The Office Sector Debt-Funding Gap is Likely to Increase

As the largest source of capital for commercial real estate, debt financing plays a major role in facilitating investment activity. Amid tighter financial conditions and a hawkish Fed, interest rates and swaps have risen sharply. As lenders become more selective, borrowers may face a debt-funding gap issue if they need to refinance.

To understand the debt-funding gap, consider a theoretical office building worth $100 million in 2019 shown in Figure 1. By 2024, we expect the value of the property to have fallen by 29% to $71.2 million. With a constant LTV of 72%, the property owner could expect to borrow $51.3 million against it. So far, this would create a debt-funding gap of ($72 – $51.3) $20.7 million. It is important to note that at this stage the owner’s equity is already completely wiped out. However, once the lower LTV of 57% is used, the property owner can only borrow $40.6 million.

Together, the combination of expected value decline and lending conditions means this building will experience a debt-funding gap of $31.4 million by 2024 ($72 – $40.6). This means that a capital structure that initially consisted of $28 million of equity (72% LTV) will be left with no equity in the asset and will have to contribute 43% of the new asset value in new equity to refinance. Borrowers facing a potential refinancing gap may pursue additional equity or mezzanine financing to pay off the existing loan. In addition, they may negotiate a discounted payoff with the lender, or an extension of the loan term if property income conditions are likely to improve. Ultimately, some borrowers may be forced to default. This Viewpoint seeks to estimate the near-term future funding gap.

Figure 1: Debt-Funding Gap Methodology for Sample Building

Source: CBRE Econometric Advisors.

So far in 2023, lending conditions have become tighter with lower LTVs across all commercial real estate sectors. The office sector in the United States in recent years has faced both lower LTVs and falling values. The retail sector faces the same problem, but at a much smaller magnitude. The multifamily and industrial sectors have also faced lower LTVs but have previously had large value increases to offset this. By combining sector-level origination data from the Mortgage Bankers Association, average LTVs and terms from CBRE-brokered commercial mortgages, and CBRE EA expected changes in values, we can estimate the funding gap each sector will face in a given year¹.

For each origination year and sector, we calculate the fraction of loans due within five years. We then divide this volume by the average LTV in the origination year to calculate the total value of a property with upcoming debt expirations. We then adjust the value of this property to reflect the expected change in the EA value index. Using this new value, we size a refinance loan based on a forecasted LTV ratio. The forecasted LTV is assumed to remain constant relative to H2 2022 average LTV figures for loans closed by CBRE Capital Markets professionals. We then compare the refinance loan amount against the original loan amount to calculate the debt-funding gap by maturity year.

Table 1 reports the total origination value, percent due within five years², origination LTV, future expected LTV, five-year expected value changes, and of course the expected funding gap for the 2019 origination year (2024 maturity year). This analysis is conducted at the origination-year level and considers the funding gap that results from loans issued in the origination year over the next five years. This likely underestimates the size of the funding gap. However, it is important to note that for simplicity, this analysis assumes loans are interest only. Empirically, roughly 40% of CBRE-brokered commercial mortgages include amortization, which means our funding gap estimate is slightly biased upward. The impact of our assumptions likely offset to a large degree.

Table 1: Funding Gap for Loans Originated in 2019 (Maturing in 2024)

Source: CBRE Econometric Advisors, Mortgage Bankers Association.
¹ Annual sector level origination figures are from the Mortgage Bankers Association’s Commercial/Multifamily Annual Origination Volume Summation reports. Sector level weighted average LTV figures are calculated using loan level data from CBRE-brokered commercial mortgages. Expected changes in values are calculated using each sector’s annual baseline value index from CBRE Econometric Advisors.
² For each mortgage, we assign a dummy variable equal to 1 if the maturity year is five years or less from the origination year. We calculate the weighted average of this variable for each sector by origination year.

Due to large, expected value declines, the office sector has the largest funding gap by far at approximately $38.0 billion during 2024. Retail is next at $2.8 billion. Due to significant value appreciation, industrial does not suffer from a funding shortfall and the gap for multifamily is negligible. As a check, we repeated this exercise using our alternative Downside, Severe Downside and Upside scenarios in Table 2.

Table 2: Scenario Comparison of Funding Gap for Loans Originated in 2019 (Maturing in 2024)

Source: CBRE Econometric Advisors.

Examining alternate scenarios highlights how the office-sector pain differs from all others. For the industrial sector, the debt-funding gap only appears in our Severe Downside scenario – reflecting our optimistic value growth expectations that are largely able to offset tighter lending requirements. Conversely, the 2024 office debt-funding gap exceeds $28 billion even in our increasingly unlikely Upside scenario and reaches $38 billion and $43 billion in our Baseline and Downside, respectively.

This large gap for the office sector suggests some distress will be forthcoming. We also expect the demand for, and volume of, mezzanine debt to increase making this a good opportunity for nimble lenders. Otherwise, investors will be forced to add more equity through cash infusions. Between 2023-2025, we expect the cumulative debt gap to reach $72.7 billion for the office sector and $5.4 billion for the retail sector. These cumulative gaps represent 26.4% and 5.2% of the unadjusted lending volume originated in 2018-2020 for the office and retail sectors, respectively. We repeat our exercise from Table 1 for the origination years 2018 and 2020. By adding each maturity year’s gap together, Figure 2 shows each sector’s cumulative 2023-2025 debt gap, as well as the sector composition by year.

