CREJ - Office Properties Quarterly - December 2016
The election of Donald Trump and signs that the country may be heading toward an inflationary environment have resulted in a massive sell-off of government bonds, creating a temporary (hopefully) disruption in the capital markets. As we’ve written in past articles, the reactionary nature of the capital markets to geopolitical events has been exacerbated by the real-time flow of information from all corners of the globe. The selloff has driven yields on the 10-year Treasury from 1.83 percent on Nov. 7 to 2.39 percent on Dec. 5. The 50-plus basis point increase has sent interest rate coupons on commercial real estate loans skyrocketing with lenders scrambling to understand what will be the “new normal” for bond prices in order to benchmark spreads for the time being. Denver’s office market has performed well since 2011 with over 6.5 million square feet in positive net absorption and well over $10.5 billion in investment sales volume in the same timeframe. Lenders and investors alike view Denver as a solid office market due to low unemployment rates and the increasingly diverse tenant base. The majority of investors acquiring office buildings in Denver have utilized short-term, floating-rate loans from banks to execute their business plans, which involve value creation by repositioning and leasing up the asset. Though lacking the interest rate protection of a fixed-rate loan, 30-day Libor – the most common index for these loans – has moved only about 40 to 45 basis points from +/- 0.20 percent to approximately 0.65 percent over the last couple of years. The result has been effective interest rates in the low 2 percent to mid-3 percent range, typically with an interest-only component, which creates healthy cash-on-cash returns and helps to manage coverage ratios during transition. Floating-rate loans also offer the ability to lend “good news” capital toward tenant improvements and leasing commissions that are accretive to the building’s value on a capitalized basis. Banks have been the most abundant sources of floating-rate capital, although there has been a slight pullback due to increasing regulations and exposure issues as we move further into the current cycle. Banking regulations have introduced classifications such as highly volatile commercial real estate that aim to limit exposure to riskier projects. At this stage in the cycle, ground-up construction financing is as challenging as it has ever been to obtain without significant preleasing, lower loan-to-cost requests or personal guarantees. The benefactor of the recent hurdles in the banking space has been the independent bridge lender category commonly known as debt funds. Similar to equity funds raised for the purchase of real estate, these groups raise capital from various sources to fund loans for transitional properties. The lack of regulations in this space allows these lenders to offer high loan-to-cost ratios (sometimes in excess of 80 percent), generous interest-only periods and the ability to pursue nonstabilized (sometimes vacant) properties, all on a nonrecourse basis. The premium is made up by charging spreads that typically are 100 to 175 basis points wide of banks with effective rates in the low 4 to 5 percent range. The typical structure, similar to bank loans, is a three-year term followed by two one-year extensions. Beyond the initial funding, debt funds typically lend additional dollars, covering up to 100 percent of the “good news” capital for tenant improvements and leasing commissions and, in some cases, will contribute to a capital budget. The sweet spot for these lenders typically is above $20 million. Long-term, fixed-rate debt is much less common in the office space since hold periods for office typically range from three to seven years. The two main lender categories in this space are life insurance companies and commercial mortgage-backed securities. Life insurance lenders generally are in high demand because of their favorable loan structures, low interest rates and prepayment flexibility. Most of the life companies have specific allocation targets each year and can afford to be picky, especially in recent years with an abundance of activity in a strong market. With more adversity to risk, life companies typically shy away from suburban office with the exception being Class A assets with strong, staggered rent rolls. Life companies favor core assets in high-barrier-to-entry markets like the central business district, specifically Lower Downtown/ Union Station, Cherry Creek and Boulder. CMBS lenders create opportunities for more leverage-sensitive investors and can offer lengthy interest-only periods that help maximize cash-on-cash returns. The Denver office market has had a strong run over the last five years and is still a favored market for lenders. Some of the perceived threats in the market are easily overcome with an appropriate amount of research, especially when comparing present-day Denver to its past. Once considered heavily dependent on energy-related jobs, Denver’s economy has diversified over the last 30 years to the point that oil and gas related jobs only use approximately 5 percent of metro Denver’s office space. While a large concentration of this space is downtown, the recent turn in oil prices suggest that the worst is behind us. Colorado’s unemployment rate sits at a healthy 3.5 percent with an additional 63,400 jobs expected to be added in 2017, according to the Colorado Business Economic Outlook from the University of Colorado Boulder. In the wake of the Great Recession, people have focused less on following their jobs and more on location based on quality of life. Employers have followed suit, relocating and expanding in the Denver market to tap into an exceptional, highly educated and abundant labor pool. Denver’s office market likely will continue to perform well over the next couple of years because of the improved fundamentals.