With inflation at 40-year highs and interest rates at 14-year highs, we see the impact personally and to the overall economy, but how does this impact office tenants? Outlined below are the key areas where tenants as well as landlords are being impacted. I also offer some strategies to address these challenges
The Federal Reserve is using its primary lever of increasing the federal funds rate to reign-in inflation. While many argue that they were too late in doing so, this is the unfortunate reality that we are living in today. With over a decade of the Federal Funds Effective Rate being near zero, whenever there is a lot of cheap debt, asset prices become distorted.
Today’s interest rates, however, are a bargain compared to what they were in 1980 where they were approaching 20%. As interest rates peaked in 1980, so did inflation at 13.5%. While inflation peaked at 9% this past June, it remains stubbornly high.
- Rising Interest Rates & High Vacancy Devalue Office Buildings. Debt is a key ingredient in office building investing. Typically, the debt is short term and interest only. The objective is to either refinance or cash out before the debt matures. For the past decade, there was strong demand for commercial real estate investing given the low interest rate environment and as a result, debt was cheap which led to oversupply. The oversupply is particularly evident today in the era of remote work and where many office buildings are barely above 40% occupancy. As reported by The Wall Street Journal on October 31, 2022, Rising Interest Rates Threaten to Expose Office Buildings’ Inflated Values – WSJ
- Effective Rents Down 16% & Values Up 91% since 1997 That article contains an insightful chart tracking office building prices and effective rents in the top 50 national office markets since 1997 revealing a striking dichotomy between effective rents and building sales prices. Over this period and adjusted for inflation, office rents fell by 16%. However, fueled by cheap debt, over this same period office-building sale prices increased 91%.
- The Face Rate Fiction The building valuations have also been boosted by a dirty little secret in the office leasing industry to “preserve the face rent” so that the rent roll supports a higher valuation. Owners engage in this fiction of signing leases for their target rent pro forma, but to be palatable to tenants the economics are heavily watered down by concessions from free rent and cash allowances where tenants can use that cash to pay their rent.
- Pursuit of Yield Several years ago when the office market was very strong, investors had a simple choice. Conservative bonds such as US Treasury 10-year bond yield was 2% as the Federal Funds Rate hovered around 0%. A well-occupied office building with strong fundamentals would yield 4% to 5% or more. With the rise in the Federal Funds Rate, the tables have turned. Today, US Treasury 10-year bond yield is around 4%. As today’s investors can earn 4% on ultra-safe US Treasuries, why would they invest in risky office buildings for the same yield?
- Market Value Re-Set As landlords look to re-finance with higher debt costs coupled with high vacancy, office building valuations will fall from their artificial peak. Landlords looking to refinance an office building with high vacancy and with today’s high interest rates are faced with a no-win situation: either add more equity to the building or walk away from the building. According to this WSJ article and Trepp LLC, in 2023 more than $17 Billion in mortgage bonds are maturing nationally. That is significantly more than $7 Billion this year and $4 Billion in 2021. In the process, we are seeing and will continue to see owners of distressed office buildings simply hand the building keys to the lender as most commercial real estate loans do not involve any personal guarantees. Lenders will be forced to sell the buildings at a significant discount in most markets which will drive down valuations.
- Landlord Due Diligence Just as owners scrutinize the financial health of prospective tenants, tenants and their representatives should likewise scrutinize their current and prospective landlords.
- Rent. The good news for tenants is that their rents will eventually go down. Getting there, however, may be a bumpy road. Tenants should check to see if they have a Nondisturbance Agreement to safeguard their lease. See our post, Plugging the Lender Loophole: Tenants need Nondisturbance Agreements – Blackacre Advisors LLC
While most office leases have set annual increases in the base rent, e.g., 3%, some leases have the rent tied to the Consumer Price Index. If the latter, tenants may want to revisit their occupancy budgets. As leases are typically 5 or 10 plus year commitments, when your lease faces expiration, will your landlord look for another form of rent escalation that is aligned with inflation? To safeguard your interests and as most office markets are very tenant favorable right now, tenants should negotiate a set rent schedule to avoid any surprise increases.
- Operating Expenses & Taxes. Many tenants will be getting an unexpected bill from their landlords for increasing costs of operating the building. Just as we personally are impacted by inflation, the costs to run an office building are no different. To mitigate the rise in operating expenses, tenants are well advised to: (a) define an all-inclusive list of items that the landlord cannot charge to tenants as an operating expense or tax; and (b) obtain a cap on increases in expenses which is typically defined as “controllable expenses”. With inflation continuing to rise, savvy landlords will be reticent to offer any such cap; but, with most markets being tenant favorable, there should be some room for compromise. For more ideas on limiting operating expenses and taxes, please see our post, Limiting the Hidden Costs of Office Rent: Operating Expenses & Taxes – Blackacre Advisors LLC. Some good news for tenants, as explained below, they may see a drop in real estate taxes if their building’s valuation drops. On the flip side, however, lower tax bills mean lower tax revenue for municipalities which for some can be as much as 10% of revenue. This leads to downgrading municipal bonds as reported December 13, 2012 in The Wall Street Journal Article, Shrinking Office Building Values Are Becoming a Dilemma for City Budgets – WSJ
- Tenant Improvement Costs. As you may imagine, the costs of construction continues to climb given cost and scarcity of materials. While labor costs remain high, the slowdown is making some contractors more motivated to accept new projects. That said, it is not uncommon in major markets like Chicago to see interior construction costs for a modest office space exceed $100/sf.
- Revise Lease Analysis Assumptions. Once we saw inflation spike, we adjusted our cash flow analysis model assumptions to assume increases of expenses and taxes to be at 5% or more depending upon the location and client. Previously, we assumed annual increases of 3%.
Don Wenig
Blackacre Advisors LLC
info@blackacreadvisors.com
312-345-4778
DISCLAIMER. Our writings are from a real estate transaction perspective and for informational purposes only. Nothing herein shall be considered legal, accounting, tax, or architectural advice. Please consult with the appropriate professional(s).