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S&P: Rising office vacancy may impact lower-rated European CMBS tranches

The rating agency’s analysis of office-backed CMBS transactions shows AAA- and AA-rated tranches can withstand higher vacancy rates, while lower-rated tranches are more vulnerable.

The lower-rated tranches of Europe’s commercial mortgage-backed securities transactions that are secured by offices would be at risk of being downgraded if vacancy rates were to rise by more than 7.5 percent, according to S&P.

In a report published on 29 June, the ratings agency argued that AAA and AA tranches of existing securitisations should withstand a rise in office vacancy levels. However, it also said that lower-rated tranches – which account for around two-thirds of European office CMBS transactions – would be more vulnerable.

S&P said that it remains uncertain how new behavioural patterns, social distancing, lower desk densities and corporate cost reductions will affect occupier demand. It acknowledged that these changes could lead to longer-term increases in vacancy levels in Europe’s office markets.

Edward Twort, S&P credit analyst, said: “At this point it is extremely challenging to project how office vacancy levels will evolve as we move into a ‘post-covid’ market, although some forecasters estimate vacancy levels in London could increase to between 6.5 percent and 7.5 percent as a result of job losses and a weakening of occupier demand.”

Of the European CMBS deals that S&P rates, offices account for 30 percent of underlying collateral, of which 93 percent is located in London.

The agency ran a stress test of UK office-backed CMBS transactions by analysing the impact of increases in their current vacancy rates of between 2.5 and 10 percent. Higher rated tranches – AAA and AA – could withstand a 10 percent rise without the need for downgrading. However, lower rated transactions risk being downgraded, albeit by a maximum of two grades.

“AAA and AA are relatively robust and even at the most severe stresses of 10 percent, we’re not seeing any rating downgrades,” said Twort.

“By contrast, single A and BBB are showing some vulnerability to increased vacancy stresses. But again, these are limited to the more stressful scenarios of 7.5-10 percent and, even in those scenarios, we’re looking at a potential one- to two-notch average adjustment across the portfolio.”

The stress test also found that while a rise in vacancies would result in an increase in the loan-to-value ratio across the sample, this would be 4.1 percent at most – even under the test’s most severe vacancy increase, of 10 percent.

Last week, S&P downgraded the notes of Taurus 2018-2 UK DAC, a London office-backed CMBS transaction. The deal was backed by a senior loan from Bank of America for the acquisition of Devonshire Square Estate, which included WeWork as a tenant. The class A notes have been lowered from AA+ to AAA and the class B from A+ to AA-.

“There were a number of factors that fed into that office downgrade, including deteriorating operating performance, but vacancy was one of the factors,” said Twort.

However, S&P has not taken any rating actions to date on any office-backed CMBS purely on the basis of vacancy adjustments. The report implied that, overall, these transactions would continue to perform in the event of a rise in vacancies.

“At this point, we don’t see any immediate risk to the portfolio as a whole,” said Twort.

He added that any significant movements in vacancy rates across the portfolio would entail a “gradual tottering” of vacancies in the medium term rather than an overnight impact, given the length of the underlying leases generally in a property portfolio.