loans is in weaker CBD markets.

Office assets in central business districts (CBDs) have enjoyed an impressive, eight-year run of robust demand and growth in both rents and valuations and are considered a low-risk bet for capital investment.

CBD office markets have benefited from the expansion of the co-working sector and a desire by millennials to live near where their work, as well as from empty nesters relocating to the cities from the suburbs, notes Stephen Shapiro, senior managing director of the New York capital markets and investment services group with Colliers International.

But as the market corrects, office assets in CBDs without a diverse economy or favorable supply-demand dynamics are at high risk for loss in values and loan loss severity , according to a new Moody’s Investor Service report.

Moody’s has created a red/yellow/green scoring system, which rates markets based on forward- looking supply-demand fundamentals, that has proven very accurate in the firm’s experience, according to Kevin Fagan, Moody’s vice president and senior analyst. “The market score at origination of a loan has been very predictive of loan performance in terms of default and loss,” he says.

Moody’s red and yellow markets have had outsized CMBS losses, with average loss severity greater than 50 percent compared to just 7 percent in green markets. As cap rates dropped into the 4 to 5 percent range in core markets, investors began shifting capital to higher-risk secondary and tertiary CBD markets with higher cap rates to obtain higher yields, Fagan notes. But when macroeconomics supporting the office sector shift, values in the weaker markets drop and loans backed by CBD office assets might perform more poorly than expected for a sector that’s generally considered very low risk.

A market’s score can drop into the yellow or red zone when economic factors supporting the sector deteriorate in combination with ample new construction , Fagan notes. In recent years Oakland, Calif., for example, had experienced extraordinary office demand as tenants moved across the Bay to avoid skyrocketing office rents in San Francisco. As a result, “Oakland had incredible new supply, but rents rose equivalent to San Francisco. Once rents normalize in San Francisco, and Oakland has excess supply, there is a strong likelihood for deep and lasting value declines in Oakland,” he adds.

Loan losses have been greatest in small CBD markets, averaging 48.9 percent compared to 23.0 percent for large markets, but property fundamentals matter most. The greatest office loan losses have been in red markets with low barriers to entry and excess new supply, such as in the Dallas CBD. Loan losses from the first quarter of 2005 through the second quarter of 2018 totaled nearly $1.4 billion. Of the 54 quarters included in that period, the Dallas CBD office market had 39 quarters with a red score, 15 quarters with a yellow score and an average loan loss severity of 52.8 percent.

A third quarter 2018 office report from real estate services firm JLL notes that the office market still has healthy occupier activity, but is moving toward more balance, with softness in asking rent growth and greater space options for tenants. With 37.7 million sq. ft. of new supply delivered in 2018, average vacancy increased to 15.2 percent, but new office development is slowing. Office developers broker ground on just 3.5 million sq. ft. of new space in the third quarter—well below previous quarters. Furthermore, nearly 85 percent of projects under way will be completed within the next two years, limiting longer-term vacancy and confining oversupply to select pockets, JLL researchers forecast.

Lack of economic diversity is another red flag for investors and lenders. “Houston ran into trouble on the supply side when the price of oil crashed,” Fagan notes. Shapiro agrees, saying, “There is high risk in markets where the economy is tied to one industry, particularly if it is a low growth industry like finance.” There is increased risk even in markets dependent on high growth industries like technology and healthcare, he says.

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In today’s environment, it can be difficult to predict which markets might deliver a great long-term performance, he adds.

“Unlike in the past, when the industry was the primary force driving market performance, today it is intellectual capital,” Shapiro says. “Universities are graduating a critical mass of talent that is focused on innovation. They are less inclined to move and [are] instead focused on building the next great thing in a city they love. This dynamic creates a young workforce that inspires economic momentum and diversity.”

He notes that, for example, a major old-line company headquartered in Cincinnati, a city with significant educated talent, encourages vendors and potential vendors to find offices nearby. As a result, a number of entrepreneurial ventures have emerged to serve the company, creating market momentum and improving office absorption in Cincinnati.

