DBRS Morningstar Confirms Vault DI Issuer LLC at BBB, Changes Trend to Negative

DBRS Limited (DBRS Morningstar) confirmed the Issuer Rating and the rating of the Series 2021 Class A-1 $25 million variable funding notes (Class A-1 Notes) and the $225 million Series 2021 Class A-2 term notes (Class A-2 Notes, and together with the Class A-1 Notes, the Senior Notes) at BBB and changed the trend to Negative from Stable. The Senior Notes are fully amortizing with a 25-year legal maturity, issued by Vault DI Issuer LLC (Vault or the Issuer), and are backed by a portfolio of seven data centres—located in generally strong national data centre markets and with generally attractive power and redundancy configurations—and the long-term leases in place with the tenants of the data centres. Although leases have regular renewal points embedded within the overall term, where the lease can be terminated by either the Issuer or the tenant, DBRS Morningstar believes that lease renewal is likely. The indirect owner of the data centres is Vault Digital Infrastructure LP (Vault Digital), a joint venture owned by DIF Capital Partners (49%) and Northleaf Capital Partners (49%), two global mid-market infrastructure investors (collectively, the Sponsors), and managed by Landmark Dividend, LLC (Landmark) (2%), an experienced operator with a strong track record of data centre management. DBRS Morningstar notes that the additional penalty interest tranche incurred if the Senior Notes are not successfully refinanced at the Anticipated Repayment Date (ARD) is not rated.

The trend change comes despite the strong financial results achieved by the portfolio over the past 12 months and reflects some headwinds, notably the significantly higher interest rate environment that is currently developing in response to surging inflation and which, if it persists, could potentially affect the rating level of the refinance in four years’ time. Average Annualized Net Operating Income (AANOI) was $21 million as of June 2022, resulting in annualized debt service coverage ratios (DSCR) of 3.13x, meeting rating-case expectations. DBRS Morningstar notes that an extension has already been signed, at accretive terms, for one of the two leases coming up for renewal in 2024, extending this lease for another 10 years to 2034 and affirming the rating case’s central thesis that lease extensions upon reaching renewal points are highly likely. The insolvency filing of an unrated, private tenant in April 2022 represents another area of uncertainty; however, DBRS Morningstar notes that this was due in large part to high debt leverage of the enterprise and that the data centre facility itself is considered competitive, located in a strong data centre market, and has a strong redundancy configuration. The insolvency process is expected to be concluded relatively quickly in the coming months, most likely with a sale of assets to a new operator. DBRS Morningstar will assess the impact of any new ownership when it is known and notes that the project is deemed capable of maintaining debt service, even with complete loss of rental revenue from this tenant at current rating-case assumptions, albeit with considerably weakened metrics and a likely lower rating level.

Because of the debt structure, where a significant portion of credit risk is deferred to the refinance period in 2026, the rating of the current debt is affected by DBRS Morningstar’s view of the rating level that the refinance could achieve, the soft nature of this refinance notwithstanding. This, in turn, is highly sensitive to the forecast prevailing interest rates at the time of refinance. The current high inflation and rising interest rate environment introduces the risk that the ascribed refinance rating could be materially deteriorated. Current market consensus appears to suggest that the pace of interest rate increase could flatten by the end of 2023 as the intended outcome of cooling demand begins to take effect. Thereafter, prevailing inflation rates and the general economic environment will affect the interest rate environment. DBRS Morningstar notes that in the last period of high inflation during the early 1980s, interest rates remained up to 50% higher than the pre-inflation period for approximately two years, while inflation was gradually wrestled down, with the steepest increase occurring over the initial 12-month period. Thereafter, intermittent periods of high interest rates (although not approaching the peak) were experienced over the next several years, even as inflation settled. DBRS Morningstar believes that a similar pattern of interest rate and inflation movement up to the 2026 refinance could result in refinance financial metrics at the low end of the current rating range, with a significant possibility of falling below the rating category. DBRS Morningstar notes for comparison that current treasury rates have almost doubled over the past half year, with long-term rates rising to the mid-3.0% range, while market consensus interest rate forecasts for Q4 2023 are at approximately the same mid-3.0% range, continuing to rise slowly into 2024, which suggests that inflation is expected to have at least settled, if still at high levels, by this time. On this basis, and on the basis of continuing forward-looking rate volatility and uncertainty, DBRS Morningstar is placing the credit on a Negative trend.

The BBB rating continues to be underpinned by the following: (1) expected stable cash flow deriving from lease payments to the data centres; (2) the resiliency and “sticky” nature of the revenue stream owing to the critical and strategic nature of the data centre assets to the tenants’ business operations; (3) strong and favourable debt package to noteholders; and (4) material upside revenue potential from unleased portions of the largest site in the portfolio. DBRS Morningstar notes the debt and security package offers protections to noteholders typical of that expected of a well-structured project finance transaction. The primary constraints on the rating include (1) the current rising interest rate environment and its impact on refinance credit level, which has a significant effect on the rating of the current debt; (2) re-leasing risk of each lease at various intervals, subjecting the Issuer to the risk of tenants either opting out of their leases or obliging the Issuer to grant concessions as an inducement for tenants to remain; (3) lower or nonrated tenants, including one tenant currently operating under insolvency restructuring; and (4) risks related to technical obsolescence or deterioration of competitive position.

The financing structure features DSCR profiles, as calculated based on DBRS Morningstar’s rating-case assumptions and revenue haircuts, with a minimum and average DSCR of 2.57x/2.85x (effectively an interest coverage ratio), and a refinance DSCR at the five and a half year mark of 1.30x (minimum)/1.49x (average) based on DBRS Morningstar’s rating case, which incorporates the constraints and challenges of the project and the refinance interest rate as assumed at financial close. The refinance metrics, together with consideration for the minimum/average DSCRs in the first five interest-only years, are consistent with a BBB (low) rating. DBRS Morningstar has applied a one-notch uplift to account for the soft refinance nature of the debt, in which a failure to refinance does not lead to a default but rather to a cash sweep where all cash after expenses and interest payments are swept to principal. Higher refinance base rates at a level consistent with consensus forecasts would result in minimum refinance DSCRs in the 1.16x–1.20x range, commensurate with a rating at the low end of or just below the current rating level. Should the elevated interest rate environment show signs of persisting beyond 2023, or if there is an adverse outcome of the affected tenant’s insolvency process, DBRS Morningstar is likely to downgrade the rating. Conditions leading to a rating upgrade are not considered likely at this time.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factors that had a significant or relevant effect on the credit analysis.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal methodologies are Rating Project Finance (August 18, 2021; https://www.dbrsmorningstar.com/research/383185) and DBRS Morningstar Criteria: Guarantees and Other Forms of Support (April 4, 2022; https://www.dbrsmorningstar.com/research/394683) which can be found on dbrsmorningstar.com under Methodologies & Criteria. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (May 17, 2022; https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings).

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link under Related Documents or by contacting us at info@dbrsmorningstar.com.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar trends and ratings are under regular surveillance.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com or contact us at info@dbrsmorningstar.com.

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