The former mayor of Providence is distressed.
When Joseph R. Paolino Jr. walks through the city’s financial district, he’s anxious about what he sees. He led Providence as its mayor for much of the 1980s, but he’s now the outspoken managing partner of Paolino Properties LP, which owns hundreds of thousands of square feet of downtown commercial real estate, including its centerpiece property, the 20-story 100 Westminster St.
As he chats with attendants at empty parking lots and looks in the windows of darkened restaurants, Paolino feels the local and national economy are on the precipice of change.
He’s not the only one.
Developers, bankers and real estate brokers in Rhode Island and nationwide are worried about the continued effects of people working from home, which is triggering a decline in office real estate values, and how that might impact banks and the ability of business owners and others to obtain credit.
“It’s all connected,” Paolino said.
Paolino is focused on his holdings in Providence and elsewhere in Rhode Island. But his concerns are echoed more broadly across the nation by financiers, C-suite bankers and real estate professionals.
On the local level, post-pandemic Providence has not fully recovered from the shifts touched off by COVID-19. The city still feels emptier, Paolino and others say. Hybrid work arrangements have dampened sales at businesses that rely on office workers. On Mondays and Fridays, some parking lots and lunch spots are deserted. “For rent” signs populate many storefronts. There are fewer people strolling the sidewalks.
At the same time, the Federal Reserve’s inflation fighting has sparked mayhem in the national market, observers say. The central bank’s interest rate spikes are wreaking havoc on commerce. Financial institutions have tightened lending. Borrowers can’t get mortgages. Loans are coming due on the office properties. Tenants are aggressively reducing their leasing footprints. Office building values are plummeting. Holders of maturing loans face skyrocketing refinancing payments.
If the problem accelerates, it will be more than rich developers and bankers who feel the effects, observers say. It could create a credit crunch for business owners and consumers as the price of money becomes more expensive and lending gets tightened.
“Across the country, the real estate market is in jeopardy because interest rates have doubled and tripled,” Paolino said. “I’m not saying we’re on the brink of a catastrophe in Providence, but the potential is definitely there.”
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TALKING IT OUT:
Julia Anne Slom, chief commercial real estate lending officer and executive vice president at The Washington Trust Co., says banks are eager to help office landlords out of financial jams.
PBN PHOTO/ELIZABETH GRAHAM[/caption]
DISTRESS SIGNALS
Paolino isn’t the only business leader concerned about the distressed office real estate market.
JPMorgan Chase & Co. CEO Jamie Dimon warned analysts in late May that souring commercial real estate is a threat to financial institutions. In its Financial Stability Report this spring, the Federal Reserve declared that commercial real estate debt – especially within the office sector – is a systemic risk to the broader financial system. Share prices for some of the largest office landlords have dropped to near-historic lows.
The topic is at the top of the minds of local bankers, too.
“We all talk about the same thing,” said Julia Anne Slom, The Washington Trust Co.’s chief commercial real estate lending officer and an executive vice president. “Office, office, office.”
That said, Slom believes the regional commercial real estate market is stable – at least the properties that Washington Trust is involved in.
“There is some weakness in office, [but] my office portfolio is not keeping me up at night. We’re not hearing a death knell,” she said. “But we’re all focused on how do we get from point A to point B during this period of volatility while serving clients and protecting the bank.”
Yet there’s ample reason for increasing concern.
Demand for office space is expected to continue to decline through early 2024. Case in point: Financial services giant Fidelity Investments Inc. recently donated a 250,000-square-foot Smithfield office building it no longer needed to the neighboring Bryant University – real estate that was estimated to be valued at $32.6 million in 2022.
The National Association for Industrial and Office Parks surveyed its members in May for its CRE Sentiment Index and found respondents believe conditions for commercial real estate likely will worsen over the next 12 months. The index forecast declines in occupancy rates and effective rents, and for debt and equity to be less available for financing.
How bad could it get? Opinions differ. Kevin Fagan, the chief of commercial real estate economic analysis at Moody’s Analytics, expects a 25% correction in commercial property values. The Boston Consulting Group was less sanguine; it recently predicted that office values will decline from pre-pandemic levels during the next 12 to 36 months by 40%.
INSULATED?
