The issuer rating is predominately driven by the anticipated resilience of the company's cash flows with a high exposure to non-cyclical tenant industries benefitting DKR's credit metrics.
Scope Ratings assigns initial issuer rating of BB to Deutsche Konsum REIT-AG (DKR). The senior secured bond (ISIN DE000A2G8WQ9) is rated BBB and senior unsecured debt is rated BB+. The Outlook is Stable.
The issuer rating of BB for Deutsche Konsum REIT-AG (DKR) is supported by the size the company has achieved in the niche market of commercial real estate with a focus on non-cyclical retail. Its Germany-wide diversified portfolio, with stable occupancy and a weighted average unexpired lease term (WAULT) of over five years, leads to predictable and steady cash flows. Relatively high profitability as well as implicit caps on leverage and floors on revenue diversification lead to good debt protection measures as well as moderate leverage.
However, the rating is limited by DKR's absolute size which is expected to burden the company's access to capital markets in times of economic turmoil. DKR's focus on a niche market leads to a heavy reliance on single tenants and weak tenant diversification with the top three accounting for 44% of net rental income (NRI). Furthermore, we see higher downside volatility for the company's property portfolio as a consequence of relatively small ticket sizes and rather weak macro locations, both resulting in limited fungibility. Scope's overall assessment of the financial risk profile is negatively affected by the company's dependence on external financing, with refinancing peaks in 2017/18 and 2019/20 as well as ambitious growth plans for the next few years.
Scope's rating scenario assumes the following:
- like-for-like rental growth of 2.0% (2017/18) and (2018/19),
- additional increase of rents from new acquisitions reflecting a net initial yield (NIY) of 9.5%,
- operational expenses to increase by 2% per year,
- no conversion of convertible bonds in 2020,
- capital expenditure of EUR 100m per year,
- mandatory dividend distribution of 90% of German GAAP result.
- Largest pure-play commercial property company with a focus on non-cyclical retail, supporting stable cash flows throughout the cycle as well as visibility towards its tenants, potential investors and vendors.
- Moderate geographical diversification with property portfolio spread across Germany with a focus on the east (89% of gross lease area).
- Stable occupancy of around 85% not expected to reduce materially as a result of DKR's acquisition strategy.
- Profitability with EBITDA margins around 70% in line with larger peers, benefitting from economies of scale.
- Sufficiently high EBITDA interest cover of greater 3x, expected to remain at that level going forward.
- Loan/value ratio (LTV) expected to remain below 50% as a consequence of implicit covenants in accordance with DKR's G-REIT status.
- Company of limited size, however, expected to accelerate growth with asset base to rise to above EUR0.5bn in the next three years.
- Modest diversification across sales formats/exposure to hypermarkets with negative future prospects.
- Concentrated tenant portfolio with top three accounting for 44% of NRI, albeit partially mitigated by the majority's good credit quality
- Properties' macro locations expected to lead to higher downside volatility for fair values, but micro locations as well as limited competition support tenant demand and thus stable cash flows
- Negative free operating cash flows as a consequence of ongoing portfolio expansion and mandatory dividend payments.
We evaluate DKR's liquidity as weak based on our expectation that sources of liquidity will only cover uses by about 0.3x in the 12 months to end-March 2019 following consistently stretched liquidity in the past. In detail:
Position Q2 2017/18
- Unrestricted cash EUR 1m
- Open committed credit lines EUR 16m
- Free operating cash flow (t+1) EUR -4m
- Short-term debt (t+1) EUR 41m
Future liquidity is burdened by a relatively high amount of short-term debt of EUR 23m maturing in 2020. This is anticipated to lead to liquidity of below 1x. However, Scope believes liquidity to be a manageable risk in the short to medium term with sufficient headroom provided by i) a high share of unencumbered assets (65% as at YE 2017) and ii) the company's excellent access to capital markets and good banking relationships with a high diversity of potential funding sources. Liquidity is burdened by the ongoing high share of short-term debt on the one hand and comparatively low free operating cash flow of a negative EUR 4m forecasted for the next 12 months (excluding non-mandatory, non-executed expansion capex of EUR 83m) on the other. According to the company EUR 18m of short-term debt due within the next 12 months have been refinanced in May 2018 with a five years tenor.
As a result, Scope has stressed the company's financial risk profile by two notches reflecting the company's heavy and ongoing dependence on external financing. However, Scope believes negative liquidity to be a manageable risk in the short to medium term with sufficient headroom provided by a high share of unencumbered assets (69%) and past extensions of short-term debt. Our assessment of the latter is also supported by our view that the company has good, well-established relationships with banks as demonstrated by a financing pipeline of over EUR 100m at the end of February which is anticipated to make use of the company's unencumbered asset position.
Senior secured debt
DKR issued an EUR 40m bond in May 2018 with a six year term (2018/24) and a coupon of 1.80% (ISIN: DE000A2G8WQ9). This bond will benefit from a first ranking mortgage on fifteen properties valued at EUR 67.2m as at May 2018. Scope believes that the structure benefits from adequate overcollateralisation, with an issue-specific loan-to-value ratio of 60%. This positively influences recovery rates in a default scenario. According to our methodology and reasonable discounts on the company's asset base (as described below), Scope expects an 'excellent' recovery thus allowing for a three-notch uplift on the company's issuer rating of BB.
Senior unsecured debt
Scope's recovery analysis signals 'above-average recovery' which translates into instrument ratings of BB+. Recovery is based on a hypothetical default scenario in FY 2019/20 with the company's liquidation value amounting to EUR 328m. This value is based on a 37% haircut applied to DKR's assets, reflecting a market value decline of one standard deviation of the German property price index as well as liquidation costs of approx. 26% for assets and 10% for insolvency proceedings. This compares to secured financing of a forecasted EUR 286m, a fully drawn unsecured credit line of EUR 25m as well as the unsecured EUR 37m in convertible bonds.
The Outlook for DKR is Stable and incorporates Scope's expectation that the company's asset base will grow as a consequence of EUR 100m in annual capex leading to recurring funds from operations of over EUR 20m by FY 2019/20. We anticipate that further expansion will be predominantly financed with debt levering the company up to a loan/value (LTV) ratio of 50% while debt protection, as measured by EBITDA interest cover, is expected to remain above 3x. The Outlook assumes that the two convertible bonds will not be converted into equity in January 2020 thus raising the company's external refinancing requirements.
Rating Change Driver
A negative rating action is possible if the company leverages up to an LTV ratio of above 55% on a continuing basis, leading to a loss of its tax-exempt German real estate investment trust (G-REIT) status.
A positive rating action could be warranted if peaks in refinancing in FY2017/18 and 2019/2020 are successfully addressed, with liquidity becoming adequate and credit metrics remaining at the levels described above.
For the detailed rating report please click HERE.