DBRS Morningstar Confirms Ratings on SAGE AR Funding 2021 PLC with Stable Trends

DBRS Ratings Limited (DBRS Morningstar) confirmed its ratings on the following classes of notes issued by Sage AR Funding 2021 PLC (the Issuer):

-- Class A notes at AAA (sf)
-- Class B notes at AA (low) (sf)
-- Class C notes at A (low) (sf)
-- Class D notes at BBB (sf)
-- Class E notes at BB (high) (sf)

The trend on all ratings remains Stable.

The rating confirmations follow the transaction’s stable performance over the past 12 months, with a slight increase of rental income since origination on 9 November 2021. There are no cash trap covenant breaches recorded to date.

The transaction is a securitisation of a GBP 274.9 million floating-rate social housing-backed loan advanced by the Issuer to a single borrower, Sage Borrower AR2 Limited. The borrower then onlent the funds to its parent, Sage Rented Limited, a for-profit registered provider of social housing, which used the funds to acquire the properties and cover the associated costs. The loan is backed by 1,712 residential units comprising mostly houses or flats located across England.

Sage Housing Group (the sponsor or Sage) was established in May 2017 and is majority owned by Blackstone. Sage's core business is the provision of new affordable homes rented at a discount to the prevailing open market and let only to people on local authority housing waiting lists. The transaction represents the sponsor’s second securitisation, following its issuance of Sage AR Funding No. 1 Plc in October 2020.

The transaction comprises a five-year floating-rate loan, maturing on 16 November 2026, with interest based on the Sterling Overnight Index Average rate (Sonia), floored at 0%, plus a weighted-average margin of the rated notes of 1.46% per annum (p.a.) for the initial five years, stepping up to 2.12% thereafter if the loan is not repaid. The first interest payment date was on 17 February 2022. There is no scheduled amortisation; however, upon failing to repay in the fifth year, the loan will be in cash sweep with a minimum of 1% scheduled amortisation p.a. of the loan balance. The loan is currently hedged with an interest rate cap of 1.0% provided by Merrill Lynch International. The hedge terminates on 17 November 2023.

Savills provided a market value subject to tenancy (MVSTT) of GBP 376.9 million and an existing use value social housing (EUVSH) of GBP 302.8 million, as of 14 October 2021. The stock is a mixture of houses (56%) and flats (44%) in new purpose-built schemes dating from 2019. DBRS Morningstar determined the quality of the buildings to be above average. The schemes are generally situated in good residential locations with the majority located in the South East (60.8%) and the East of England (11.1%). The portfolio’s reported loan-to-value (LTV) ratio has remained unchanged at 68.0% since origination in November 2021.

Most of the rented units are on a “starter lease” and then transferred to a periodic assured shorthold tenancy after an initial probationary period of 12 months, which is extendable to 18 months. Tenants in social housing typically occupy the units for more than five years beyond the probationary period. As of August 2022, the contracted annual rent (let units) for the portfolio stood at GBP 14.7 million, and the net rental income at GBP 11.2 million. The leases are indexed to the consumer price index (CPI) plus 1% from years one to six, and to the CPI alone after year seven.

Sage’s affordable rents business has an arrears level of 2.3% (in respect of tenants in occupancy for over eight weeks) and 3.1% (in respect of tenants who have been in occupancy for over 18 months). However, Sage takes the approach that any amount that is overdue, by even one day, is an arrears. Sage has an expected bad debt level of 0.2%, as of the August 2022 interest payment date. Given the newness of Sage’s portfolio, there have been very few relets, so the portfolio does not yet have a meaningful tenancy churn level.

The debt yield (DY) slightly increased to 4.4% in August 2022 from 4.3% at cut off in November 2021, due to a 2.8% increase in net operating income to GBP 11.2 million from GBP 10.9 million at the cut-off date. The occupancy has improved to 99.4% from 84.0% since origination in November 2021. Since the properties are new-build, Sage does not anticipate any capital expenditure until at least year three since cut off.

At the cut-off date, DBRS Morningstar assumed an average annual rent per unit of GBP 7,718, which equated to a total portfolio gross rental income (GRI) of GBP 13.4 million. DBRS Morningstar assumed a rental growth of 1.5% p.a. DBRS Morningstar has not changed its assumptions of annual costs of approximately 23% of the GRI across the portfolio (equating to deductions of GBP 3.0 million).Also, DBRS Morningstar made further deductions of 2% to account for arrears and bad debt. DBRS Morningstar estimates net cash flow (NCF) at GBP 10.2 million. The capitalisation rate applied to the DBRS Morningstar NCF estimate is 4.22%, equating to a value of GBP 242.6 million, which represents a haircut of 35.6% towards Savills’ MVSTT valuation. DBRS Morningstar calculated a LTV of 105.7% for the rated loan and a DY of 3.99%.

Based on DBRS Morningstar’s calculation, the current debt service coverage ratio stands at 1.66 times (x). However, a sensitivity analysis on interest stress scenarios reveals that further increases in the three-month compounded Sonia rate would result in a shortfall of debt service coverage. The current hedge terminates in November 2023, offering protection to debt service coverage until then. Meanwhile, DBRS Morningstar understands that a new valuation will be mandated and is expected to be available early in 2023.

DBRS Morningstar considers that rising interest rates will challenge the borrower’s ability to pay the hedging costs. As discussed in the commentary dated October 2022, “Short-Dated Interest Rate Caps: an Emerging Feature in European CMBS”, DBRS Morningstar notes that premiums for interest rate caps increased five times between January 2022 and July 2022. Increased hedging costs may result in a liquidity issue and heightened credit risks along with the possibility of a loan event of default under the terms of the facility agreement (if the loan is not rehedged at hedge termination).