“In today’s market, new companies are helping old companies innovate, creating momentum in places we didn’t expect,” Shapiro says. “With a renewed focus on urbanization, the co-working and co-living platforms have provided the engine for this growth. From a capital markets perspective, some of these markets aren’t as risky as they may seem. In fact, some of these markets actually provide the ideal investment thesis as investors are able to invest in markets witnessing a growth trajectory.”

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Reading the Texas Tea Leaves: Will Lenders Abandon CMBS Refinancings Tied to the Energy Sector?

By Andrea Bryan, Managing Director

As oil prices skid to levels not seen since 2009, the prospects for refinancing commercial mortgage-backed securities (CMBS) loans to assets in the oil patch take on new meaning. Of the nearly $300 billion in CMBS loans that come due between 2015 to 2018, nearly $7 billion are secured by commercial real estate properties located in Texas, Oklahoma, North Dakota, and Louisiana, according to a review of data from Trepp LLC. The loans were originated between 2005 and 2008, and the 2007-2008 vintage was originated at the height of the most aggressive lending boom of the last decade.

Many of these assets were susceptible to default due to the aggressive leverage and more conservative current lending standards, but the impact of lower economic performance due to declining oil prices will put additional stress on their refinancing prospects. Market participants point to abundant capital available to refinance legacy CMBS loans, but the willingness to lend to the energy sector amid a slump in energy prices will depend on market perception of the depth and breadth of any downturn.

Short-Term Jitters

The market is already on edge, exemplified by two major Houston office buildings recently pulled from the market due to market conditions or buyer withdrawal. On the other hand, the newly constructed JW Marriott hotel in Houston was able to secure financing of $115 million for the 328 room property, according to a report in Commercial Real Estate Direct. Moreover, a recent report by the Dallas Fed noted that there is a slight pull-back in hiring and some drop-off in leasing activity in the commercial real estate sector in Texas.

Among the major assets up for refinancing are The Houston Galleria’s $800 million of debt. The loan matures in November 2015. The Galleria is a well-known destination center and while it is likely to face competition from a newly constructed retail center, it has performed well. With a 70% LTV and a debt yield in the 7% range, it should have no problem securing refinancing. The same goes for Houston’s One City Center’s $70 million loan, which matures in August 2015, and Fort Worth’s Burnett Plaza’s $114 million matures in April 2015, as their tenants are diversified with leases that extend beyond the next few years.

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We expect these types of core, well-positioned assets located in Houston, as well as the Dallas CBDs and submarkets, to remain competitive. While still energy-dependent, both cities’ economies are more diversified than they were in the 1980s. More importantly, they are likely to benefit from the global hunt for yield as investors reach into secondary markets for compelling values. Strong property assets are producing returns that are more than double the yield on 10-year U.S. government treasuries. After double-digit increases in commercial property prices in gateway cities over the last five years, many investors have been priced out of those markets and are seeking better opportunities in non-gateway centers.

Exposure to Energy Tenants

Beyond the high profile and core assets, there are several loans to watch, primarily because many of their tenants are concentrated in the energy sector. We expect service companies will be the first to bear the brunt of any cost cutbacks, with mid-size producers and drillers also looking to reduce expenses as they ride out the downturn. While a true assessment of the impact of sliding oil prices will not be seen until after the second quarter, a review of assets secured by loans that mature over the next three years identifies exposure to some key concentrations.

Among the high profile loans are Houston Two and Three Allen Center as Devon Energy is a major tenant of both assets. The firm occupies 10% of Three Allen, which is secured by a $157 million loan that matures in 2016, and leases 52% of Three Allen Center, which is secured by a $191 million loan that matures in 2020. Devon also occupies 36% of Corporate Tower, which is located in Oklahoma City and is secured by a $13 million loan that matures in August 2016. Any expense reductions that include space consolidation could have an impact on these assets. The prospectus of Two Allen notes a reserve for re-leasing of Devon’s space if the tenant departs. Northborough Tower, 98% occupied by Noble Energy, has an $18.8 million loan maturing in January 2016. Apache Corp. and SEM are the major tenants in Two Warren Place, a $36 million loan that matures in 2018. The loan was originated in 2011 and is about 50% occupied by energy-related companies. The $115 million CityWest Center loan matures in 2016 and is undergoing re-leasing activity following departure notices from Halliburton and BMC Software, which occupied about 90% of the space.

