Scope maintains the BBB- (SF) rating under review for downgrade of the credit-linked note (Inhaberschuldverschreibung) issued by Herrenhausen Investment SA via its Compartment 1. Ongoing restructuring of one delinquent loan remains in process.
Scope Ratings has taken the following rating action on the credit linked notes issued by Herrenhausen Investment SA – Compartment 1:
Inhaberschuldverschreibung, EUR 21.3m: BBB-SF review for downgrade
Scope used quarterly investor reporting up to 28 February 2018 and the annual loan-by-loan portfolio update as of February 2018.
The review for downgrade reflects the continued uncertainty over the ongoing restructuring of one delinquent loan, as reported by the issuer on February 2018. Scope has taken into account that the operational restructuring and re-letting of the property underlying the delinquent exposure is in line with the restructuring plan. The debt service ability is almost restored and the re-letting resulted in a reduction of the vacancy rate to 15%. The tenant base is more granular than before the restructuring and has an average lease term beyond the maturity of the loan. In addition, an updated valuation from April 2018 shows an increase of the property value to 42.3m, up from 35.5m from last reporting. Scope will resolve the review as soon as possible, following the successful restructuring of the delinquent loan.
The action takes into account the performance of the overall transaction, which exhibits increased portfolio concentration through asset amortisation, partially mitigated by a marginal increase in credit enhancement of subordination to 1.45% from 1.22% at last monitoring.
Scope maintains a stable outlook on the German commercial real estate (CRE) market. The French and Dutch CRE market are also evolving positively. The later markets are however characterised by higher levels of price volatility, which Scope took into account.
The stable credit profile of Deutsche Hypothekenbank AG, the transaction’s account bank and holder of the notes’ cash collateral, supports the current rating.
Key rating drivers
The rating drivers remain unchanged from closing, including updates from previous monitorings.
Rating change drivers
The rating can be affected positively, if the largest-sized and worst-quality assets in the portfolio prepay or if their credit quality materially increase.
The rating can be negatively affected if the German CRE market deteriorates and refinancing conditions change adversely leading to lower than anticipated recovery rate upon loan default In addition, an erosion of credit enhancement from portfolio losses will also reflect negatively on the rating.
Stress testing was performed by applying rating-adjusted recovery assumptions.
Scope tested the resilience of the ratings against deviations of the portfolio’s tenant quality and the portfolio recovery rate. This analysis has the sole purpose of illustrating the sensitivity of the ratings to input assumptions and is not indicative of expected or likely scenarios.
The following shows how the quantitative results for the rated instrument changes when the portfolio’s tenant quality deteriorates by three notches, or the portfolio’s expected recovery rate reduces by 10%, respectively:
The CLNs sensitivity to tenant quality assumption is, one notch; sensitivity to recovery rates, four notches.
Quantitative assumptions and cash-flow analysis
Scope derived the default distribution of the reference portfolio loan-by-loan from a Monte Carlo simulation. For each loan, Scope estimated a default probability (taking into account the default over the loan’s term and at refinancing), a recovery upon default and asset correlations between the loans. The resulting portfolio default distribution was then used to perform a cash flow analysis to compute the expected loss and expected life of the rated instrument, reflecting the transaction’s amortisation and loss-allocation mechanisms, as well as the credit enhancement of the credit-linked note.
Scope has assumed for the outstanding portfolio an average default probability of 14.4% for a weighted average life of 4.9 years. This assumption is the result of loan defaults associated with i) tenant defaults, and ii) the failure to renew property lease contracts that end before the maturity of the related loans. The portfolio default rate also accounts for high probabilities of refinancing failure for some loans, driven by Scope’s long-term market-value-decline assumptions.
Scope has assumed a rating-conditional average portfolio recovery rate of 92.3%. This considers a BBB rating-conditional stress for the assumptions on the properties’ market value declines and accounts for distressed-sale discounts of 12.5% to 15%, liquidation costs of 12.5% to 16%, and an absolute recovery-rate cap of 98% loan by loan.
Scope has applied pairwise asset correlations ranging from 5% to 45%, which incorporate a common factor, the property type and location, and the exposure size to reflect a more concentrated portfolio than at closing.
The probability of default accounts for the property quality as represented by Scope’s property grade, the tenant credit quality, the contracted lease length and the loan-to-value at the time of default. The recovery rate is driven by the loan-to-value at the time of default, the property grade and the property liquidation costs.
Scope considers the average property quality to be good, reflected in an average property grade of PG2. Scope’s property grades account for a property’s distinct characteristics (type, location and attributes) to ascertain its condition and attractiveness to the market. Scope examines: i) maintenance costs and capex (historical and expected); ii) vacancy rates (historical and expected); iii) micro and macro location; iv) age; and v) the expiry of lease contracts. The analysis uses information from: i) on-site visits; ii) valuation reports from established industry experts; and iii) market studies from reputable sources. The highest property grade is PG1, e.g. a prime landmark building in a micro/macro location ideal for its usage type. The lowest is PG5, e.g. a property in poor condition in a degraded or undeveloped/unconsolidated location.
For the tenant quality, Scope made the assumption that the average tenant credit quality is commensurate with a BB rating. The assumption on tenant credit quality is based on the average default frequency observed in Germany, France and the Netherlands for corporates and households (based on the statistical offices of Germany, France and the Netherlands), and is stressed by one rating notch equivalent.
Scope assessed the contracted lease length based on weighted average underwritten lease terms (WAULT) reported for the different properties, either in the form of tenant lists or aggregated data. The portfolio shows an average WAULT of 10.5 years. Scope assumes a 50% probability of default in the year of lease expiry for loans, where the WAULT for the related property is shorter than the maturity of the loan.
The recovery upon default of a single loan is driven by the outstanding loan balance at default and the corresponding market value of the property, net of recovery costs. Scope analysed the market value declines for each loan, depending on the development of each regional market and the loan’s time to maturity. Scope’s rating conditional market-value-decline assumptions range from 12% to 32%, reflecting the current states and expected long-term developments of the property markets in the relevant countries. Scope compared a mean reversion of current property prices with the development of long-term historical prices.