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Vacancy Up, Ratings Down? European Office CMBS Transactions After COVID-19

As the COVID-19 infection rate starts to decrease in Europe, countries are taking steps to re-open their economies. However, the pandemic may have an enduring effect on working practices in some areas of economic activity. In particular, many companies are now re-evaluating their relationships with office spaces in light of their experience during the pandemic and ongoing restrictions. The demands of employees and the viability of remote work, given improvements in technology, means that the traditional office is likely to evolve.

The Potential Effects Of COVID-19 On Europe's Office Markets

Factors such as GDP growth, job creation, and companies' expansion plans generally support demand for office space. In Europe, we expect GDP to fall by 7.8% in 2020 and unemployment to increase to 9.1% by 2021. In the U.K., we expect GDP to contract 8.1% this year and we forecast unemployment to increase to 6.0% and 6.2% in 2020 and 2021, respectively, before falling to 4.9% in 2022. This deterioration will likely have a short-term effect on the office leasing markets. For example, JP Morgan estimates that job losses might double the available office accommodation across core London.

We anticipate that the pandemic and its aftermath will dampen companies' growth plans and need for additional office space. The cost cutting and staff reductions that may result from prolonged disruption will exert pressure on office occupancy rates. Flexible office providers may be the first to feel the pressure, given the short-term nature of their leases, but they may also represent a credible alternative to long-term traditional offices for corporate tenants that are on the path to recovery.

The restrictions on movement and social gatherings that most governments have imposed have led companies to temporarily close their offices, limit face-to-face business interaction, and deploy remote-working processes. The success and the duration of remote working may convince companies to maintain this practice and optimize their office space and related costs. However, remote working is not a new threat for landlords either, as many took action to address this trend long ago by developing a wide range of attractive services within their offices, like investing in common areas to improve employees' wellbeing, and refocusing their office portfolios on central locations with excellent transport connections (see "How Are Lockdown Measures And Remote Working Affecting European Office Landlords?," published on May 27, 2020).

It is also likely that office tenants will scrap their future plans for expansions and maintain their existing office space. Other market participants are saying that they might no longer need their disaster recovery sites, as their staff's living rooms have proven to be a suitable recovery site during this period. This, in turn, would not so much affect central office locations but would put pressure on the suburban, secondary markets.

Finally, while many employees may enjoy working from home, not all want to do so on a permanent basis. This means employers still need to maintain a number of desks at their existing offices, even if they introduce frequent work-from-home systems.

Consequently, it remains uncertain whether, and to what extent, new behavioral patterns, social distancing, lower desk densities, and corporate cost reductions will affect European office vacancy levels in the medium to long term. However, the residual effect of COVID-19 may potentially result in longer-term increased levels of vacancy. We have therefore performed a deeper analysis into how, on a hypothetical basis, this could affect rated European CMBS office transactions in our surveillance portfolio.

Given that most office-backed CMBS transactions that we rate are centered on the London office market (as detailed in our overview of our surveillance portfolio below), this analysis is largely focused on the London office sub-markets.

Scenario Analysis: London-Based Office-Backed CMBS Transactions

Our analysis shows that ratings in the 'AAA' and 'AA' categories are robust and unlikely to be lowered, even when increasing vacancy rate by 10 percentage points from the current levels. By contrast, ratings in the 'A' and 'BBB' categories are more vulnerable to increasing vacancy, although the movement is limited to one or two notches under scenarios where the vacancy rate increases by 7.5 or 10.0 percentage points.

As detailed below, our current S&P values incorporate long-term capitalization (cap) rates, which are above the current market valuation cap rates. However, an increase in vacancy lowers the S&P net cash flow (NCF), leading to an increase in the S&P loan-to-value (LTV) ratios, albeit limited to 4 percentage points even under the most severe stress (10 percentage point increase in vacancy rate).

Chart 1

Sensitivity calibration

We present the aggregated effect from various levels of increasing vacancy rates across approximately 85% (by debt balance) of U.K. office CMBS transactions that we rate. We tested their performance by increasing their in-place vacancy rates by between 2.5 and 10.0 percentage points. These increases in occupancy levels are not our expectations, but rather a hypothetical sensitivity range to gauge the ratings movements and changes in the S&P LTV ratios.

