Given our position mid-business cycle, it is time for banks to consider decreasing their lending to Class A office space and increasing their exposure to Class C space. This is the opposite of what most banks are doing and the concept of going “down market” is counterintuitive for most bankers at this stage of the economic cycle. After all, don’t you want to lend in the highest quality properties in a downturn? The answer is no and in this article we look at the data plus the logic behind shifting your commercial portfolio to a lower class and more worn properties.
Supply, Demand, and Risk
To understand the risk of Class C space, bankers must consider the supply and demand of the office product. Few developers set out to build new Class C space. In good times, rents are rising, and there is a catalyst to develop class A space. For example, in 2016, according to CoStar, 84% of new construction was for Class A properties. Foreign money, in particular, loves to own Class A in the US and approximately 88% of overseas office investments that are in the US are targeted at trophy or Class A properties. These new investment dollars serve to drive up valuations, make headlines and drive down capitalization rates. In times of growth, new supply of Class A expands rapidly and becomes a major driver of the real estate business cycle. In other words, lending on Class A space serves to exacerbate any bank’s economic business cycle often creating more risk, not less.
Most of the Class C product, by comparison, comes from aged Class A and B space and isn’t a major driver of the real estate cycle. With little new investment, supply often lags. As can be seen by the data below, while Class A space availability has increased over 1.2% per year over the past five years, Class C space has decreased. In most markets, this sets up positive economics for lending.
Rent and Cash Flow Cycles
The lag effect of supply in Class C space means rents don’t go up as much in good times. While that seems positive for banks lending on Class A space that is not the complete picture. Rents often go down more in Class A space as well. As can be seen, by the graphic below, Class C cash flow is about twice as stable or is about half as volatile.
Regarding expenses, while Class C properties require more relative maintenance, it is the Class A space, with their additional amenities that are more costly to operate. In addition, Class A buildings usually have more and longer term operating contracts for items like security, maintenance, elevator operation and similar. These two facts further give Class C properties an advantage of having a more flexible cash flow structure that can adjust quicker to changing economic times.
The supply/demand stability, combined with the rent stability also equates to more favorable occupancy characteristics. In pro-growth cycles, rents rise faster in Class A property pushing a larger number of tenants out to Class B and C properties. In downturns, new companies gravitate towards cheaper office space while established companies that are coming up for lease renewal leave Class A product in high percentages than in stable times. As a result, you get this dampening effect on the cash flows of Class C properties.
As can be seen in the graphic below, occupancy is usually greater in good times and in bad for Class C space compared to Class A space. Further helping this aspect is that Class C space tends to lease in smaller square footage packages thereby making the space more flexible.
Putting This Into Action
In good times, lending on high profile properties feels good. There is nothing like knowing that your bank is adding capital to the community in the form of a tangible real estate development. The buzz combined with the rapid cash flow growth and a higher quality tenant mix/structure does mean lower risk for the near term. However, over a full real estate cycle, it is the loans on Class C properties that usually outperform from a probability of default perspective and loss given default basis. That makes expected losses about 30% less on Class C properties when compared to Class A. To optimize the credit portfolio, banks would be well served in devoting more relative capital to getting the higher risk-adjusted margins, more favorable loan structure and lower credit risk that come with Class C lending. This is especially true during the mid to late part of the economic cycle such as we are experiencing now. While lending on Class C property is never sexy, preservation of capital always is.
Submitted by Chris Nichols on October 31, 2016