Risks of Weakening Labor Market Could Be Next Barrier for Office Sector: Moody’s

The office sector, hit hard by COVID-induced hybrid working trends and higher interest rates over the past four years, is at risk of facing a new headwind.

While the Federal Reserve is poised to continue lowering interest rates following a 50 basis point cut at its September meeting, risks of a weakening labor market would add another barrier to office property owners meeting their debt obligations, according to a Moody’s Ratings report released Thursday. There are around $750 billion in outstanding office loans in the U.S, which accounts for 16 percent of outstanding commercial real estate debt, according to Moody’s. 

Moody’s is projecting a soft landing for the U.S. economy with estimated gross domestic product growth of 2.4 percent in the fourth quarter and 1.8 percent in 2015’s first quarter. However, it also predicts a slower labor market due to weaker job creation, less hiring by companies, reduced working hours and a recent uptick in the unemployment rate.

The Moody’s analysis notes that if rate cuts are followed by “severe” employment losses, the CRE industry would feel the effects even if lower borrowing costs boost valuations. Most CRE sectors would be positioned to withstand economic pressures, but office assets with maturing loans face particular distress from cash-flow losses resulting from lower tenant revenue as firms lease less space.

Darrell Wheeler, head of commercial mortgage-backed securities (CMBS) research at Moody’s Ratings, noted that the office sector is just now starting to reap benefits of 7.3 million jobs created since 2020 from new companies seeking space. He said a dip in the labor market would curb that momentum.  

“If we were to lose employment sometime during 2025, that effect would go away and it would have an impact that might be outsized,” said Wheeler, who was co-lead on the report with Stephen Lynch, vice president and senior credit officer at Moody’s. “As the office market is trying to stabilize, it would be a hindrance to have an employment slowdown at this point.”

Moody’s estimates that hybrid work has lowered office demand by 14 percent to 22 percent since the COVID-19 pandemic began in 2020, and many analysts expect that tenants will continue to downsize their space needs as leases come up for renewal. Recent property trade data indicate that average office values have dropped by 23 percent since mid-2022 when interest rates began spiking, the most of any property type, followed by multifamily, which is down 19 percent. 

The Fed implemented 11 interest rate hikes in 12 meetings between March 2022 to July 2023 followed by eight straight pauses and then a half-point cut in September to between 4.75 percent and 5 percent. 

“Jobs fill buildings, which is good, but the problem is jobs and employment and spending have supported inflation, which leaves interest rates high, which is a financing problem for CRE,” Lynch said. “It’s the ‘Catch 22’ of wanting rates to fall, but not for the economy to do poorly.” 

Despite the elevated interest rate environment of the last two and a half years, Moody’s stressed that lending markets have remained largely open with employment growth supporting all CRE sectors except for office. Most lenders have been proactive in extending or renewing loans before their scheduled maturity dates to buy time for interest rates to fall, but labor market woes would spur more property owners to default, particularly for offices far from transportation hubs, according to Wheeler. 

The U.S. now has nearly $6 trillion in CRE mortgage debt outstanding, according to Moody’s citing data from the Federal Reserve. The most CRE loans are held by banks (50.8 percent) followed by government-sponsored enterprises (17.2 percent), insurance companies (12.8 percent), CMBS (8.5 percent) and private lenders or mortgage real estate investment trusts (3.3 percent). 

Market share for most lenders have remained stable since 2019, but mortgage REITs have decreased their CRE holdings by over $100 billion in that period, according to Moody’s.

“The mortgage REITs I cover have all been shrinking their balance sheets to support capitalization,” Lynch said. “When you start having problem loans or loans on a watchlist, you start taking payoffs. And any payoff you get, you don’t redeploy that capital because it will bring down your leverage and support your capitalization as you’re building credit loss reserves.” 

Andrew Coen can be reached at acoen@commercialobserver.com