Continual interest rate hikes over the past year have brought transaction levels close to a standstill as buyers and sellers absorb ongoing pricing adjustments. For many, this has been challenging to do, encouraging potential sellers to remain on the sidelines and pushing out expectations of a return to dealmaking until at least later this year.

Some owners – particularly those of industrial and multifamily assets – expect tailwinds in rental growth and occupier demand to offset losses and steer an eventual return to robust performance. But, for one property type, the trajectory is anything but straightforward.

For more on valuations and when the market can expect a return to dealmaking, read PERE’s May cover story here

Office is subject to the same rate pressures as other sectors of real estate, but faces more complexities in revaluation, particularly for buildings outside of prime locations. “This is the first time in a downturn where offices in secondary locations have been sitting in an uncertain position,” said Mark Wynne-Smith, global head of valuation advisory at broker JLL. “There are two obvious factors that give cause for concern: one is the return to work and the second is around sustainability.”

Well-let offices with high environmental ratings and attractive amenities are more resilient, he added. Research by JLL shows that for US office buildings built in 2015 or later, net absorption since the onset of covid-19 stands at 8.8 million square meters as of the end of last year. All age categories prior to 2015, by contrast, experienced net negative absorption. For non-prime offices facing demand shortfall, “investors are marking those buildings down, as are valuers, because the future is a lot less certain than it was five years ago.”

Office values began to correct in the latter half of last year. In the US, where the work-from-home trend is particularly embedded, the NPI index recorded a return of -4.8 percent for the property type in Q4 2022. This was the lowest return of any sector, deepening an already negative return in Q3 2022.

“We can approximate the impact of increased borrowing costs on office values, and those should be considered by appraisers now. But we don’t know how expected equity returns for the sector have changed with the continued change in perceived risk for the sector,” said Matt Pomeroy, a director on the valuation, reporting and analytics team at US risk advisory firm Chatham Financial.

With office still smarting from the structural sea change that is hybrid working, not to mention the broader economic challenges that could further reduce demand, Pomeroy said valuers are keeping a close eye on occupancy levels in particular. In Q4 2019, the global office vacancy rate was 10.3 percent, according to JLL Research. In Q4 2022, it had risen to a record 14.9 percent.

According to Pomeroy, predicting future occupancy rates is a key point of contention in the valuation community: “Do we think that office buildings will lease to 90 or 95 percent occupancy in the near term? That’s a conversation that started in fourth quarter, and will ultimately drive values down if there’s consensus that stabilized occupancy in the office sector in the future should be something lower than it has been in the past.”

Wait for it

Distress in the sector has yet to reach significant magnitude, but the wall of upcoming loan maturities will likely catalyze the full extent of post-pandemic impact on offices around the world. According to research firm MSCI, approximately $900 billion of commercial property loans in the US alone are set to mature in 2023 and 2024. Office assets are collateral for one quarter of mortgages that will come due in 2023.

The recent turmoil in the banking sector, which began with the collapse of Silicon Valley Bank and Signature Bank in mid-March, will put further pressure on borrowers in the face of tightening credit conditions. According to forecaster Oxford Economics, this will compound value declines for office and retail over and above other sectors, given the two properties suffer from weaker performance and higher obsolescence risk.

Paula Thoreen, executive managing director of brokerage and advisory firm Cushman & Wakefield, agreed that office is particularly susceptible to pricing adjustments given the structural shifts already underway, and said the banking troubles will put further downward pressure on pricing over the next two quarters. “Of course, the degree to which office values continue to correct depends on what the Fed does over this timeframe,” she added.

Prior to the bank failures, early signs of office distress manifested in a number of high-profile loan defaults on portfolios, either comprising wholly or partly offices, from the likes of Brookfield and PIMCO in the US and Blackstone in Europe. Developer RXR’s chief executive, Scott Rechler, also said he would “give the keys back to the bank” for some of his Manhattan offices.

While such headlines will have been concerning for owners of sub-Class A office, valuers believe these defaults are not indicative of intrinsic market value – at least for now. “A distressed sale, by definition, is not a market sale,” said Richard Kalvoda, president of US analytics at adviser Altus Group. “It’s not a willing buyer and a willing seller. But, that said, if you start seeing more of that, then distress becomes part of the market, and we will consider that [in our appraisals].”

Such distressed transactions are only early indicators, Pomeroy agreed: “It may take the balance of the year or more to understand what more stabilized return expectations are for the sector. So, there should be and probably will be a partial correction early this year, but a full correction may take more time.”

Identity crisis

What these recent defaults do indicate, however, is what borrowers will do with non-prime office assets where significant capex spend is out of the question. “Even when market and economic conditions stabilize, if second-tier office buildings no longer align with an investor’s portfolio strategy, they will sell these buildings rather than invest the additional capital needed for sustainability and increased amenities. Those are the ones you’re going to start seeing come back to the market and being repriced,” said Kalvoda. “It really comes down to the individual asset – not all buildings are One Vanderbilts.”

Recent analysis by Cushman & Wakefield claims that upwards of 60 percent of US office stock faces “competitive obsolescence” and will require upgrading or repurposing to avoid this fate.

For assets in need of complete reimagining, which Cushman estimates is at least a quarter of office stock in the US, determining value requires a complex calculation. “You have to do a little bit of a highest-and-best-use or a feasibility study to work out what the rents are for [an asset’s] alternative uses, and how that plays out in terms of where that cashflow would fall, and determining what the highest profitability is,” Thoreen said. “And you weigh that with the land value less the demolition [required for] those improvements.”

As such, transitioning an asset to a different risk-return profile will prolong the valuation process. “The realization that office is actually no longer the highest and best use for a building will take some time, and then the development of the new business plan based on that will take more time,” said Pomeroy.

The number of factors involved in mapping the trajectory of office values is numerous. With huge variations in asset quality, local demand and obsolescence risk, the repricing of the sector will be equally uneven. Since the UK is ahead of other global markets in the correction, all eyes will be watching London office as value-add players re-enter the market in the coming months.