An increase of sublet space in London's office sector beckons caution but does not immediately jeopardize any securitizations of assets within this market, say market analysts.

It does, however, exhibit a slowdown greater than expected. In a prior forecast conducted last year, Salomon Smith Barney regarded the London office sector as "relatively under-built" and considered it well positioned for an economic recession. It did not at that time consider the diminishing head count that has swept through a number of corporations, which tapered the need for office space.

In its previous forecast Salomon anticipated under a worst-case scenario analysis that it would take a three-year downturn before the market experienced a vacancy rate above 11%.

Although the London office market has not yet reached that level, the rise in fourth quarter 2001 supply of sublet space is alarming enough to merit reconsideration. Vacancy figures reached 5.7% from the prior 2.8% figure and simultaneously the demand for space during this period fell by 15%.

This rise in sublets is significant enough to draw anxious conclusion from some market participants that analysts say is still unfounded. "One of the reasons we followed up on our report from last year is that there have been articles recently published where it is concluded that there is a possibility that rents will crumble as a consequence," said the source at Salomon. "We don't agree with that conclusion; either the economy will improve or if it doesn't then we must consider that tenants have already leased the space. It's a non-issue."

In most cases, the slowdown has curbed future construction plans of further space and tenants who presently vacate buildings often provide ample forewarning that allows room for a landlord to replace them. Least affected are the Canary Wharf buildings, where most of the buildings are securitized. The majority of the buildings are pre-sold and pre-let, which means that regardless of whether the tenant occupies the space he is ultimately responsible to pay.

"Even if the economy does not get better and banking activity diminishes as a natural reaction to the situation, one alternative for these companies is always to move to cheaper accommodations," said one source. "Prime rents are still cheaper here [in Canary Wharf]." According to the Salomon report the latest trend shows that tenants with large office needs are leaving other London locations and moving to Canary Wharf.

And investor appetite appears to remain unwavering, as proven with the early February tap of Canary Wharf Finance II. Dresdner Kleinwort Wasserstein said: "Compared to where the initial issue and the first tap of this deal were launched, the pricing of the Class A1, A3 and B tranches look tight and reflects the extent to which technicals have driven in spreads in the long-date fixed sterling market." But this latest tap also included a large U.S.-dollar denominated floating-rate tranche that highlights the issuer's effort to widen the investor base; past transactions have always been fixed-rate and sterling based.

While the rise in vacancies clearly has little effect on current securitizations, particularly the Canary Wharf buildings, it's clear this increase does suggest a more vulnerable environment that is expected to most affect the city of London office space. It's likely that any immediate future developments with Canary Wharf will be limited only to buildings that have a tenant secured.

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