The issuer rating is predominately driven by the industry specific risks and the currently low diversification of the issuer, but also by it’s low leverage.
Scope Ratings assigns initial issuer rating of B+ to JSC Lisi Lake Development. The Outlook is Stable.
The B+ issuer rating for JSC Lisi Lake Development (‘LLD’), a Georgia-based premium residential real estate developer, is supported by the company’s: i) conservative financing structure that relies on equity with negligible net debt; ii) above-average cash profitability that partially offsets external financing needs; and iii) strong local brand recognition and industry network that enables off-market deals, particularly on new attractive plots for large residential developments.
The issuer rating is negatively affected by LLD’s current small size and scope compared to other European residential property developers and its full dependency on the sale of properties and/or land to end-customers. The pure-play developer business model implies a small share of recurring revenues, which risks high cash flow volatility should property sales drop. Diversification is deemed low given the substantial cluster risk posed by the Lisi Lake projects, which will comprise more than 75% of the value of all the issuer’s investment properties for the next two years. The issuer rating is also limited by the fact that the company operates entirely in Georgia, generating risks related to a less resilient economy, inflation and foreign exchange rates as well as the low liquidity of the country’s premium real estate market compared to that of the more mature markets in western Europe.
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Key rating drivers
Business risk profile
Scope assesses industry risk for LLD to be high. As a pure-play developer, the company is exposed to the most cyclical part of the real estate industry. The agency’s short-term credit view for the industry is stable but increasingly sensitive to changes in politics, economic conditions and interest rates. Scope also takes account of the higher volatility of Georgia’s less mature market. The core activity consists of developing premium residential real estate in Tbilisi and other cities in Georgia. For the time being, the company has a very concentrated project pipeline with a focus on Lisi Lake projects and another major early-stage project on the Black Sea shoreline. However, there are plans to expand the number of projects, targeting other regions in Georgia.
With total assets of c. USD 144m at year-end 2017 and funds from operations (FFO) of USD 4m in 2017, LLD is a small company, but exhibits strong growth in its Georgian home market. Scope judges the issuer’s average asset quality as credit-positive because all residential units are newly built at a premium quality and the company’s land bank to date consists of prime Georgian locations only.
Size is expected to grow further in the next two years thanks to an expanding project pipeline. However, the company’s limited size and market position also indicate a heightened sensitivity to unforeseen shocks and volatility in cash flows, particularly as LLD is highly exposed to inherent cyclicality in the real estate market, with almost 100% of revenues currently linked to development activity.
LLD’s potential cash flow volatility is negatively affected by its very concentrated pipeline of two main projects (divided into several sub-projects and phases that can be managed and timed separately to a certain extent), the largest of which (Lisi Lake) represents the lion’s share of expected revenue within the next 30 months. This very modest diversification may affect future cash flows if the projects suffer delays or cost overruns. However, Scope and other third-party market observers predict excess demand for premium residential real estate in Tbilisi in the coming years, provided there is no major external economic shock. Moreover, management intends to improve geographical diversification by investing in more Georgian projects, with the exception of further projects in Tbilisi. Scope views this strategy positively.
LLD’s profitability has been above industry average and is relatively less volatile regarding its business model. EBITDA margin stood at more than 30% in the 2016 and 2017 business years, when significant sales volume was recorded. Scope believes this margin will decrease over time: the significant competitive advantage of having acquired the land bank at low prices in 2010 to 2011 is now shrinking as new projects are acquired at current market prices. Nevertheless, Scope sees substantial volumes of land at Lisi Lake that can be developed in later project stages. In a conservative scenario, the agency expects EBITDA margin to remain at or above 20% for the next two to three business years due to increasing competition.
Financial risk profile
LLD’s EBITDA interest cover stood at very comfortable levels of c. 12x in 2016 and 18x in 2017. This ratio has been unusually high due to negligible debt levels in recent business years as more than 90% of the balance sheet was equity-financed. Even after assuming an additional USD 15m in debt from the issue of a corporate bond in the second half of the 2018 business year, Scope expects EBITDA interest coverage to stay in a range of 7x to 10x. Nevertheless, operating profit at EBITDA level depends entirely on ongoing land and property sales owing to LLD’s pure-play developer business model.
