Diving “Debt-First” Into U.S. Office

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Diving “Debt-First” Into U.S. Office

Work-from-home (WFH) headwinds combined with pressure from elevated interest rates, higher borrowing costs, and decreasing investor flows have hit the U.S. office sector especially hard. Meanwhile, a wave of upcoming loan maturities is creating the need for significant capital at a time when funding availability is challenging.

Against this backdrop, we see an opportunity forming for investors to sequence their exposure to the office market—a process we believe starts with a risk-adjusted approach to tactically leveraging debt. However, this is only the case for assets that can thrive in a WFH world. There is convincing evidence that higher-quality, well-located assets may do just that.

Why do we think the U.S. office sector may be especially attractive for debt investors at this point in the market cycle?

■ Returns Appear to Favor Debt: Debt means yield for investors, and although there is volatility in the data, the average mortgage constant on U.S. office fixed mortgages currently exceeds the average yield on equity, as measured by the capitalization rate (see chart below). This has generally persisted since the middle of 2022. Looking back over history, this hasn’t happened very often. We would argue that this inversion presents a rare opportunity for debt investors to earn high cash yields.

Why recent themes in U.S. office are forming an intriguing story for investors
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Returns Favor Debt at the Moment

Sources: American Council of Life Insurers and Hines Research. As of 2Q 2024. Note: Using the period for which data is available.

■ Reset Property Pricing: Valuations are down, and the headwinds from WFH look to be priced in. This is helping to lessen risk, particularly for senior mortgage holders on newly originated loans.

■ Right-Sized Loan-to-Value Ratios (LTVs) and Debt Yields for New Senior Mortgages: Lower LTVs at this new price point further mitigate the risk of any principal loss as the additional equity sitting above their position in the capital stack provides an increasingly reassuring cushion. High debt yields—Net Operating Income (NOI) divided by loan amount—are also providing additional cushion.

■ Re-Priced Loans for Acquisition: Outstanding loans available for acquisition are more likely to be priced at a discount that reflects current property pricing.

■ Mezzanine Opportunities Proliferate: Higher-yielding debt opportunities in the mezzanine tranche are likely to multiply as owners of properties look to fill the gap between equity and likely smaller senior mortgages.

Why U.S. office may be especially attractive for debt investors

Learn more about why we believe the current U.S. office landscape offers a compelling, risk-adjusted, and multi-pronged investment thesis for debt investors.

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The U.S. Office Debt Opportunity

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Where Momentum Is Building in U.S. Office

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Disclaimer


The content herein and in the report is provided for informational purposes only. Nothing above or in the report constitutes investment, legal, or tax advice or recommendations. Such content should not be relied upon as a basis for making an investment decision and is not an offer of advisory services or an offer to invest in any product or asset class. It should not be assumed that any investment in an asset class described herein will be profitable. Any projections, estimates, forecasts, targets, prospects and/or opinions expressed in these materials are subject to change without notice. Opinions or beliefs expressed in these materials may differ or be contrary to opinions expressed by others. Certain information above and in the report has been obtained from third-party sources. Hines has not independently verified such information.


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The U.S. Office Debt Opportunity