Struggling Retail Face New Challenges

Lower energy costs are a boon for consumers, but in areas dominated by energy and energy-related industries, the benefits of lower prices may not be enough to offset the impact of concentrated job losses. As a result, we can expect struggling retail assets to face additional challenges in refinancing loans that mature over the next 14 months. The $30 million loan to Williams Trace Center in suburban Houston matures in July 2015. According to Trepp, recent financials show DSCR at 1.0x and 88% occupied. Arrowhead Mall in Muskogee, Okla., is secured by a $16.9 million loan that matures in March 2016. The center has lost its theater, which filed for Chapter 11 bankruptcy, and Sears recently announced that it was leaving the center. In addition, Collin Creek Mall in Denton, a suburb of Dallas, was caught up in the General Growth bankruptcy filing in 2009, and saw Dillard’s depart last year. According to servicer notes from Trepp, the borrower has already stated that it cannot meet debt service and will default on the $58 million loan. Killeen Mall, in Killeen Texas, is secured by an $82 million loan, maturing in 2017. According to servicer notes from Trepp, occupancy has increased from 70% in 2009 to about 90% in 2013. With a debt yield of 8%, this asset is on the borderline of refinancability.

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The following table highlights several non-core assets secured by loans that mature over the next three years.

Using debt yields as a preliminary screen for refinancability, there are several loans with current debt yields below 9%. (The 9% threshold does not apply to trophy assets and major CBD core assets that typically are attractive in the 5%-6% range. In addition, some lenders are willing to finance good retail and multifamily assets in the 8% range.) Many of the loans fall below the $10 million mark, a key threshold that market participants believe will struggle to secure financing. While there has been an increase in the number of lenders targeting the $5 million to $10 million range, today’s more conservative lending standards will cause many loans to fall short. In addition, any increase in interest rates will put additional pressure on the refinancing prospects.

Boomtown Shakeout

Across the Midland-Odessa and Laredo, which are located in the Permian Basin and Eagle Ford regions, respectively, approximately $139 million in loans mature through 2018. To date, most of the assets have been strong performers and all have debt yields that far exceed 9%, based on the most recent financials reported by Trepp.

Williston, N.D., the home of the Bakken formation and the biggest beneficiary of the recent energy boom, has three assets that were originated in 2013 and mature in 2018. All of the loans are secured by multifamily assets and, depending on the extent of the oil market slump, are most susceptible to default. Moreover, the $30 million Roosevelt Apartment loan was built for individuals and corporate tenants of ND Contract Services, Bakken Contracting and RHR Construction, according to the deal’s prospectus. It is very likely that residential home construction, home sales, and construction in general will be delayed in the short term in North Dakota, where the firms have business concentrations.

Over the past two years, some $114 million of loans secured by multifamily and hotel assets in the Williston area were pooled in CMBS 2.0 and 3.0 transactions. Any prolonged downturn that results in a halt or slowdown in drilling operations will cause these assets to struggle to service their debt.

Watching the Lodging Sector

The hospitality industry will provide the first indications of stress. Performance to date is strong, and there are few hotel loans that need refinancing in the next year or so. In Williston, some 1,200 rooms have come online since 2010, and the ability of the market to absorb all of this supply in the face of declining energy prices and an ensuing drop-off in business demand will be a challenge. We believe that the next six months will be an indicator of the impact on revenues and net operating income.

But Liquidity Abounds

While the outlook may seem uncertain in the short-term for refinancings in the sector, there is significant liquidity available in the property markets. Unlike the 1980s when much of the capital for property financing was centered in the regional banking sector, today’s capital flows are global. Over the past five years, CRE investments were concentrated in gateway cities, which drove prices in those markets. While still attractive to global investors, many have begun looking elsewhere for better returns. And it is here that energy sector refinancings may find some support. We expect that many of the assets may turn to bridge loans to ride out any short-term instability; and over the long term, the more patient capital will take advantage of any value degradation and benefit from increases in values by the end of the decade.