More than three years on from the COVID-19 pandemic, and it is clear that remote and hybrid working are here to stay. This together with challenging economic conditions has reduced demand for European and U.K. office accommodation, as companies reevaluate their requirements, and in some cases relocate to smaller premises to accommodate lower physical presence. Companies must also meet growing environmental, social, and governance standards--key to attracting and retaining the workforce. In light of this, and negative office market sentiment, we assessed how increased office vacancy may affect the creditworthiness of our rated European and U.K. commercial mortgage-backed securities (CMBS) transactions. Our scenario analysis assumed increased vacancy rates for office assets to determine how lower recovery values may affect our ratings.

We found that 'AAA' and 'AA' rated tranches can withstand increasing vacancy rates with little risk of downgrade. Lower-rated tranches are more vulnerable in higher vacancy stress scenarios but are exposed to principal losses in only a limited number of cases. Given that our recent rating actions consider current market vacancies as well as in-place vacancies for the assets, we expect that our ratings will not change in the near term. Our hypothetical scenarios mean that our vacancy assumptions for some transactions would have to double from an already high starting point before ratings are affected. If vacancies rise significantly from their current levels and we revise our assumptions, then low-investment-grade and speculative-grade tranches are vulnerable to downgrades.

Post-Pandemic Remote Working Weighs On Office Vacancy

The shift to remote and hybrid work has decreased demand for office space. According to U.K. real estate agency Knight Frank, the London office vacancy rate increased to 9.6% in Q1 2023 from 5.7% in Q1 2020. Office attendance in London is still among the lowest in Europe, although significantly up from June 2022 (U.K. real estate agency Savills European office occupancy study, March 2023).

Within London, return to office appetite in Canary Wharf and the surrounding Docklands area has been weaker than in the West End and in the city. For example, Knight Frank reports a first quarter 2023 Canary Wharf submarket vacancy rate of 17.3% compared to 10.2% in the city and 5.5% in the West End. Furthermore, in the West End, office vacancy decreased at the end of 2022 (albeit showing an uptick in Q1 2023), while it continued to increase in the City and Canary Wharf.

Chart 1

Despite declining occupancies in these submarkets, prime rents have increased since before the pandemic. While this underscores the resilience of London's office occupational market, it somewhat hides landlord incentives, which effectively reduce rent. Rent-free periods, for example, have increased to 24-27 months on average on a 10-year lease from 21-24 months before the pandemic.

According to real estate advisory firm, Green Street's Commercial Property Price Index (CPPI), pan-European office property prices in the 30 most liquid markets it tracks had decreased by 28.7% in April 2023 from a year earlier, and were 27.8% lower than just before the pandemic. For London, office property prices declined by 30.9% since 2022 and were 32.1% lower than pre-pandemic levels. Office price performance followed a similar trend in the five markets shown in chart 2, with Amsterdam showing the smallest decline of 26.7% and Frankfurt showing the largest decline of 33.3%. That said, both of those markets had doubled in value in early 2022 compared to 10 years earlier.

Chart 2

Chart 3

Chart 4

Chart 5

Vacancy Stresses Highlight Overall Ratings Resilience

We performed a scenario analysis of the CMBS transactions we rate, which are secured entirely or in part by office buildings. The scenario analysis involved varying the vacancy rate used in the analysis of the office assets. The vacancy rate is one of the inputs that we apply in our analysis to determine the long-term net cash flow (NCF) of each property or portfolio of properties and, in turn, the recovery value of the assets in a workout scenario. Our European CMBS transaction analysis is essentially a recovery analysis. Thus, the application of our criteria considers whether a European CMBS transaction can repay with the amounts recovered following a default of the underlying loans and a liquidation of the mortgage collateral. See the Appendix for information on how we categorize office properties securing our rated European and U.K. CMBS transactions, and how we formulate our cap rates.

