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  • Writer's pictureMAREJ

Precarious Office Market Poses Risks

Today’s office market poses a number of risks for tenants. Office landlords today are frequently tight on cash and have limited ability to pay for major tenant improvements. Couple that with the high cost of construction and you have a recipe making it challenging for tenants to renovate or relocate when major improvements are required.

In typical market conditions, landlords demand to see a tenant’s financial statements before underwriting the risk associated with the lease transaction. Now, however, we are in a market where it’s essential that the tenant understands the landlord’s financial condition: How healthy is the landlord’s capital stack? What is their loan to value (LTV), debt service coverage ratio (DSCR), and loan maturity date? Is a landlord’s debt at a set interest rate, or is it floating and subject to interest rate fluctuations? With a near-term loan maturity, are the loan extensions defined or achievable? Is the current lender willing to refinance, given many lenders are redlining office building loans and trying to reduce exposure to the office market?

Tenants committed to providing offices for their employees are retrofitting to create an environment conducive to how employees work today. Employers are increasingly focused on a workplace strategy that encourages collaboration. Workplaces require numerous conference rooms, small huddle rooms, casual soft seating and plug and play space where today’s mobile workforce can drop in and collaborate with their teams. Employers are getting away from providing dedicated offices, as increasingly employees do independent work tasks at home or out of the office. Renovating older traditional space is expensive and many landlords are tight on cash.

Construction prices have not eased as material pricing and labor costs have not dropped, despite lower inflation rates. This has created a capital environment that’s very challenging for employers to create the offices they desire.

Tenants interested in relocating are increasingly studying prospective landlords’ financial health to ensure they have the capital to fund improvements and operate the office building in a first-class manner. Tenants entering the market are smart to qualify a prospective landlord’s financial health.

Requests for proposals now frequently include provisions for landlords to disclose their DSCR.

Tenants should focus on buildings where the DSCR is 1.20 or better. However, many lenders are requiring borrowers to set aside reserves for capital improvements, tenant improvements, and loan reserves. These requirements can reduce the DSCR and put a cash strain on the landlord. These factors need to be understood by prospective tenants.

Tenants should also study a prospective building owner’s LTV. A high LTV indicates the loan is high relative to the value of the asset. A low LTV indicates the loan is low compared to the overall value of the asset and is a healthy condition for an office building and its owner. Today we are seeing many buildings under water, meaning the loan is higher than the value of the asset. This is an untenable condition and creates a precarious scenario, whereby the landlord may not be able to refinance without coming to the settlement table with extra cash. In today’s market, we are seeing landlords, handing the keys back to the lender when unable to refinance. Tenants want to avoid these buildings as the lender will look to cut costs, reduce services, and postpone repairs and maintenance. This in turn can begin a long slow death for an asset where existing tenants look to relocate and prospective new tenants select other healthier assets.

Today’s office market poses many risks. Tenants are smart to hire experienced brokers and consultants who can navigate these waters, have the wherewithal to study the financial health of the existing landlord, and can carefully evaluate prospective buildings prior to signing a lease obligation.

Todd C. Monahan is executive vice president & managing director at WCRE | CORFAC International.


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