The office market is in trouble. Lower interest rates might not be enough to save it.
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- Fed rate cuts will make it slightly cheaper to refinance commercial mortgages.
- Yet, it'll still be tough to convince banks to keep lending to offices facing weak demand.
- Offices have struggled as hybrid work persists and companies reassess how much space they need.
Offices have been the weak spot in the commercial real estate market since the pandemic gave rise to widespread remote work and caused companies to reassess how much space they need.
With $1.5 trillion in commercial real estate debt set to mature by the end of next year, questions have arisen about office owners can do to get loans either refinanced or extended in the face of widespread vacancies.
The Federal Reserve's likely interest rate cut, expected at the end of its meeting on September 18, could give office owners some relief with lower interest rates when they refinance.
But that doesn't mean they're in the clear, according to commercial real estate experts.
Given Fed easing, office owners may be more likely to get loans extended, according to CRE Finance Council executive director Lisa Pendergast.
"When you extend a loan, what you're doing is giving that borrower time to, one, stabilize their property, and perhaps also, knowing that the Fed at some point was going to move and ease rates, that when they start doing that, it will make the refinance that much more palatable," Pendergast said.
Pendergast added, though, that the key for office owners to actually get their loans extended is to prove they will be able to stabilize assets in coming years. That likely won't be easy, considering office vacancy rates rose to 18.1% nationally in July, according to data from CommercialEdge.
"The values of the assets are going to increase as [vacancy] rates decline, assuming all else equal," Pendergast told Business Insider. "But if the cash flow in that property can improve over time, it's going to end up being very much a dividing line" between "the haves and have nots," she added.
Owners of offices that can show improvement in occupancy and rental rates—likely newer offices with higher tech offerings—will likely see greater success getting loans extended, and fare better than older office buildings.
"All of the technology that you need in an office today weren't required back in the 40s," she said, adding, "You could see this as sort of a changing of the guard situation."
Some investors may be able to buy those properties for cheap. CommercialEdge data shows that of the offices sold since the start of the year, 28% went for less than the building was purchased for, up from 18% last year.
Which offices are able to escape a potential coming wave of distress depends on the length of leases they're able to get tenants to sign on for, according to EisnerAmper head of real estate Lisa Knee.
Before the pandemic, companies wanted an office space with a 10 or 15 year-long lease, Knee told Business Insider.
"We're seeing a lot of three to five to seven year leases now in offices, which again changes the value of the building, changes the desirability for people to lend money," Knee told Business Insider. Those shorter leases make banks less likely to lend money, she said, as the long-term stability of the cash flows dwindles with more frequent turnover of tenants.
Right now, most commercial real estate loans come from small, regional banks, but that could change.
"It's just not going to be sustainable to have the number of these regional banks, and the number of them in the marketplace, to lend to commercial real estate. So there will be bigger banks or bigger institutions coming in and taking those loans off of their balance sheets," Knee said.
Yet even with the weakness in the office market, lower interest rates are a net positive for the industry, economist Richard McGahey says.
Adapting existing office buildings to apartments is often touted as a one-size-fits-all solution to the sector's troubles and the US housing shortage, but there's a wide array of associated costs, in addition to zoning issues — but cheaper borrowing costs will likely make office space conversions more feasible, McGahey said.