Though it's too soon to tell what the exact effect of the rather dramatic increase in office vacancies will be for CMBS, market players are playing it safe and putting the sector under close scrutiny.

And there is enough reason to be extra careful. According to Torto Wheaton Research (TWR), the national office vacancy rate at the end of the second quarter of this year is now at a four-year high of 10.8%, up from 8.1% at the end of 2000. A Standard and Poor's report on property market trends said that the amount of occupied office space may have declined again by 17 million square feet during the second quarter, just after declining by 16.9 million square feet in the first quarter of the year.

Because of the problems that have plagued the office sector, CMBS investors have taken a cautious stance.

"We have to be much more selective in our due diligence and in making investment decisions," said Marc Peterson, a CMBS manager at Principal Capital Real Estate Investment. "As you see vacancies spike up, you're forced to take a look at the underwriting that has been done on the loan by issuers to make sure that they have not been too aggressive in their assumptions on factors like vacancies and rent."

He cites San Francisco as an example where investors have to come up with their own estimation of rent levels that are sustainable in the market and that borrowers can achieve. If an underwriter or an issuer chooses to underwrite rent at today's high rate, the level of rent would likely not be sustainable.

Effect on CMBS is

minimal as of yet

According to investors, the bad publicity surrounding the office sector has not affected CMBS spreads yet. There is still strong demand for below triple-A securities such as single-As and triple-Bs, and double-Bs as well.

Other observers say that it is difficult to estimate what impact the recent rise in office vacancies has on spreads because investors have been pricing in economic softness into problematic sectors since the middle of last year.

"It is hard to attribute an impact of increasing vacancy rates to CMBS market spreads," said Darrell Wheeler, CMBS strategist at Salomon Smith Barney. "Investors have been pricing an economic slowdown into several property segments since mid- 2000. The impact can be seen in stand-alone hotel or retail transactions which price 10 to 20 basis points wide of other property segments. We really haven't seen an increase in office property spreads that I would attribute to a slowing economy."

Losses have also proved to be minimal in equally problematic sectors such as hotel and retail. Wheeler said that at the beginning of the year several investors actually saw retail and hotel spreads as cheap and started buying those products.

"Even if the economic slowdown is severe, the triple-A bonds of these deals are unlikely to be impacted by losses or downgrades which suggest these value investors have made smart investments," he said.

Wheeler explained that it is also important to understand that the underlying real estate fundamentals are significantly stronger than before the last recession so many markets can withstand significant tenant loss with little impact. In addition, the models that the rating agencies developed to assess CMBS were based on the worst experiences of the early 1990 recession, which means many times they've been underwriting the loans and sizing the bonds to very conservative levels.

Rating agency perspective

Sally Gordon, a vice president and senior analyst at Moody's Investor's Service, said that in rating CMBS they are mindful of the fact that they are rating ten-year bonds and that during that ten-year period, the real estate markets are likely to go through a recessionary period so, in effect, events like rising office vacancies have already been priced in.

Because of this, the rise in office vacancies would likely not impact investment- grade bonds. However, if vacancies continue to rise and remain at high levels for a long time, this would probably lead to an increase in defaults that would affect the lower-rated tranches in CMBS deals.

Zanda Lynn, an analyst from Fitch, explained that the rating agency typically looks at sustainable vacancy rates over time.

"We would not have used a 3% vacancy rate in our underwriting in the past even if the market was there.," said Lynn. "In most markets, 10% is a number that we've been using as a minimum."

A glut in oversupply

The scenario is not getting any prettier. Aside from the fact that office vacancies are rising quickly, demand for office space has dried up as corporate profits continue to go down and layoffs are getting to be much more frequent.

However, the situation is helped by the fact that these vacancies started at a very low level.

For instance, in downtown San Francisco and in the Boston area vacancy rates were at about 1.6% at the end of last year. The rates rose up to over 10% in San Francisco and 8.7% in Boston at the end of the second quarter. These show that vacancy rates are now reaching historic levels.

Aside from this, capital market discipline has also prevented a major fall-out by preventing overbuilding.

"The capital markets have brought some discipline to the marketplace," said Ken Doiron, assistant vice president at Hartford Investment Management Co. "For instance, when overbuilding occurred in the limited service hotel sector, the spigot was turned off and no new capital to build or refinance was available."

There is also evidence of building projects getting pulled off the planning stage. However, despite these positives, Doiron said that the office market is in a very cautious position. A continued decline in the economy could be detrimental to the sector. And if the rapid rise of vacancies continue, the office market will suffer serious consequences.

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