S&P Global Ratings has published a report that attempts to predict where stresses might occur when it comes to €6.4 bn of securitised instruments backed by offices in the region, mainly in London.
It is estimated that €1.5 trn of European office real estate debt is backed by offices. Of that entire spectrum, S&P says it rates £6.4 bn (€7.37) of CMBS notes in 11 transactions backed by European offices – and most of those (86%) are secured by UK offices.
The largest rated by S&P is the £10 bn Land Securities Capital Markets Plc backed by a pool of assets sponsored by Land Securities, 55% of which are offices, of which more than half are in the west end of London where vacancies are the lowest among London office submarkets.
Other particularly large CMBS it rates are Broadgate Financing plc secured by 11 buildings in the Broadgate estate next to Liverpool Street station, Canary Wharf Finance II plc named after the east London estate, Taurus 2018-2 UK relating to Devonshire Square, Salus European Loan Conduit relating to the City Point building, and Viridis relating to the Aldgate Tower to the east of the traditional CBD.
The ratings giant says it is clear that a model of remote and hybrid working is ‘here to stay’.
Under its stress tests, it assumes increasing office vacancy levels.
S&P cites Knight Frank for data on recent London vacancy levels. The level is 9.6% as of Q1 2023, which has risen from 5.7% in Q1 2020 – the quarter when covid-related lockdowns accentuated trends in flexi working.
It says office attendance in London is among the lowest in Europe, although more people have been returning to the office since June 2022. It states Canary Wharf and the surrounding area of central London has been weaker than the stronger West End of London and the Central Business District of the city to the east.
S&P concludes that triple A rated tranches can withstand increasing vacancy rates with little risk of downgrade. However, lower-rated tranches are more vulnerable. But even for those, tranches exposed to principal losses are present in only a limited number of cases.
Indeed, for some CMBS, vacancy levels would have to double from a high starting point before ratings are affected. So, the agency is watching to see if vacancy levels do significantly swing upwards, in which case it will have to revise its findings – lower grade tranches might well be downgraded as a consequence.
Despite some weakness in occupancy, prime rents have increased, S&P notes. But that has not stopped valuers taking a red pen to valuations, as underscored by Great Portland Estates’ results on Wednesday.
S&P quotes Green Street’s Commercial Property Index pan European office property prices in the 30 most liquid markets to suggest values have been hit 28.8% in the year to April 2023 from April 2023.
S&P said that 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, it adds.
ESG
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.
However, the ratings agency said it had been in contact with the CMBS sponsors, and seemed encouraged.
Under the existing UK 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 under certain exemptions.
From 1 April 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 UK 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.
S&P said it was reviewing the EPC ratings of the assets securing the CMBS transactions and monitoring the risk that they may not comply with the proposed legislation.
It said: ‘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.'
The transactions it rates 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, it added.
For more information, visit www.spglobal.com/ratings
