CREJ

Page 4 — Office Properties Quarterly — September 2020 www.crej.com Market Update A t the start of the first quar- ter, many in the commercial real estate finance industry felt the country was headed toward at least a minor national recession. This thinking was enhanced by an election year as well as global oil concerns, in addition to many simply feeling the time finally had come after a record expansion period. The out- look for Denver office, however, still was positive as record unemploy- ment, steady job growth and posi- tive office absorption persisted. It goes without saying that all of that has changed since March. On top of downward trends in occupancy and lease rates at midyear, the elephant in the room is now the question of how much office space compa- nies really will need in the modern world and how will that material- ize as leases come due and new spec buildings become available. Denver does have much going for it compared to other cities however. The silver lining to the pandemic might be that more companies now have flexibility to locate where they want, and for many that might just be right here in Denver. For office financing in Denver, the past few months have seen a flight to qual- ity, especially as Class A office has fared far better than B since the pandemic began. At the end of 2018, it seemed that rent growth finally was stabiliz- ing after seven years of significant run-ups. By second-quarter 2019, the office market went back on the upswing and kept on through the first quarter of 2020. Starting with the second quarter of this year, and likely to persist into at least the near future, absorption for office space metro- wide was down significantly. For the second quar- ter, there were two reasons for this: companies electing not to expand, renew or sign new leases due to the pandemic; and the fact that all of the new deliveries year-to-date were in the second quarter. Class A space has not been hit too hard, although many in the lending world fear a softening is inevitably com- ing. Class B space, however, already has seen a major decline in absorp- tion, losing nearly 500,000 square feet of occupied square feet in the second quarter, and much of that in the central business district. Lend- ers have gravitated toward Class A buildings since the spring as they tend to have more established ten- ants who are more likely to weather the storm. But Class A office build- ings are not without concern. There still is over 1 million sf of new Class A space under construction that has yet to hit the market in the CBD alone. When you combine this with fears of a prolonged reces- sion, continued negative absorp- tion/lease rates, and a trend mov- ing away from companies needing more office space, even solid Class A buildings must have a very robust rent roll and solid sponsorship to make lenders comfortable at the moment. A glimmer of hope does exist for office space demand in Denver however. The trend of tech com- panies moving more employees to Denver seems to continue with companies like Palantir recently naming Denver as its headquarters. The pandemic-accelerated work- from-anywhere environment seems to have made many companies reevaluate the real estate expenses involved with having all or the majority of their employees in a coastal market. Denver always has been favorable to tech and telecom given the location in the middle of the country combined with the lifestyle, and it should continue to bring companies here from the expensive coastal markets. The other good piece of news is the interest rate environment. Every index from Treasurys to Libor had fallen significantly prior to the COVID-19 lockdowns that began in March, which at that point fell off the cliff. Interest rates on office buildings regularly have been in the 3% to 3.5% fixed-rate range for 10- to 20-year nonrecourse debt since the second quarter. This has made it increasingly attractive to refi- nance, if possible, to lower carrying costs. However, this does become much more difficult if there are any perceived issues with a rent roll or if any tenants have been given rent relief during the pandemic. The only remedy in those situa- tions seems to be a lower leverage and more conservative approach. As this trend of uncertainty contin- ues for properties lacking a credit- oriented rent roll, I foresee equity, mezzanine and other forms of subordinate capital becoming more of a necessity in order to acquire and refinance these types of office assets. Many lenders were very open and willing to provide relief in the form of interest-only payments if not all out forbearance when the pandemic began. Now those relief periods are over or about to run out, and if situations with delinquent tenants haven’t been resolved, we will start to see far more delin- quencies than we have in the past decade. Certainly more capital will become available in the market as we see some signs of normality re- enter the world, whatever that ends up looking like. Until then, expect caution from capital sources on office unless you have the very best in terms of quality, location and tenancy. We still live in an attractive city for companies when it comes to lifestyle and talent pool. The trend of major companies moving or expanding here will help us weath- er this storm, but only time will tell what the office landscape will look like in a post-COVID-19, remote- working office environment. Capital sources continue to make loans on office properties, but are much more cautious than before the pan- demic and sustainability of tenants has become paramount. s Midyear update: The state of office financing Mark Jeffries Vice president, NorthMarq