KBRA Places 50 Ratings Across 12 Single-Borrower Office Transactions on Watch Downgrade
21 May 2024 | New York
KBRA is placing 50 ratings across 12 commercial mortgage-backed securities (CMBS) single-borrower (SB) office transactions on Watch Downgrade due to the potential impact of ongoing deterioration in the office sector amid weaker office fundamentals (see Figure 1 and Figure 2). The Watch Placements follow our evaluation of 42 KBRA-rated CMBS SB transactions that are secured by office properties to determine transactions that may need rating adjustments based on their ability to continue to service their debt and/or obtain refinancing when the loans mature. The underlying loans have maturities between now and 2028 and are more susceptible to defaulting on loan payments and/or refinancing challenges if their sponsors do not infuse equity into the loans. They are generally characterized by one or more of the following: low or declining occupancy, low KBRA debt yield (KDY), high KBRA loan-to-value (KLTV), low KBRA debt service coverage (KDSC), or high lease turnover during their terms or shortly after maturity.
Of the 12 securitizations placed on Watch, eight are collateralized by Class A office buildings in Manhattan and four are secured by portfolios of office properties in other cities or markets. Eleven of the loans are current in payment, while three are specially serviced, including one that is delinquent. Eleven of the loans already had KBRA Performance Outlooks (KPO) of Underperform, and five were also identified as KBRA Loans of Concern (K-LOCs). In conjunction with the current Watch Placements, we are revising the status of the remaining loan to Underperform and remaining loans to K-LOC. Two of the 12 transactions were previously downgraded.
KBRA will continue to monitor the transactions and loan performance and will seek to resolve or update their Watch Downgrade status within 90 days.
Office Sector Faces Continued Deterioration and Uncertainty
Buffeted by weak demand, rising vacancies, lower valuations, and high interest rates, the office sector continues to face strong headwinds. Uncertainty about future office demand remains high with the prevalence of hybrid and remote work and many tenants rethinking their space requirements. Since Q1 2020, the national office vacancy rate has increased 6.7 percentage points to 19% in Q1 2024, according to CBRE. Effective rents are under pressure, as many landlords are forced to offer generous concessions to retain or attract tenants. For example, concessions as a share of lease term in Manhattan have climbed to over 25% in 2024 from just over 15% in 2015, according to Avison Young, a global real estate advisor. In addition, it appears valuations for distressed assets have not yet hit bottom, even for higher quality buildings in major markets. Green Street reported that values for office properties are down 16% over the past 12 months (as of May) and have fallen by about 37% from their recent peak. Moreover, although newer Class A properties built since 2010 are faring better than their Class B/C counterparts, they have not been immune to the effects of slack demand and lower property values.
The special servicing rate for office loans in KBRA-rated CMBS has continued to rise, reaching 11.5% in April. Properties with significant near-term lease expirations will be more directly exposed to these stresses. Lending standards for new office loans have tightened considerably, and the refinance interest rates for maturing loans will in most cases be higher than their existing rates. Therefore, borrowers with loans approaching final maturity may face refinancing challenges. In addition, some borrowers who might otherwise be able to obtain financing may seek extensions to avoid higher debt costs, which could lead to transfers to special servicing. KBRA anticipates a higher office delinquency rate and more transfers to special servicing of loans secured by certain office properties over the next 18-24 months.
Watch Placement Determinations
In determining the Watch Placements, KBRA reviewed each of its 42 SB transactions backed by office buildings, focusing on factors that could result in higher term default risk such as low or declining occupancy, high near-term tenant rollover risk, and low term KDSC. We also considered factors that could lead to increased refinance risk, such as near-term maturity, weak or deteriorating cash flow, high lease rollover risk after maturity, low KDSC based on assumed refinance interest rates (KDSCm), low KDY, and high KLTV. We used KBRA net cash flow (KNCF) from the most recent surveillance review for each loan to determine the KLTV and KDY and to calculate stressed KDSCs based on a hypothetical refinance interest rate of 7.50%, regardless of whether the loan’s rate is fixed or floating. The KNCF may differ from servicer-reported net cash flow, as KBRA uses the current leasing information at the time of our review, considers long-term property operating performance, and adjusts for market vacancies and near-term lease expirations. We also considered the property quality and office market conditions in which the property is located.
Key elements of the transactions include the following:
- Eleven of the 12 loans are current in payment, while three are in special servicing, including one that is delinquent.
- Eight of the 12 reach final maturity between now and 2026, and the other four in 2027 or 2028.
- Eleven of the loans have a KLTV of 97% or higher, including seven with a KLTV of 110% or greater.
- Eleven of the deals have a KDY of less than 8% as of our last surveillance review. The 12th has a 9.4% KDY, but 46.8% of its leases expire by year-end 2026.
- Occupancy at the collateral properties ranges from 65% to 100%. For the three properties with 90% or higher occupancy, all have significant lease roll during their remaining term or shortly after maturity.
- The average lease roll as a percentage of base rent through year-end 2026 is 34.7%, ranging from 0.5% to 71.2%.
The ratings placed on Watch Downgrade are shown in Figure 3.
