Office vacancy rates are on the rise throughout Europe, and the threat of a softening economy could mean that the numbers will continue to rise going forward. Nonetheless, the strength behind credit tenant leases is likely to shield repercussions felt in CMBS transactions emerging from this sector.

According to a report by Morgan Stanley, prime office rates have fallen rapidly during this quarter. In Madrid they has fallen by 8.1%, in Frankfurt by 4.4%, and in London by 2.4%. And economic growth for the UK, Germany, Spain, France and Italy has reached a plateau at a current average GDP/GNP of 0.9% per annum. "We are cautious of the European office market in general due to unfavorable and uncertain market conditions, falling rents and values, and increasing vacancies," reported economists at the bank. "We believe the market will continue to fall, saddled with oversupply; however, it is difficult to ascertain when the market will bottom out."

Although the future for the European sector has suffered as a result, with office vacancies steadily on the rise, market sentiment remained positive for CMBS deals that emerged from this sector. This confidence is bolstered by the strong credit tenant lease fundamentals backing these transactions. Deals like those in the Canary Wharf series are expected to fare well from a credit perspective, though continued negative market perception could pressure spreads to widen.

The leases that back these transactions are long dated, and stipulate that unless the tenant goes bankrupt, rents must be secured to reflect at least the present levels or higher. And even within a bankruptcy scenario, there are different tranches that can withstand lower rent flow from a replacement tenants or increased vacancies, explained analysts.

Still, the Canary Wharf II transaction is exposed to the underlying credit risk of financial service firms, and if a bankruptcy occurred the contagion effect could seriously affect the deal. The five largest tenants in Canary Wharf II represent 89% of rental income. They include Citigroup, Lehman Brothers, Clifford Chance, Credit Suisse First Boston and Morgan Stanley.

Canary Wharf II is issuing an additional GBP510 million under its Canary Wharf II series. Standard & Poor's has assigned preliminary ratings: the Class A6 and R1 are rated AAA', and the class R2 notes are rated AA'. The notes are backed by a loan secured by mortgages on office, retail and parking facilities. Four of the five new properties are under construction. If the buildings are not completed, the transaction could rely on the pre-funded construction reserve accounts and rental undertakings from rated counterparties to pay the rent.

According to S&P, this transaction includes floor space in two buildings involved in previous securitizations that was pre-let to the law firm Clifford Chance and to the financial services company Northern Trust; a new office property partly pre-let to law firms Skadden Arps and Allen & Overy; the Waitrose/Reebok building; and the Jubilee Retail Mall and Car Park.

Analysts at S&P expect the current development, which includes the opening of Waitrose Food & Home store, the introduction of seven-day trading, and the recent opening of Jubilee Mall, should establish Canary Wharf as a major sub-regional shopping center in East London.

The Canary Wharf I transaction is not as exposed, as only 30% of its rental income comes from tenants in the Financial services. The major tenants there include two government entities - London Underground and Financial Service Authority, as well as publisher Mirror Group. "No one expects any of these names to be hit to any substantial degree, but if it were to happen it's important to consider the possible effects a major bankruptcy might have on the transaction," said one market analyst.

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