We typically assume vacancy rate to be the greater of 5%, the in-place vacancy and the market vacancy. In this scenario analysis, we stressed our vacancy assumptions by adding 5%, 10%, and 15% to our current vacancy assumption for office assets. These increases in vacancy levels are not our expectations, but rather a hypothetical sensitivity range to gauge the ratings movements in different scenarios.

Overall, our analysis shows the resilience of our ratings under a significant stress in underlying assumptions. 'AAA' and 'AA' rated tranches can withstand increasing vacancy rates assumptions with limited risk of downgrade, while lower-rated tranches are more vulnerable in the higher vacancy stress scenarios. Chart 6 shows how sensitive our ratings are at each rating category.

Chart 6

In the 'AAA' category, increasing the vacancy assumption by 5%, 10%, and 15% results in an average downgrade of 0.36, 0.73, and 1.00 notches, respectively. We rate 11 tranches 'AAA', and only two tranches experience a three-notch downgrade in the most severe scenario.

In the 'AA' category, the most stressful assumptions lead to an average 0.95-notch downgrade. This rating category includes 20 tranches and is dominated by 12 classes of notes issued by Land Securities Capital Markets PLC, which is secured by a mixed pool of assets, is resilient to changes in assumptions, and maintains the same rating in all scenarios. Among the other eight tranches rated 'AA', the most sensitive are three tranches secured by office assets in the Netherlands, which experience a four to five-notch downgrade in the most severe scenario.

'A' rated tranches experience a 1.71-notch downgrade on average and, also, a greater dispersion around the average. We rate 14 tranches in the 'A' category, and eight are unchanged in any scenarios, while three show a four to six-notch downgrade in the most severe scenario.

'BBB' rated notes are the most sensitive to stressed assumptions among investment-grade categories. A 5%, 10%, and 15% increase in our vacancy assumption results in an average downgrade of 1.17, 2.33, and 3.5 notches, respectively. We rate six tranches in the 'BBB' category, but only one declines to 'B-' or lower in the most severe scenario, and could potentially incur losses.

Our updated assumptions incorporated in our most recent rating actions take into account current market vacancy and in-place vacancy at the assets. Therefore, our assumptions already consider increased vacancies across U.K. and European markets, due to changing tenant requirements and office accommodation demand since 2020.

Scenario Analysis Results By Transaction

Our property evaluation reflects the underlying collateral's long-term expected-case value calibrated to a 'B' rating level. The average value haircut between the market value and the S&P Value (resulting from a calculation considering the long-term sustainable net cash flow and an applicable capitalization rate) for the 11 transactions secured by office assets is 32%, based on recent market valuations as of 2022. The exception is Salus (European Loan Conduit No.33) DAC, where the market value is as of September 2021 and our value haircut is 41%. Chart 7 shows the evolution of the market valuations for each transaction since before the pandemic to the most recent market valuation, compared with the current S&P Value.

In the scenarios described above, the increased vacancy rate results in market value haircuts of 35%, 39%, and 42% when the vacancy assumption increases by 5%, 10%, and 15%, respectively, compared with our current vacancy assumption. Overall, our S&P Value reflects a significant cushion against market value decline, which the rated notes can absorb before incurring a loss.

Chart 8 shows how sensitive our ratings are for each transaction across the capital structure under the most severe scenario where we increase the vacancy assumption by 15%.

Chart 8

Broadgate Financing PLC

• The transaction is secured by 11 buildings that form part of the Broadgate Estate in the City of London.
• In our last review we assumed 12% vacancy for this portfolio, which exceeds the 10% vacancy rate for the city submarket. Further, our S&P Value includes a deduction for voids and reletting costs. Our model output results in higher ratings than currently assigned.
• The class A notes exhibit low leverage and are resilient to the stressed vacancy assumptions in all scenarios. The class B and C notes benefit from scheduled amortization, which reduces the class leverage and is credit positive. These two classes of notes show little sensitivity to stressed vacancy assumptions.