Rhode Island may be insulated from the worst of a potential economic downturn, says Thomas Sweeney, owner and principal of Sweeney Real Estate & Appraisal in Providence.
“We’ll certainly see some of the turmoil,” Sweeney said. “The good news is that we don’t build a lot here. If we don’t build anything, we’re not going to have that many empty offices.”
Data published by Hayes & Sherry Real Estate Services shows that office vacancy rates in downtown Providence and Rhode Island have been stable in recent months, hovering around 14% downtown and 12.5% in the rest of Rhode Island. The downtown office vacancy rate in late 2019, before the COVID-19 pandemic, was 12.2%.
In its first-quarter 2023 report on Rhode Island’s commercial real estate, Hayes & Sherry said the workforce is slowly returning to the downtown as companies try to bring people back to the office “with varying degrees of success.”
“We are beginning to see tenants make long-term decisions around their footprint needs, often resulting in square foot reduction due to flexible workspace strategy,” the report said.
While shrinking office space, companies are looking at higher-quality buildings with amenities to attract workers back to the office, such as on-site dining and fitness areas. The report cited the property at 3 Davol Square as an example, where a $15 million overhaul of a brick-and-beam building in the city’s Jewelry District has attracted tenants.
Alden Anderson Jr., senior vice president for the Providence office of CBRE Group Inc., believes that southern New England has so far avoided a major real estate crisis.
“We don’t have huge vacancy rates now,” Anderson said. “However, we expect an uptick [in vacancies] in the midyear. In other markets, the urban centers have had a more difficult time coming out of the pandemic.”
Slom says Rhode Island has had two factors work in its favor when it comes to the amount of empty office space.
“First, we don’t have the vast tracts of land that other states do. So that means we’re not constantly building,” she said. “Second, [lenders in the region] are much more conservative here. People are prudent in their underwriting and risk tolerance.”
On May 1, CBRE reported the national office vacancy rate was 17.8%, and it projects that the rate will peak at between 19.3% and 21.4% in late 2024 and then gradually decline to roughly 16% by 2028.
With increased vacancies comes decreased cash flow, which dampens property values.
Sweeney says property owners in America’s biggest markets are starting to unload troubled office buildings at fire-sale prices.
“A tower in San Francisco was valued in 2019 at $300 million,” he said. “Now it’s expecting to sell for about $60 million.”
Discussions in real estate circles are turning to the looming risk of loan defaults.
“The conversation is being driven by loan maturities,” Anderson said. “If you did a loan that has a five-year term on it four years ago, in the next 12 months that loan is maturing. That loan could have a 3.5% rate currently. But when you go to refinance it, it’s possible the rate could be 6% to 6.5% or higher. The borrowing costs have nearly doubled.”
In those situations, the banks will likely write down the value of the assets.
“If the buildings are still leased, the values may not change. They could even go up. However, if you have a bank with a struggling commercial real estate portfolio, and they were to reappraise the values, that could open up Pandora’s box,” Slom said, creating a risky situation in which borrowers owe more than the property is worth and defaults become more likely.
“That hasn’t happened,” she said. “The underlying conditions are still OK. Unemployment is low, people are working, and the retail numbers are still good.”
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WEATHERING IT:
Alden Anderson Jr., senior vice president for CBRE Group Inc.’s Providence office, says the amount of unoccupied office space has been manageable so far.
PBN PHOTO/MICHAEL SALERNO[/caption]
‘JURY IS STILL OUT’
Financial institutions aren’t taking any chances. In the wake of this year’s failures of Silicon Valley Bank, Signature Bank and First Republic Bank, many financial institutions have cut back on lending to preserve capital and strengthen balance sheets. They are also bracing for future Federal Reserve interest rate hikes.
Slom said smaller institutions such as hers are “sticking to our proverbial knitting” while proceeding with caution.
“I don’t think you’ll find any bank financing a new spec office building,” she said. “There’s no demand for it. The jury is still out on the office market. It will always be there, but people are waiting to see.”
Already, high interest rates are starting to cause stress in consumer lending. Slom says some borrowers are increasingly late on loan payments and maxing out their credit cards. Another interest rate hike by the Federal Reserve could affect discretionary spending.
