S&P stress test indicates office backed CMBS are resilient

European and UK office commercial mortgage-backed securities (CMBS) ratings are generally resilient to higher vacancy rates according to S&P Global Ratings in its report, European Office CMBS Withstands Vacancy Stress.

CMBS exposure to office assets in Europe is estimated at €1.5 trillion.

S&P looked at the sector in the light of diminished demand for offices in the region owing to the post-covid growth in remote and hybrid working and challenging economic conditions. The firm set out to assess how increased office vacancy could affect the creditworthiness of rated European and UK commercial mortgage-backed securities (CMBS) transactions.

S&P’s research revealed 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”, the report states.

“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.”

The report refers to Knight Frank research which indicates that the London office vacancy rate increased to 9.6% in Q1 2023 from 5.7% in Q1 2020, and Savills research that shows that office attendance in London is still among the lowest in Europe, and is still more severe in Canary Wharf and Docklands.

S&P also pointed out that higher interest rates will make it more difficult for loans to be refinanced when they reach maturity and that minimum energy efficiency requirements, both regulatory and those of occupiers, also mean that many office assets will require significant capital spending.

“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,” the firm said.