Office market panic is easing, but a critical period looms

The office market hysteria appears to be easing — at least if the performance of real estate investment trusts are any gauge. But the office market isn't out of the woods yet, and risks could loom over the market for years to come if interest rates stay anywhere near current levels.

Consider where we've come from. The Bloomberg REIT Office Property Index has returned about 25% since its lows in late May, nearly three times the S&P 500 Index. Dividend yield spreads on office property REITs — a rough measure of perceived risk — have plunged back closer to historical norms from their highs after the banking crisis. In May, the spread just about grazed the post financial crisis peak. And since then, it's plunged to 1.74 percentage points at the end of August — not quite "normal," but close.

So what's happened since then? First, near-term recession fears dimmed, fueling a broad recovery in the U.S. stock market. Second, industry giant SL Green Realty sold a 49.9% stake in 245 Park Ave. at a relatively rosy $2 billion valuation, assuaging concerns about the availability of capital at a reasonable price.

But there are a few caveats to bear in mind. For starters, office REITs have turned out to be a poor proxy for the overall office market. As Bloomberg Intelligence senior REIT strategist Jeffrey Langbaum told me last week, REITs tend to hold property that is higher than average quality. "There's a big discrepancy between better-quality assets and lower-quality assets," he said. "The majority of the pain that I think will be felt will be felt outside of the REIT space." For all the hype about the emergence of working from home, landlords will probably still find demand for marquee buildings in the heart of the nation's central business districts. The trouble may come in the murky closely held parts of the market, where real-time visibility is generally poor.

Additionally, the yield spread may not be the signal that it once was. One reason it's this narrow is because firms have cut their projected dividends for the next 12 months to preserve capital. In the second quarter, Vornado Realty Trust temporarily suspended its dividend after having previously cut it by about 29%, and a half dozen other office REITs (representing around 18% of the index) have made large and noteworthy cuts in the past year.

For office real estate overall to come out of this episode intact, several developments need to happen. In the year ahead, property owners need to prove that they can refinance their expiring mortgages despite the retrenchment of regional banks. As Langbaum put it recently, the SL Green property stake sale was a positive signal, but investors will need to see more evidence like it that both equity and debt capital remain available.

To permanently resolve the situation, at least one of two things must transpire:

• Demand for office space needs to inch back toward pre-pandemic norms (unlikely)
• Borrowing costs need to sustainably decline (possible, but how soon?)

The onus here really appears to be on interest rates, which are something of a crap shoot. Yields on five- to 10-year Treasury notes recently hit their highest since 2007, and Cushman & Wakefield data show lenders are demanding an additional 305 basis points on five-year fixed-rate office mortgages with a loan-to-value ratio above 60%. That's an all-in mortgage rate of around 7.2%, and it's a shock to anyone rolling over loan issued years earlier. Simultaneously, elevated discount rates mean that property values (used to qualify for loans) are also compressed.

Investors may temporarily look past that daunting reality if they believe that high rates are transitory. Perhaps private equity investors and others will see this as a time to get greedy, bringing additional capital to the table. The main problem emerges if interest rate expectations start to become anchored at current levels, maybe out of long-term inflation fears or concerns about sustainably high government deficits. If that happens and regional banks remain shy about extending new credit, the wave of refinancings over the next year could easily get ugly in a hurry. So while the good news coming from the REIT market is a welcome development, it may yet be a bit premature to forget the risk posed by the office market in the U.S.