Differentiating North American Office Properties Amid Sector-Specific Pressures

Morningstar DBRS released a commentary detailing the sector-specific pressures office properties are facing. At the outset of the coronavirus pandemic, although office properties were exposed to closures and other measures taken to discourage congregating in large groups, the leases in place were largely honored and property cash flows were not materially disrupted. The effects, however, have been somewhat delayed, with the change in remote work habits that took hold amid the pandemic now influencing business policies that can allow for significant flexibility, and, in turn, the possibility of a reduced need for physical workspaces in office buildings across the U.S. Although office properties' longer-term leases are generally viewed as a benefit, that benefit can also mean a lag in the ability to measure the impact of macro stress events on occupancy rates and cash flow trends.

Key highlights include the following:
-- The disruption in transaction volume has contributed to an information lag for the sector. However, as transaction volume has begun to show signs of life in recent months and appraisers have more information to work with in determining property values, the information flow has improved. As such, we now believe we have stronger evidence of where market capitalization rates (cap rates) are settling across office property classes and markets, with year-over-year trends becoming available to better inform the trajectory we can expect going forward.

-- Morningstar DBRS has also been monitoring refinance trends for office loans, with the data generally showing significant quality differentiation between those loans that did not successfully refinance and those that were repaid at loan maturity.

“In the case of single-asset/single-borrower transactions backed by office property types, these trends are particularly impactful given the weight of the Morningstar DBRS value approach in determining the credit ratings,” said Erin Stafford, Managing Director, Global Structured Finance. “As such, Morningstar DBRS expects there will be increased scrutiny for that asset class in the coming year from both a surveillance and a new issue perspective, as the factors we consider when deciding our cap rates could be further stressed and differentiated according to the specifics of the assets in question.”