On the closing date, GBP 5.7 million of the proceeds from the issuance of the Class A notes was used to fund the Issuer liquidity reserve (ILR), which can be used to cover interest payment shortfalls through the Class A to D notes. DBRS Morningstar calculates that the ILR can cover interest payments on the covered notes up to 12 months, based on the interest rate cap strike rate of 1%, or five months, based on the Sonia cap of 4% (the interest on the notes being capped at 4.0% plus their respective margins).

The initial loan maturity date is in November 2026 with 20 one-year extension options available after that. Therefore, the final maturity date is in November 2046, followed by a five-year tail period. The legal final maturity date of the notes is in November 2051.

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. (17 May 2022).

Notes:
All figures are in British pound sterling unless otherwise noted.

The principal methodology applicable to the ratings is: European CMBS Rating and Surveillance Methodology (17 December 2021).

Other methodologies referenced in this transaction are listed at the end of this press release. These may be found at: https://www.dbrsmorningstar.com/about/methodologies.

DBRS Morningstar has applied the principal methodology consistently and conducted a review of the transaction in accordance with the surveillance section of the principal methodology.

A review of the transaction legal documents was not conducted as the legal documents have remained unchanged since the most recent rating action.

For a more detailed discussion of the sovereign risk impact on Structured Finance ratings, please refer to "Appendix C: The Impact of Sovereign Ratings on Other DBRS Morningstar Credit Ratings" of the "Global Methodology for Rating Sovereign Governments" at: https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments.

The DBRS Morningstar Sovereign group releases baseline macroeconomic scenarios for rated sovereigns. DBRS Morningstar analysis considered impacts consistent with the baseline scenarios as set forth in the following report: https://www.dbrsmorningstar.com/research/384482/baseline-macroeconomic-scenarios-application-to-credit-ratings.

The sources of data and information used for these ratings include servicer reports and quarterly data provided by Situs Asset Management Limited, U.S. Bank Trustees Limited since issuance, along with the initial valuation report provided by Savills Advisory Services Limited at issuance.

DBRS Morningstar did not rely upon third-party due diligence in order to conduct its analysis.

At the time of the initial ratings, DBRS Morningstar was not supplied with third-party assessments. However, this did not impact the rating analysis.

DBRS Morningstar considers the data and information available to it for the purposes of providing these ratings to be of satisfactory quality.

DBRS Morningstar does not audit or independently verify the data or information it receives in connection with the rating process.

The last rating action on this transaction took place on 15 November 2021, when DBRS Morningstar finalised its provisional ratings on the notes with Stable trends.

Information regarding DBRS Morningstar ratings, including definitions, policies, and methodologies, is available on www.dbrsmorningstar.com.

Sensitivity Analysis: To assess the impact of changing the transaction parameters on the rating, DBRS Morningstar considered the following stress scenarios as compared with the parameters used to determine the rating (the base case):

Class A Risk Sensitivity:
-- 10% decline in DBRS Morningstar NCF, expected rating on the Class A notes of AA (high) (sf)
-- 20% decline in DBRS Morningstar NCF, expected rating on the Class A notes of A (high) (sf)

Class B Risk Sensitivity:
-- 10% decline in DBRS Morningstar NCF, expected rating on the Class B notes of A (low) (sf)
-- 20% decline in DBRS Morningstar NCF, expected rating on the Class B notes of BBB (sf)

Class C Risk Sensitivity:
-- 10% decline in DBRS Morningstar NCF, expected rating on the Class C notes of BBB (sf)
-- 20% decline in DBRS Morningstar NCF, expected rating on the Class C notes of BBB (low) (sf)

Class D Risk Sensitivity:
-- 10% decline in DBRS Morningstar NCF, expected rating on the Class D notes of BBB (low) (sf)
-- 20% decline in DBRS Morningstar NCF, expected rating on the Class D notes of BB (high) (sf)

Class E Risk Sensitivity:
-- 10% decline in DBRS Morningstar NCF, expected rating on the Class E notes of BB (high) (sf)
-- 20% decline in DBRS Morningstar NCF, expected rating on the Class E notes of BB (low) (sf)

For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

These ratings are endorsed by DBRS Ratings GmbH for use in the European Union.

Lead Analyst: Mirco Iacobucci, Senior Vice President
Rating Committee Chair: Christian Aufsatz, Managing Director
Initial Rating Date: 18 October 2021

DBRS Ratings Limited
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Registered and incorporated under the laws of England and Wales: Company No. 7139960

The rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

-- European CMBS Rating and Surveillance Methodology (17 December 2021), https://www.dbrsmorningstar.com/research/389947/european-cmbs-rating-and-surveillance-methodology.
-- Derivative Criteria for European Structured Finance Transactions (20 September 2021), https://www.dbrsmorningstar.com/research/384624/derivative-criteria-for-european-structured-finance-transactions.
-- Legal Criteria for European Structured Finance Transactions (22 July 2022), https://www.dbrsmorningstar.com/research/400166/legal-criteria-for-european-structured-finance-transactions.
-- Interest Rate Stresses for European Structured Finance Transactions (22 September 2022), https://www.dbrsmorningstar.com/research/402943/interest-rate-stresses-for-european-structured-finance-transactions.
DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (17 May 2022), https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

A description of how DBRS Morningstar analyses structured finance transactions and how the methodologies are collectively applied can be found at: https://www.dbrsmorningstar.com/research/278375.

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