There’s been little doubt that office properties continue to struggle. Increasing concessions, negative absorption and vacant sublease space approaching records continue dogging this property type. As a result, it isn’t surprising that the office sector is facing debt challenges. One potential exception to this idea has been the Class AA well-located, trophy asset, especially in light of the flight to quality trend. But even this asset class might be in trouble, especially buildings secured with CMBS financing. At least, that’s the thinking, according to recent report issued from Morningstar Credit Information & Analytics.

Appropriately entitled “A Focus on Office Leverage,” the report indicated that the combination of uneven return-to-office edicts and “an aging stock where the bifurcation between desirable and undesirable buildings is growing” has many speculating that aging office properties might replace replacement malls as “the bane of commercial mortgage-backed securities investors’ existence.”

Specifically, property values continue falling. Rising interest rates continue putting stress on future refinancing. And “as buildings seek to add amenities to remain or become desirable to tenants,” buildout costs and growing TI allowances are adding to the problem, the report said.

In analyzing single-asset/single-borrower CMBS transactions backed by office properties, MCIA researchers revealed that even the trophy office properties are facing considerable headwinds in the current and near-term environment. One alarming metric was that “six loans with underperforming recent cash flows appear to be 100% leveraged,” with SASBs in the 70%-100% leveraged category more than doubled. The reason for this increase is because of the decrease in asset value, which tends to push up leverage.

In testing how some of these loans might react to different types of financial stressors, the MCIA researchers noted that “even a 10% haircut to current cash flow pushes more than half of the loans above a 70% LTV,” with a 20% decrease in asset valuation pushing that number above two thirds. “The bigger takeaway is that the majority of deals show significantly weakening metrics in nearly all scenarios,” the researchers pointed out.

Along these lines, refinancing could end up being a challenge. “Borrowers may be faced with coming out of pocket with fresh equity (and the same time they’re expending capital on renovations or adding amenities) to get adequate leverage points on the refinance,” the report indicated.

The researchers acknowledged that they considered only trust debt as part of the analysis. But 43 loans in the population researched had additional debt in place at issuance including secured subordinate debt, mezzanine debt or a combination of the two. “This could become problematic as additional debt increases the total proceeds needed upon loan maturity, and also adds a layer of complexity in the event a workout is needed,” the report said.

The researchers also said that their efforts were directed toward the SASB sector, “but we’ve begun to note these factors taking hold in the conduit space as well.” Many $100-million-plus conduit office loans have moved toward special servicer status since December, and the researchers said “we’re not seeing many payoffs among larger conduit loans (the exception is previously defeased loans).”