Land Securities Capital Markets PLC

• The collateral pool includes 55% U.K. offices, of which more than half are in the West End where vacancies are the lowest among London office submarkets.
• The sponsor can replace assets in the collateral pool and the transaction operates within tiers. As a result, the transaction benefits from low leverage and the loan-to-value (LTV) ratio is currently 32.5%.
• Due to the low leverage and our conservative base-case assumptions, the notes can withstand increased vacancy assumptions for offices without any impact on ratings.

Canary Wharf Finance II PLC

• In our latest rating action, we assumed 16% vacancy, higher than the securitized portfolio's vacancy but in line with the Canary Wharf submarket at the end of 2022.
• The hedging counterparties' ratings constrain the note ratings. Therefore, although the model output suggests higher ratings than 'A+', the highest rating the senior classes can achieve is 'A+'.
• Furthermore, the senior notes benefit from scheduled amortization. The transaction can withstand significant stress before the ratings are affected by the lower S&P Value resulting from the stressed vacancy assumptions.

Taurus 2018-2 UK DAC

• The transaction is secured by an office campus in Devonshire Square in the City of London.
• Our S&P Value assumes 12.5% portfolio vacancy, which exceeds the market average but is lower than the in-place vacancy.
• However, our analysis considers the capex facility available for the refurbishment of existing space and a deduction for void periods, rent free periods, and brokers' commission.
• Despite assuming high vacancy rates, the rated notes show little sensitivity because of the low loan leverage of 25.3%.

Salus (European Loan Conduit No.33) DAC

• The underlying collateral is backed by the City Point building in the City of London. The senior LTV ratio is 49.7%.
• Our latest rating action assumed 15% vacancy compared to 20% vacancy at the property and 10% vacancy for the city core submarket. Our base case gave credit to asset management initiatives, and we also deduct void period and brokers' commission.
• The building has been fully renovated since the start of the pandemic, is Building Research Establishment Environmental Assessment Method (BREEAM) Excellent rated, and is well positioned to lease up and achieve occupancy in line with the broader market. However, in our most severe scenario, the junior class C and D notes, currently rated 'BBB-' and 'BB', are potentially exposed to a downgrade to 'B-' or below.

Viridis (European Loan Conduit No. 38) DAC

• The underlying collateral is backed by Aldgate Tower next to Aldgate East station. The loan leverage is 64.0%.
• We had already assumed 15% vacancy at closing in 2021. Vacancy improved from over 30% at closing to less than 10% in 2022, but subsequently increased to 15% after a large tenant left the property. Therefore, we maintain our vacancy assumption, which is comparable to the Aldgate submarket.
• Similar to Salus (European Loan Conduit No.33) DAC, in the most stressful scenario the junior class E notes, currently rated 'BB', are potentially exposed to a downgrade to 'B-' or lower.

Table 1

'AAA' And 'AA' Rated Tranches Are The Most Resilient

We incorporated the risk of high vacancy rates in our recent rating actions where our base-case vacancy rate assumptions reflect both the in-place vacancy at the underlying properties and the broader market vacancies. The rating transitions since closing are shown in Chart 9.

In this scenario analysis, we stressed our vacancy rate assumptions by adding up to 15% to our already conservative base-case vacancy rate. The results show that 'AAA' and 'AA' rating categories can withstand increasing vacancy rates with little risk of downgrade. Lower-rated tranches are more vulnerable in higher vacancy stress scenarios but are exposed to principal losses in only a limited number of cases.

The situation for commercial real estate backed by offices remains challenging. In addition to increased vacancy rates, higher cap rates are contributing to lower valuations across the sector. Higher interest rates will make it more difficult for loans to refinance when they reach their maturity dates. Further, minimum energy efficiency requirements, both regulatory and by occupiers, mean that many office assets will require significant capital spending to achieve the desired energy efficiency. Nevertheless, the transactions we rate are backed by better-quality assets, are less leveraged, and benefit from positive structural features, all of which make them resilient to further decline in valuations.

Appendix

Property categories

For all properties in Europe, our rating analysis divides each property type into three categories based on a qualitative assessment of an asset or portfolio. In our view, this enables cap rates to be consistently applied to similar properties and facilitates comparisons. Categories are designed to reflect the market's perception of a property's relative quality and desirability within its sector.