Fundamentals continue to deteriorate for the office sector during the start of 2023. As an example, a previous version of this report published in December 2022 estimated a cumulative gap of $52.9 billion for the office sector. Based on more recent data, our value forecasts have become even more pessimistic for the sector driving the estimated funding gap higher.

Figure 2: Debt-Funding Gap by Maturity Year by Sector ($ Billions)

Source: CBRE Econometric Advisors.

To put this in perspective, it is worthwhile to compare the coming debt-funding gap to the situation during the GFC. While historical origination data for this period is not available, we use the fraction of total U.S. CMBS origination in each year relative to 2019 to determine annual sector-level origination figures. The next parameter we assume is the fraction of origination volume due within five years for each year and sector during this period. Using 100% gives us an upper bound on the size of the GFC funding gap. Figure 3 shows the comparable years during the GFC to compare the relative sizes of the two funding gap events. The cumulative $72.2 billion gap (assuming 100% due within five years) we estimate for the office sector was slightly smaller than the one markets are currently facing. With a more conservative 75% fraction due within five years assumption, this gap falls to $54.9 billion, significantly below the current gap.

There are two key differences between the current situation and the GFC:

• The GFC had large debt gaps across all asset classes whereas currently it is concentrated in the office sector.
• The GFC was characterized by a steep one-year decline in office values followed by a quick recovery, whereas our forecasted losses are deeper and longer lasting due to secular decline in demand for office space and higher borrowing costs.

Figure 3: Debt Funding Gap by Maturity Year by Sector ($ Billions)

Source: CBRE Econometric Advisors.

Figure 4 displays the Baseline CBRE EA value index for national office values. Peak-to-trough, our office value index loss was lower during the GFC (24.2% loss from 2008-2009) than our forecasted loss of 31.5% from 2019-2023. Unlike the current gap that was driven by lower LTVs and value losses, the 2008 office funding gap was almost entirely driven by lower LTVs.

Figure 4: Baseline Annual National Office Value Index

Source: CBRE Econometric Advisors.

In addition to comparing funding gaps over time, it is also useful to compare across geographies. While loan origination volume is not available at the metro level, we have measured cumulative sales volume from 2018 to 2020 as a proxy for origination activity. Figure 5 presents 2018-2020 sales volume against our forecasted value loss from 2019 to 2024 for different office markets. The expected value decline of nearly 40%  from 2019 to 2024 is likely to create a substantial funding gap. However, we expect values to eventually recover, so owners able to delay refinancing, through loan extensions for example, could be able to avoid a funding gap.

Figure 5: Cumulative 2018-2020 Sales Volume vs. 2019-2024 Value Change

Source: CBRE Econometric Advisors, Real Capital Analytics.

To further identify variation in geographic exposure to this debt funding gap, CBRE EA created the Office Distress Index. This index uses market-level cap rate movement combined with building-level changes to economic rent (occupancy adjusted rent) to benchmark the quantity of distressed office buildings in any market, and the magnitude of that distress. This index provides a good barometer of which markets will likely see outsized funding gaps. And since it is benchmarked to the GFC, it provides a much-needed comparison point for the likely path through the current distress. Figure 6 benchmarks office sector distress to that experienced across the Sum of Markets³ in Q1 2010.

Distress across the country is currently at 78% of GFC levels. Based on EA forecasts, the national index is likely to climb to 90% over the next year. Unsurprisingly, the index is currently highest in Manhattan and San Francisco, as these markets have been hit by shifts in working patterns and generally see greater cyclicality during downturns. Taken together with Figure 5, these markets could see a relatively larger share of the national funding gap. However, there has historically been strong appetite for gateway market investing, especially in times of broader distress – potentially filling large chunks of the expected funding gap. Other notable gateways, such as Boston, appear to be significantly better positioned both relative to the broader market and to its own history during downturns.

Figure 6: CBRE EA Office Distress Index Score – Q4 2022 vs Q1 2010

Source: CBRE Econometric Advisors.
³ Sum of Markets refers to the top 52 largest U.S. office markets tracked by CBRE Econometric Advisors.

This cumulative funding gap will likely create distress for some investors unable or unwilling to invest additional cash because it does not make sense to do so. Lenders will face losses in some cases due to falling property values and illiquid markets. Indeed, we have already seen some high-profile defaults during the start of 2023. Among bearish lenders, we might increasingly see non-performing loans (NPLs) packaged together and sold on the secondary market at discount. For lenders with more conviction and those working with established owners, we expect to see an increase in loan workouts and short-term loan accommodations. At the same time, this gap will create many opportunities for equity investors interested in entering joint ventures at an attractive basis as well as creating significant opportunities for mezzanine lenders. However, demand for mezzanine debt to fill this gap will not guarantee its availability. There is evidence in Europe of lower subordinated debt origination as debt investors bide their time. Which of these strategies any individual borrower or lender enacts will be driven, at least in part, by their outlook for the sector and their individual asset(s). How this funding gap is bridged in the coming years will provide key insights into large investors’ expectations for the sector.