The good news thus far for the beleaguered office real estate sector is that the surge of distress that many observers have predicted has yet to be actualized. The bad news, though, is that according to research from Yardi Matrix, many markets remain at risk of distress from offices that don’t have the income to cover their debt obligations.
Debt costs for commercial real estate have climbed recently, thanks in no small part to the increase of interest rates over the past year and a half. Net operating incomes for office-using companies, meanwhile, have dropped. This has led to decreased debt service coverage ratios (DSCRs) — a measure of income against debt — for the office sector in recent years, with some metros on the lower end than others.
Yardi estimated market-level office sector DSCRs for 91 metros and found that five had average DSCRs below 1.0: Brooklyn (0.81), Oklahoma City (0.89), Chicago (0.90), El Paso (0.92) and Cleveland (0.96). Another eight, including Manhattan (1.05), St. Louis (1.16) and Nashville (1.25), have DSCRs at or below the 1.25% ratio required by most lenders. Taking into account that these market-level ratios are only estimates and that distress on the property level can easily occur in high-DSCR markets, it’s these low-DSCR cities that are at highest risk of a wave of office turbulence.
Unfortunately, it’s not likely that the market factors pushing DSCR downward are going to reverse anytime soon. The entrenchment of hybrid and remote work in many areas has helped keep demand sluggish. As with the residential market, increases in costs like maintenance and insurance remain bothersome. Interest rate cuts may materialize late in the summer or early in the fall, but per Yardi, “in all likelihood will not be steep enough to save properties that are teetering on the edge of distress.”
