Citigroup's announcement earlier this month that it would not immediately occupy all of its space in the Canary Wharf development has led to some market speculation that this may be a sign of the hard times awaiting the European office property sector.

With a softening economy, overall take-up of office property is less likely to occur, which could adversely affect office rentals going forward as well as deflate rental values, said an analyst at Dresdner Kleinwort Wasserstein.

Although the hazards of this trend are abated by mitigant factors in CMBS deals, analysts emphasize that going forward, investors and banks will have to further investigate each deal to better understand both credit risk and relative value.

What is of most concern is that a structure like the Canary Wharf Finance II plc is largely dependent on collateral offered by three financial institutions, in this case: Citigroup, Morgan Stanley and Credit Suisse First Boston. However, market analysts agree that in this instance there is very little chance that any of these entities would be in danger of defaulting, as other deals may not be backed by collateral with a similar credit.

Master mitigating skills

The Canary Wharf Group securitizations are largely dependent on the lessee rental payments of properties in the Canary Wharf area. Citigroup accounts for 55% of the property. The Canary Wharf Finance II plc requires that Citibank pay up on the lease regardless of its intentions. The announcement translates to the bank subletting the remaining space but ultimately it is Citigroup who is accountable for the payments.

However, with the economic downturn, market analysts at Dresdner expect the office rental sector to face increasing pressure, which will ultimately lead to depleted rental values.

"Citigroup could theoretically get a tenant that might not be the same quality. Investors and bankers must assess the possibility that as the transaction unfolds they may be looking at different conditions," said one bank analyst.

Still, if CMBS deals that include collateral from the office sector are handled with precise mitigating terms, it is easy to avoid the repercussions of a slowdown, said a Moody's analyst familiar with the deal. "Generally there are requirements in similar long-term agreements."

To be sure, the structure of Canary Wharf Finance II incorporates a DS5 facility that absorbs a triple-A guarantee from the Citigroup lease obligation for the full term of the lease.

A credit-linked note issue from a bankruptcy-remote Cayman Island SPV achieves this, reports Moody's in its analysis of the deal. The earnings are invested in a guaranteed investment contract.

This is insurance, should Citigroup default on its rental obligations.

Citigroup is also required to move ahead with a subleasing plan in such a way that the bank finds a lessee rate of a single-A or above. "The quality of any assignees should protect the credit of the transaction to a large degree," explains Fitch in its analysis of the deal.


According to a Morgan Stanley report on European commercial property fundamentals, statistics calculated by Jones Lang Lasalle point to an anticipated increase in office space supply over the next two years. Vacancy rate volumes are expected to stay within the soaring rates of the last property cycle.

It is estimated that vacancies have picked up by 0.5% in London during the first quarter of 2001. Nonetheless, an over-supply of European office property in 1990 caused office rents to fall dramatically.

While a spokeswoman for Canary Wharf Group said Citigroup entered the lease with the intention of subletting some of the space, analysts say that the bank's recent general announcement is of little surprise, to the extent that subletting allows it to diminish obligations in the agreement.

"It really doesn't affect the deal because ultimately it is Citigroup who is making the payments," said the Moody's analyst.

"They take uncertain risks when they enter a long-term agreement. If they rent all the space they get it at GBP40 per sq. ft and if they rent only half they pay GBP80 a sq. ft. At the end of the day I think Canary Wharf is looking at it from a long view and the banks included are all very strong banks."

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