The net effect is that the underwriting of credit has become much more stringent, Anderson says.
Also adding to strictness: federal regulators mulling measures to rein in risky practices that caused the recent bank failures.
“There’s a general fear that the cure could be worse than the disease,” said Bruce Van Saun, CEO and chairman of the Providence-based Citizens Financial Group Inc.
“[The banks that failed] were idiosyncratic. They grew too fast,” Van Saun said in an earnings call earlier this year. “They have management failure, supervisory failures. It doesn’t look like lack of regulation was the root of the problem.”
Van Saun said Citizens is well prepared to weather turmoil in the commercial real estate market, in part because a high percentage of the office properties it has financed are in suburban areas, which were less impacted by the COVID-19 pandemic.
Employees concerned about catching the virus were more comfortable returning to their low-slung offices in less-densely populated areas that wouldn’t have closely packed elevators.
Nearly 70% of Citizens’ $4.1 billion general office portfolio is located in suburban areas, and the majority of its office holdings is considered Class A or premium space.
About 90% of the portfolio is income producing, according to Van Saun.
“The geography is relatively dispersed and in relatively strong markets,” Van Saun said. “We currently expect losses to be manageable, and we’ve already set aside meaningful reserves.”
Slom says Washington Trust has a small exposure to urban office markets.
“We have some soft spots. We have some office properties that aren’t 100% occupied and showing the strain of the post-pandemic economy,” she said. “Most of our office [portfolio] is in the suburbs of Boston. Fortunately, we don’t have a concentration in any one area, which is serving us well.”
When the value of office space falls, the possibility of defaults rise. That may spell catastrophic losses for some developers, banks and investors. It may also set up tremendous opportunities for distressed asset specialists to swoop in and buy properties for low prices.
The delinquency rate on all commercial mortgage-backed securities in May jumped to 3.62%, from 3.09% a month earlier, the highest rate it’s been since 2018, according to international real estate analytics firm Trepp.
The increase was driven by a spike in office delinquencies, which jumped from 2.77% to 4.02%, the highest that rate has been since 2018, according to Trepp. The April-to-May spike was the largest month-to-month increase for office special servicing since 2012.
Loans coming due in 2023 are enough of a problem. There’s an even larger wave on the horizon set to come due across the U.S. in 2024.
“Now that borrowing costs have nearly doubled, the whole situation is very challenging,” Anderson said. “In our region, we may be fortunate that we don’t have a lot of assets maturing during the next zero to 18 months. Therefore, we don’t expect it to have as much of an impact here.”
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LONG VIEW: Joseph R. Paolino Jr., managing partner at Paolino Properties LP, in his office atop 100 Westminster St. in Providence.
PBN PHOTO/MICHAEL SALERNO[/caption]
REFI TENSION
Still, there has been some impact locally, even for the commercial landlords who aren’t in trouble.
Paolino says leery banks are increasingly reluctant to refinance office buildings and want to see solid cash flow, a large balance sheet and sufficient assets to finance a new loan. Most of his portfolio fits those criteria, but he isn’t looking forward to refinancing some of his holdings next year.
In recent years, when a borrower remortgaged a property, the increased value of the building usually resulted in the borrower walking away with extra cash, he says. No more. Now the bankers want borrowers to pony up additional funds.
“The financial institutions are wanting more equity to be put in,” Paolino said. “If the borrower doesn’t have more equity, the bank could take the building. I have to ask, what bank can manage a building better than a good developer?”
Many mortgages have loan-to-value covenants that limit the allowable outstanding amount of the loan based on the property value. If the value drops, a bank can demand the borrower put in more equity or risk default.
But Slom says banks are not eager to put pressure on struggling clients.
“We learned our lesson during the great financial crisis,” she said. “You don’t bring a big sledgehammer to a meeting, but you look for solutions that work for both the bank and the borrower. We’re going to do our best to support them. But it doesn’t mean we won’t take severe measures if we have to.”
Right now, the banks Paolino works with in the local market – such as Bank Rhode Island, Rockland Trust Co., Washington Trust and Citizens – have been amenable during the recent volatility, he says.
“You can start working with them early to get ahead of the problem. I have a big mortgage coming due in February,” Paolino said. “I’m taking care of it now.”
