Office Lenders Are Proceeding With Caution Amid Rising Inflation

Lenders are proceeding with caution when it comes to office deals amid a challenging interest rate environment, as the Federal Reserve weighs its next steps to keep the economy chugging forward.

As the economy reopened last year, the Fed balanced anticipated price growth by installing policies designed to let inflation run above typical targets.  But while “this was initially done to prompt economic growth, producer and consumer prices continued to advance at persistently high paces into this year, prompting a turnaround in monetary policy,” analysts from Marcus & Millichap note in a new outlook on the office sector. The Fed began scaling down quantitative easing, and the Federal Open Market Committee has implied another rate hike is likely on the horizon this year.

That’s led economists like those at the National Association for Business Economics to downgrade growth forecasts this year, with the median forecast for inflation-adjusted GDP at 2.9% (down from the 3.6% predicted in the December 2021 survey). The median forecast calls for GDP growth of 2.3%, with supply chain issues and geopolitical tensions emerging as the biggest downside risks to growth estimates.

While the Fed typically targets inflation in the 2% range, it currently sits at between 5 and 7%—and “the Fed doesn’t like inflation that high,” says Marcus & Millichap’s John Chang. “They’re trying to curb inflation by tightening the money supply.”

The Fed’s position could change if additional shutdowns occur, or if tightening monetary policy overestimates the strength of the current economy and triggers a double dip recession.

“Investors are currently hungry for long duration assets with an inflation hedge. There are times when real estate has provided such a hedge, other times, not so much,” Real Capital Analytics’ Jim Costello said in November. “Investors should not assume that all real estate is protected from inflation, if the market cycles of tenant demand and new supply are working against one’s investments, inflation is not likely to help paper over any mistakes in underwriting.”

Lenders have returned to the marketplace this year, but are more restrained with underwriting practices given the inflationary environment.

“Capital providers are carefully considering the strength of the borrower and their experience in the office sector,” the Marcus & Millichap outlook says. “Specific property characteristics such as location within a market and submarket are also vital factors in obtaining financing, as is the credit quality of the tenants in place. The remaining term of any leases as well as the build-out of the specific facility are also important determinants.”

Against that backdrop, lenders have enacted “fairly conservative” loan criteria, with  loan-to-value ratios ranging from below 60 percent for traditional life insurance companies up to the 65 percent-to-70 percent range for larger banks and CMBS sources.

“These traditional lenders may become more involved with investor-driven funds that accumulated an ample amount of capital in anticipation of distressed sales,” the report notes. “As that distress has failed to materialize on a large scale, these buyers will turn to more traditional assets and lenders.”

Debt and equity funds are also becoming more active in financing office construction, which looks radically different from the pre-COVID era. Marcus & Millichap notes that lenders for ground-up development prefer pre-leasing of at least 30 percent of the asset’s square footage, ideally to a single credit anchor tenanta move they say curbs speculative construction activity. 

Borrowers are also taking advantage of alternative financing options, many of which are non-recourse and offer more pre-payment flexibility.