We categorize all office properties securing the CMBS transactions we rate as Category 1. These properties are among the highest-quality buildings in their respective submarkets, are well-located, have good access, and are professionally managed. As a result, Category 1 assets attract the highest-quality tenants and command the highest rents in their markets.

In our opinion, the office assets that secure the CMBS we rate are well located close to transportation links, have high quality amenities and have undergone recent refurbishments. Tenants include professional and financial firms, which are generally considered high-quality tenants. Moreover, they can achieve rents at the level of prime market rents for their respective submarket.

Under the existing U.K. Minimum Energy Efficiency Standards (MEES) requirements, commercial property landlords in England and Wales are prohibited from granting a new lease unless the property has an EPC rating of E or higher (except for certain exemptions). From April 1, 2023, the prohibition on letting a commercial property with an EPC rating below E applies to continuing and existing leases as well as new leases.

As part of its target to reach net-zero by 2050, the U.K. government is expanding the MEES regulation such that existing commercial properties must achieve a minimum EPC rating of C by April 2027, and a minimum EPC rating of B by April 2030. We are reviewing the EPC ratings of the assets securing the CMBS transactions we rate and monitoring the risk that they may not comply with the proposed legislation. Based on our communication with the sponsors on their plans to meet the minimum EPC ratings we believe they are proactively planning for changes in regulation and using any void periods to upgrade their buildings to achieve higher EPC ratings.

Cap rates

Our cap rates for individual jurisdictions and category types are based on available historical data and are average long-term rates that encompass an entire real estate cycle. Therefore, our cap rates remain relatively constant and do not change in line with market cap rates. High interest rates and high borrowing costs translate into higher market cap rates. As a result, for some property types, our cap rates are below the market cap rates.

Chart 10

Chart 10 shows the increase in Green Street economic cap rates as of Q2 2023 since before the pandemic in Q1 2020, and compared to our S&P cap rates, which have remained constant. Our analysis of the underlying properties focuses on long-term sustainable trends, often resulting in cash flow haircuts and the use of our cap rates, which typically maintain 100-150 basis points or more in spread to prevailing market cap rates. The positive spread between our cap rates and Green Street economic cap rates has narrowed but remains positive for most office markets. For London our anchor cap rates are 6% for Category 1 assets in the city and 6.75% in Canary Wharf, and the Green Street cap rate, which is 6.2%, currently exceeds our cap rate for the city.

Related Criteria

• European CMBS Methodology And Assumptions, Nov. 7, 2012
• CMBS Global Property Evaluation Methodology, Sept. 5, 2012

Related Research

• European CMBS Monitor Q1 2023, April 25, 2023
• European CMBS Faces Crunch Time With Loan Maturities Amid Higher Interest Rates, Feb. 23, 2023
• Taurus 2021-3 DEU DAC German CMBS Ratings Lowered On Four Classes; Two Classes Affirmed, March 23, 2023
• Land Securities Capital Markets’ Class A17 Fixed-Rate CMBS Notes Assigned Rating; Other Ratings Affirmed, March 15, 2023
• Canary Wharf Finance II European CMBS Ratings Affirmed Following Review, Jan. 27, 2023
• Berg Finance 2021 DAC Class B To D Pan-European CMBS Ratings Raised Following Review; Class A And E Ratings Affirmed, Nov. 18, 2022
• Oranje (European Loan Conduit No. 32) DAC Class B To D Dutch CMBS Ratings Raised; Class A And E Ratings Affirmed, Nov. 17, 2022
• Broadgate Financing PLC U.K. CMBS Ratings Affirmed Following Review, Nov. 8, 2022
• Salus (European Loan Conduit No. 33) DAC U.K. CMBS Class C And D Ratings Lowered; Class A And B Ratings Affirmed, Oct. 6, 2022
• Vacancy Up, Ratings Down? European Office CMBS Transactions After COVID-19, June 29, 2020