One of the hottest global real estate talking points - US offices - is back in the conversation as CBRE publishes an update to a 2022 study that suggested a big "funding gap" exists in the sector.
The agent found in December 2022 that the cumulative funding gap for offices had reached $52.9 bn signalling distress is coming as well as a good opportunity for mezzanine debt providers.
But based on more recent data, it now says the gap is even wider than it first predicted, standing at $72 bn as increased pessimism for the asset class takes hold.
What gap?
CBRE explains that commercial properties face “funding gaps” when investors are forced to refinance at a loan-to-value (LTV) ratio lower than the one at which they first borrowed or when the value has fallen since the loan was originated.
The US office sector faces a large aggregate future funding gap in the near-term due to lower LTVs and substantial value erosion.
Between 2023-2025, the agent forecasts office owners will face a financing gap of $72.7 bn, with 26.4% of the lending volume originated in 2018-2020. This will likely lead to distress for some property investors and force others to inject more cash into their properties.
CBRE gets its figures by combining sector-level origination data from the Mortgage Bankers Association, average LTVs and terms from CBRE-brokered commercial mortgages and expected changes in values.
To understand the debt-funding gap, it provides a working example.
Consider a theoretical office building worth $100 mln in 2019. By 2024, the agent expects the value of the property to have fallen by 29% to $71.2 mln.
With a constant LTV of 72%, the property owner could expect to borrow $51.3 mln against it. So far, this would create a debt-funding gap of $20.7 mln ($72 – $51.3).
It is important to note that at this stage the owner’s equity is already completely wiped out. However, once the lower LTV of 57% is used, the property owner can only borrow $40.6 mln.
Together, the combination of expected value decline and lending conditions means this building will experience a debt-funding gap of $31.4 mln by 2024 ($72 – $40.6). This means that a capital structure that initially consisted of $28 mln of equity (72% LTV) will be left with no equity in the asset and will have to contribute 43% of the new asset value in new equity to refinance.
Worse
CBRE carried out its original analysis in 2022, but things have worsened since then. So far in 2023, lending conditions have become tighter with lower LTVs across all commercial real estate sectors.
Due to large, expected value declines, the office sector has the largest funding gap by far at approximately $38 bn during 2024. Retail is next at $2.8 bn – a small figure comparatively. Due to significant value appreciation, industrial does not suffer from a funding shortfall and the gap for multifamily is negligible.
The large gap for the office sector suggests some distress will be forthcoming, argues CBRE: ‘We also expect the demand for, and volume of, mezzanine debt to increase making this a good opportunity for nimble lenders. Otherwise, investors will be forced to add more equity through cash infusions.’
It added: ‘Between 2023-2025, we expect the cumulative debt gap to reach $72.7 bn for the office sector.’
Borrowers facing a potential refinancing gap may pursue additional equity or mezzanine financing to pay off the existing loan. In addition, they may negotiate a discounted payoff with the lender, or an extension of the loan term if property income conditions are likely to improve.
‘Ultimately, some borrowers may be forced to default.’