Table 1

Steps To Stress The Effect Of Increasing Occupancy Across Four U.K. Office CMBS Transactions
Step Description
Initial rating As the initial rating we have used the rating category as a starting point. 'AAA' incorporates all notes rated 'AAA', 'AA' incorporates all notes rated 'AA+'/'AA'/'AA-', and so on.
Increased vacancy rates We have increased the vacancy rate of each individual transaction by 2.5, 5.0, 7.5, and 10.0 percentage points.
S&P LTV effect We looked at the average effect on the current S&P LTV when increasing the vacancy rates by 2.5-10.0 percentage points. This report lists the average S&P LTV increase, but we used the individual valuations when analyzing on a transaction-by-transaction basis.
Rating change We then analyzed the average change across each rating category in order to derive the rating effect of increased vacancy rates.
LTV--Loan to value.
Cap rates maintained

In our analysis, we have maintained the S&P cap rates we use in our property analysis as they are average long-term rates that encompass multiple real estate cycles. Therefore, S&P values often differ from point-in-time market values. We have not adjusted our S&P cap rates because of the COVID-19 pandemic.

Scenario analysis assumptions

This analysis looks at the asset-level effect of increasing vacancy only. It does not factor changes in counterparty or sovereign ratings, operational risks, or legal changes.

We have run the standard recovery analysis and loan tranching as detailed in our European CMBS criteria.

Our analysis is somewhat limited by the fact that this is an "occupancy shock stress". In reality, if structural vacancy were to increase within these transactions it would likely be over a more protracted period given the current lease commitments. Furthermore, over time many loans will likely deleverage, reducing the transaction's credit risk.

S&P Global Ratings' European CMBS Office Exposure

Our surveillance portfolio currently comprises CMBS transactions totaling £21.4 billion of outstanding debt, of which 30% by debt balance is exposed to the office sector.

Chart 2


While we monitor CMBS transactions secured on office accommodation in European markets such as Germany, The Netherlands, Finland, Italy, and Ireland, most of the office exposure in our surveillance portfolio is from U.K.-based transactions (91% of the outstanding office-backed debt, arranged over 10 transactions).

Of the U.K.-based office transactions, 93% by outstanding debt is based in London submarkets (primarily the City, West End, and Canary Wharf).

Table 2

S&P Global Ratings' European CMBS Office Exposure
European sector exposure Debt balance (mil. £) Split (%) No. of transactions
Office 6,502 30.3 18
Other 14,938 69.7 26
Total 21,440 100.0 44
Geographic exposure (office)
U.K. 5,939 91.3 10
Non-U.K. 563 8.7 8
Total 6,502 100.0 18
U.K. submarket exposure (office)
London 5,546 93.4 5
Rest of U.K. 393 6.6 5
Total 5,939 100.0 10
London vacancy rates

We have reviewed the most recent available data as published by the largest real estate consultants and market commentators, which indicate central London vacancy rates are currently at about 5%. In terms of the main individual submarkets, while there is some variation, the current reported vacancy figures for the West End are between 3.5% and 4.5%, the City between 5.0% and 6.0%, and Canary Wharf between 7.5% and 9.0%.

In order to establish sensible vacancy stresses, we have reviewed historical peaks in vacancy levels experienced in prior real estate cycles. Market data from various sources indicates the central London office vacancy rate peaked at between 10% and 12% in 2003 and again between 7% and 10% in 2009, following the collapse of the dotcom bubble and the global financial crises, respectively.

Chart 3


In central London, the current amount under construction is about the same as in 2007 (about 15 million square feet [sq. ft.]) but the amount of speculative construction is three times lower. According to research recently published by CBRE, of the space currently under construction and due to complete before the end of 2023, approximately 60% is under offer or pre-let. Furthermore, given the effects of COVID-19 on construction progress, together with reduced leasing demand in the short term and less appetite from developers to take on speculative risk, we expect that additional new office space will come on-line over a longer period of time (when compared with pre-COVID projections).

We are not forecasting a sharp increase in London vacancy rates similar to the aforementioned levels, and we don't necessarily believe that there will be any significant structural shift as a result of a recession or oversupply. Moreover, we believe that any change will not happen overnight but will instead be the result a process that takes months, if not years. However, we do believe that there will be further corporate cost reductions and occupational demand will decrease to some extent.

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% and 7.5% as a result of job losses and a weakening of occupier demand. Rather than forecasting, we have derived our hypothetical stresses based on the magnitude of historical downturns as illustrated in chart 3 above. Our scenario analysis above is closely aligned to the vacancy levels experienced in the last two downturns as we consider the dynamics of the office market and the demand drivers and risks to be more comparable looking forward.

S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The consensus among health experts is that the pandemic may now be at, or near, its peak in some regions, but will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: As the situation evolves, we will update our assumptions and estimates accordingly.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Edward C Twort, London (44) 20-7176-3992;
Secondary Contacts:Darrell Purcell, Dublin + 353 1 568 0614;
Mathias Herzog, Frankfurt (49) 69-33-999-112;

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