Marcus & Millichap : Shorter Leases are Adding a Wrinkle to Underwriting Office Investments

There remain ongoing debates in the office market on whether the pandemic-driven shift to work-from-home strategies will drive long-term structural changes. Will office tenants require more or less space? Will there be an outmigration from urban centers? How much will the glut of sublease space affect rents? Even with vaccinations now taking place and a 'new normal' potentially only months away, many agree that it is too soon to tell. That uncertainty is manifesting in many tenants opting for shorter-term lease commitments, which is creating underwriting challenges for both investors and lenders.

'As of today, most companies don't really know what their office footprint should look like one, or two or three years from now,' says Will Pattison, head of real estate research at MetLife Investment Management. 'As a result of that, there is uncertainty in the office sector and most traditional core real estate investors have been more cautious about investing in new office properties.'

That uncertainty is weighing on investment sales. Office property sales dropped 40 percent last year to $86.1 billion, according to Real Capital Analytics. Transaction volume for the sector also trailed both apartments and industrial, which posted sales of $138.7 billion and $98.8 billion respectively.

Although there are plenty of anecdotal stories from brokers frustrated by tenants who are reluctant to commit to longer terms, the shift to shorter lease terms has been emerging over the past several years. Some blame the rise of co-working space and growing tenant demand for greater flexibility, while other companies have moved to shorter lease terms as they braced for the potential impact of new lease accounting standards. New International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) rules that took effect in January 2019 require companies to recognizes leases as liabilities on balance sheets.

The shift to remote working during the pandemic has further exacerbated the move to short-term lease commitments. 'We continue to hear stories of major corporations and large firms postponing their decisions to renew or sign new office leases, often leading to short-term renewals of 12 to 18 months until they have more clarity on their ability to safely bring employees back to the workplace,' says Leah Gallagher, San Antonio City Leader at Transwestern.

To better quantify that trend, the San Antonio office of Transwestern analyzed internal transaction data on 835 office leasing transactions completed over a five-year period (2016-2020). The results reveal that the average office lease term during that period was 4.25 years (51.8 months), when including new leases and renewals. Looking only at deals done in 2020, the average changed only nominally to 50.8 months. What that suggests is that short-term leases are more the norm than the exception.

Leasing risk is par for the course for the majority of commercial real estate investments. The question is how investors and lenders are getting comfortable with uncertainty that appears to be hanging over the office sector.

'We are seeing more liquidity coming back to the office sector in general as lenders slowly become more comfortable,' says Evan Denner, executive vice president and head of business at Marcus & Millichap Capital Corp. (MMCC). For example, MMCC is working on a requirement for a client looking to raise capital for a 500,000-square-foot office building in Las Colinas, Texas that is 78 percent leased and in need of capital improvements. They have received multiple quotes with terms up to 65 percent LTV (as is) and 75 percent stabilized LTV, a 3-year term and interest only at a rate that is sub 400 basis points over Libor.