The company’s cash flow generation was sufficient in the past two to three business years, during which substantial volumes of properties were sold to clients for the first time. Free operating cash flow was positive for the past four years despite the business expansion over the same period. Scope expects free operating cash flow to become slightly negative in the single-digit USD millions for the next two business years, owing to both the expectation of further growth and the nature of real estate development. Furthermore, LLD’s credit rating at this point is constrained by its limited size and scope, which creates a very clustered project pipeline.
The company’s loan/value ratio (LTV) has stayed at very conservative single-digit percentages in past business years, indicating very low net debt of less than USD 10m. Scope expects LTV to remain below 10% in the next two business years, even after assuming a USD 15m bond issue in the second half of the current 2018 business year.
While the company’s strong financial metrics like SaD/EBITDA of around 1.0x, FFO/SaD of 141% and FOCF/SaD of 68% (2017) would typically imply a higher sub-score for the financial risk profile, Scope assesses the sub-score at BB due to the uncertainty over future sales and thus EBITDA levels. The inability to generate significant recurring revenue without selling properties limits the analytical value of leverage ratios based on projected operating income. The company is targeting more properties in asset classes that contribute recurring rental income in the near future such as hotels or office properties, starting with hotel revenues from Tsikhisdziri, but development will remain the core business according to the management. This diversification of revenues should mitigate cash-flow volatility in the future. However, in Scope’s opinion, high cash flow volatility is typical for a developer, with projects not assessed and financed in annual tranches but over the whole development period.
- Good market position due to large land bank, established brand and excellent network within the local real estate and financial industry
- Track record from the construction and sale of the existing residential units in Lisi Lake
- LLD’s development portfolio as well as land bank in Tbilisi and Tsikhisdziri is in good locations within the Georgian market and should offer above-average liquidity
- Strong operating cash profitability thanks to i.a. very low land bank acquisition costs among other factors
- Single digit loan/value ratio (LTV), even after the assumed issue of a USD 15m bond
- Low SaD/EBITDA leverage of c. 1x to 1.5x and excellent liquidity situation thanks to strong cash generation and only negligible short-term debt
- High dependency on the main development project in Lisi Lake, despite recent diversification efforts
- Exposure to the still relatively volatile Georgian economy with inherent risks such as high inflation and (indirect*) FX risk
- Pure play developer without significant recurring (rental/other) income resulting in weak visibility regarding future SaD/EBITDA leverage
- Small player with lack of scale when compared to other International/European upscale residential developers
- For the time being, unproven access to capital markets
* the issuer is not exposed to material direct foreign exchange risks since the functional currency (construction costs as well as unit sales prices) is USD. Nevertheless, we hint at the potential risks that would arise from a sharp decline in value of the local currency (Georgian Lari) due to the resulting loss of purchasing power of local clients. We therefore deem this a potential indirect currency risk.
There has been sufficient operating cash flow generation in recent years that is expected to further increase and free cash flows in a range of USD -2.5m to -1m for the next years according to our financial forecast, despite the significant expansion plans. Furthermore, the issuer has only little short-term debt going forward (USD <4m) that is covered more than 3x by unrestricted cash plus free cash flow according to our forecast.
The rating Outlook is Stable, supported by Lisi Lake’s development pipeline and the Georgian premium residential real estate market that shows growing demand. The Stable Outlook incorporates Scope’s expectation that the EBITDA margin will remain at more than 20% going forward, and that the project pipeline can be developed and sold without a major drop in demand and/or prices that would cause a slump in operating cash flows.
Rating Change Driver
The rating Outlook is Stable, supported by the Lisi Lake development pipeline and growing demand in Georgia’s premium residential real estate market. The Outlook incorporates Scope’s expectation that EBITDA margin will remain at more than 20% going forward and that the project pipeline can be developed and sold without a major drop in demand and/or prices that would impair operating cash flows.
A negative rating action is possible if the company’s sales volume fell sharply or if a serious deterioration in Georgia’s real estate market negatively affected LLD’s overall business prospects.
Scope would consider a positive rating action if LLD managed to significantly improve its business risk profile by further diversifying its development portfolio and/or creating a substantial share of recurring cash flows independent from continual asset sales in order to mitigate potential cash-flow volatility and provide sufficient interest coverage from recurring EBITDA.
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