While volume in the European CMBS market has risen, property fundamentals are softening. Demand conditions are expected to remain weak, and subletting is becoming more common. The office sector is looking increasingly ominous - office rents continues to fall throughout most major European cities, and vacancy rates have reached nearly 10% in London alone - magnifying the importance of a close look at what property sector exposure a transaction might have.

"As vacancy rates approach 10% in central London - from a low of 2% in December 2000 - a number of investors have expressed concerns about the health of the U.K. office sector, which accounts for more than half of the underlying property exposures in European CMBS," explained analysts at Merrill Lynch.

Nonetheless, the CMBS sector is considered to be one of the safest asset classes because most structures provide limited exposure to the property sector. According to Morgan Stanley, the market has seen substantial volumes over the last few years, and 2002 issuance volumes reached $18 billion - a growth of 35% from the previous year. This year's numbers are expected to reach $22 billion.

For investors concerned with negative office property exposure, the key going forward will be diversification. According to the Merrill report on property market cycles, the growing supply of assets within European CMBS means a growing variety of investment opportunities. "We emphasize that rather than one homogenous asset class, CMBS is compromised of many sub-sectors, each of which has a distinct cycle and with a unique risk profile," said analysts.

CMBS transactions can be distinguished by both geography and property type. Real estate exposure can be a positive or a negative factor depending on the structure, so it's important for investors to pay particular attention to what type of portfolio, property or tenant exposures an asset pool might have. Portfolio exposure, for example, typically means the structure incorporates multi-borrower, diversified loan pools with over 100 individual loans, while property exposure refers to multi-borrower loan-pools with less than 20 loans. Single tenant exposure typically refers to sale-lease back, single-borrower, single-property loans or multi-tenant loans with long tenancies, said Merrill Lynch.

"Investors should bear in mind that, historically, CMBS has proved to be a very resilient asset class, even compared to other ABS, and we believe that CMBS investors are generally very safe," explained analysts at Morgan Stanley. "Deals are typically structured to withstand severe recessions and are well protected either through strong LTVs and DSCRs or via limited exposure to the property sector."

At Morgan Stanley's Research Roadshow in London last month, panelists cited the Canary Wharf II transaction as an example of a deal with limited exposure to the property sector. With its long average lease life of 26 years and no dependence on rental uplifts, the transaction acts more like a CLO structure - with the added benefit of recourse to the underlying property were the tenant to default.

In the Canary Wharf I transaction, however, if tenant London Underground opted to take the break options in April 2004, the transaction could lose some value in credit. According to Morgan Stanley, replacing the London Underground tenancy might prove difficult under current rental conditions; once a tenant were to be found, the new tenancy would likely begin with a rent-free period.

"Whilst there are reserves to cover this eventuality, if there were no cash flow from the London building, the transaction would be reliant on moderate rental increases at rent review for the rest of the portfolio over the next year to avoid drawing the liquidity facility," said analysts. Further, in the event of a tenant default a similar scenario would ensue that could cause drawing on the liquidity facility.

London Underground must give a one-year notice if it plans to break the lease, which means they would have to announce a decision by April 2003.

Morgan Stanley deals with office property exposure - including the Canary Wharf transactions and the Broadgate transaction - have widened by around 20 basis points over the past months. Analysts attribute at least 5 to ten basis points to the concerns related to the London office market, and said that the widening could continue if the negative sentiment persists - even though these transactions are generally well positioned for a further downturn.

Going forward, investors could find the market less limiting as more jurisdictions enter a market that has historically been dominated by U.K. issuance. "In the five years leading up to 2000, nearly 80% of the properties in European CMBS were from the U.K.; in the last three years, 50% of supply reflects pan-European or Continental transactions," said Merrill Lynch. "This trend is expected to continue throughout 2003."

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