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In This List
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European Office Real Estate Companies: After A Resilient First Half, Upcoming Lease Maturities Should Test The Market

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European Office Real Estate Companies: After A Resilient First Half, Upcoming Lease Maturities Should Test The Market

After A Sudden Slowdown In The Second Quarter, The Future Is Unclear For Office Rent Pricing

Unsurprisingly, the second quarter of 2020 was extremely weak for leasing activity in most European office property markets. The Paris market, for example, recorded its worse quarterly performance in 20 years, with a 65% decline from the previous quarter, according to Knight Frank ("Paris Ile-de-France Office Market / Q22020 – July 2020"). Small and intermediate surfaces recorded the biggest transaction declines. We understand that technology firms and professional service providers represented the few active space seekers, which preferred central locations and business districts over city outskirts and other decentralized locations. Arguably, there hasn't yet been any clear sign of a move in rental rates because most leasing transactions concluded in the second quarter were initiated before the outbreak. Vacancy rates, on the other hand, have flattened and somewhat increased in most office markets in the second quarter, after years of continued decline.

Looking ahead, we think the wait-and-see position that tenants have adopted in their real estate decisions could benefit some landlords if renters agree to short-term lease extensions. On the other hand, such a stance would likely make it harder for landlords to lease vacant space and newly built surfaces to be delivered this year--especially where pre-letting of new construction is currently low, such as in some decentralized areas. Moreover, space needed by occupiers may also decrease as remote working increases, companies take cost-saving measures, and economies may only slowly rebound. Those factors could weigh not only on occupancy but also on market rents—the extent of which remains unknown in the absence of a significant number of leasing transactions.

Chart 1

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Rents And Valuations Have Been Resilient So Far

Rental growth remained mostly positive in the first half, boosted by a strong first quarter

Despite a sharp slowdown in leasing activity in the second quarter, most office property portfolios reported positive rental growth in the half, compared with first-half 2019. This organic growth was fueled by indexation and strong rent increases in the first quarter and was fully or partly offset by rent concessions and occupancy declines during lockdowns. Societe Fonciere Lyonnaise's performance suffered from the closure of conference centers, Hotel Indigo, and the Edouard VII car park, without which rent growth would have been stable for its office portfolio. For our rated companies, we do not expect revenues from office assets to rebound strongly in 2021 because of what are likely to be subdued indexation rates and rent increases on extensions or renegotiations.

Chart 2

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Occupancy started declining slightly, except in German portfolios

While rents have remained relatively resilient, we observe a widespread trend of declining occupancy, as shown by a 90 basis points drop on average in financial occupancy--actual rental income divided by potential rental income that could be received if the portfolio was fully leased and occupied. France, Belgium, and Spain, for example, saw declines. In contrast, rated companies in the German office market recorded increases in financial occupancy.

Chart 3

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Rent collection remained high at the peak of lockdowns, highlighting limited tenant stress

Reported rent collection in the first half has been high and between 95% and 100% in the second quarter, which is close to normal for the office market. While the figure generally excludes rent deferrals and agreed rent fees, we note it is much higher in the office segment than in the retail property segment. We believe this is due to the higher diversity and stronger creditworthiness of tenants, at least within our rated group of companies.

Chart 4

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Valuations declined moderately, mainly because of cash flow readjustment by appraisers

Valuations of office assets declined slightly as of June 20, 2020, from Dec. 31, 2019. For most of the devaluations, the main driver was a cash flow adjustment by appraisers based on lower indexation expectations for next year and some stressed operating assumptions due to COVID-19. However, we understand that none to very little of the value depreciation actually came from yield expansion, the other possible factor of valuation loss, mostly due to the absence of benchmark transactions. For German assets, revaluations were slightly more negative while rents were more resilient. What's more, for most of the diversified players we rate, revaluations of office assets often offset revaluation losses from other assets. Further devaluations are likely in case vacancies rise further, market rents decline more than what appraisers currently anticipate, or assets are sold at a large discount to their last appraisal value.

Chart 5

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The Next Expiring Leases Could Test Landlords

Generally speaking, rents coming to expiry or break options represent risks for landlords of reletting space below the previous rent or leaving it vacant, which in both cases mean a revenue loss for them. We estimate that about 19% of companies' rental income is coming to maturity or is being subject to a tenant's option to exit without penalty in the next 18 months from June 30, 2020. If the current market uncertainty prevails, we conservatively assume 10%-15% discounts on newly signed leases for the next 12 months in our forecasts.

That said, average lease terms vary, with Central and Eastern European countries exhibiting lower maturities than Western countries. The type of tenant is also a factor, as government-owned entities are more inclined to lease over longer periods.

Chart 6

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Chart 7

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Most Companies Have Enough Rating Cushion, Despite Some Thinning

As we expected, our key credit ratios weakened for most of our rated office property companies to June 30, 2020. However, this is within the rating cushion that companies had previously built in their credit metrics, that is, for a 5% decline in rent and revaluation by end-2020, also our base-case scenario.

Chart 8

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EBITDA-to-interest coverage ratios have been slipping somewhat because of weak or stagnant revenue. In most cases, rated issuers showed ratios within our minimum expectations for the current ratings, with headroom of 90 basis points on average as of June 30, 2020. The decline in interest coverage ratio for Merlin Properties and CPI Property came from the temporary closure of some of their retail assets and discounts granted to tenants recognized in the second-quarter revenues. We expect their revenues to rebound gradually and move the ratios more strongly above 3x in 2021.

Chart 9

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The real estate investment trusts (REITs) we rate in Europe have built large buffers, as illustrated by strengthening debt-to-debt and equity (D/D+E) ratios, owing to a rise in valuations in the past few years. As of June 30, 2020, the pandemic has led to some valuation losses that lifted issuers' D/D+E ratios by 1 percentage point on average. CPI Property Group's D/D+E ratio has increased more sharply mainly because of the devaluation of its retail assets. However, we estimate average headroom of 5.4 percentage points under our current rating thresholds, excluding companies that have not yet reported first-half earnings and DIOK, which has no D/D+E rating threshold.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Franck Delage, Paris (33) 1-4420-6778;
franck.delage@spglobal.com
Secondary Contacts:Marie-Aude Vialle, Paris (33) 6-1566-9056;
marie-aude.vialle@spglobal.com
Nicole Reinhardt, Frankfurt + 49 693 399 9303;
nicole.reinhardt@spglobal.com
Additional Contact:Industrial Ratings Europe;
Corporate_Admin_London@spglobal.com

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