DBRS Morningstar Confirms Rating on Class A Issued by Salus (European Loan Conduit No. 33) DAC with Stable Trend; Places Ratings on Class B to Class D Under Review with Negative Implications

DBRS Ratings Limited (DBRS Morningstar) confirmed its rating on the following class of commercial mortgage-backed floating-rate notes due January 2029 issued by Salus (European Loan Conduit No. 33) DAC (the issuer):

-- Class A at AAA (sf)

The trend on the Class A notes remains Stable.

DBRS Morningstar also placed its ratings on the following remaining classes of notes in the transaction Under Review with Negative Implications (UR-Neg.):

-- Class B rated AA (sf)
-- Class C rated A (low) (sf)
-- Class D rated BBB (sf)

The transaction is a securitisation of a GBP 367.5 million floating-rate senior commercial real estate loan that Morgan Stanley & Co. International plc (Morgan Stanley) advanced in November 2018 to CityPoint Holdings I Ltd., which is controlled by Brookfield Asset Management Inc. (the sponsor). The senior loan is split into two pari passu facilities: Facility A, which totals GBP 354.0 million, and Facility B—the capital expenditure (capex) facility—which totals GBP 13.5 million. Facility A refinanced the borrower’s existing debt whereas the capex facility financed some refurbishment works that the sponsor planned at issuance. Additionally, there is a nonsecuritised mezzanine facility totalling GBP 91.9 million that is contractually and structurally subordinated to the senior facilities.

The senior loan is secured by a single asset known as the Citypoint office building located in the City of London. The asset is a 36-storey office tower that was originally built for British Petroleum Plc in 1967. It is one of the largest office buildings in the City of London, and was subject to a comprehensive reconstruction in 2001 and to several refurbishment works that were completed in 2021. The building offers 704,657 square feet (sf) of office space and more than 60,000 sf of retail space, including several restaurants as well as the largest health club in the square mile, Nuffield Health.

In September 2021, Knight Frank LLP revalued the single asset at GBP 740 million, which is 16.5% higher than the previous valuation of GBP 635 million as of January 2020 and 23.3% higher than the valuation of GBP 600 million in October 2018, both of which Jones Lang LaSalle Inc. conducted. As a result, the senior loan’s loan-to-value ratio decreased to 49.7% in October 2022 from 61.3% at issuance.

The portfolio has been performing steadily since the last annual review, with contracted gross rent slightly increasing to GBP 30.4 million in October 2022 from GBP 29.1 million in October 2021. The rental income stream continues to be highly concentrated in the largest five tenants, which account for 71% of total contracted rent. As of October 2022, the office tower was around 80% occupied by 26 tenants. The vacant space includes four floors, floors five to eight, which were recently refurbished as part of the sponsor’s business plan to capture the asset’s reversionary value potential. DBRS Morningstar understands that marketing to let these floors is ongoing, with some preliminary interest from a few prospective tenants. New terms were recently agreed on Regus’ surrender of its space on floor 11 that has been regranted until March 2034 to Simpson Thacher & Bartlett LLP, which now occupies approximately 110,000 sf in the building (15.6% of the total area) for an annual rent of GBP 7.2 million (23.6% of total contracted rent). As a result, the weighted-average lease term to expiry (WALTe) increased to 7.9 years, compared with 6.5 years at issuance.

Projected net rental income (NRI) also increased by 19.1% year over year to GBP 27.8 million in Q3 2022 from GBP 23.3 million in Q3 2021 and by 9.5% compared with GBP 25.4 million at issuance, as a large number of rent-free periods are set to expire in the coming months. As a result, according to the latest available servicer report as of Q3 2022, the senior loan’s debt yield (DY) ratio increased to 7.56% in Q3 2022 from 6.34% in Q3 2021; however, it has been hovering above the cash-trap trigger of 7.50% since the last annual review. Excess cash had been trapped from Q1 2021 to Q4 2021 and, once the breach was cured in January 2022, it was released to the sponsor and depleted in capex for renovations works on floors five to eight.

The senior loan was initially scheduled to mature on 20 January 2022 with two one-year conditional extension options available to the borrower. The borrower exercised the first extension option, thus extending the senior loan’s maturity to 20 January 2023 (the first extended senior loan maturity date). According to a notice from the issuer dated 14 December 2022, the borrower has requested the second extension option as well. Upon satisfaction of the applicable conditions, the senior loan maturity will be extended to 20 January 2024 (the second extended senior loan maturity date).

The senior loan is interest only and accrues interest at the aggregate of compounded Sonia and a credit adjustment spread of 0.1193%, plus a margin of 2.15% per annum (p.a.). It is fully hedged with an interest rate cap provided by Wells Fargo Bank, N.A. with a strike rate of 2.5%. The cap agreement’s expiry coincides with the senior loan’s first extended maturity date. For the senior loan to be further extended, the borrower is required to ensure that a subsequent hedging agreement is purchased, with a termination date that coincides with the newly extended loan maturity date and with a maximum strike rate set at 2.5% p.a.

In today’s market, a hedge at this level is likely to be difficult and/or expensive to procure and, although the servicer indicated that discussions are ongoing, it is not yet known whether the hedge has been secured. Failure to comply with the hedging conditions will result in a senior loan event of default (EOD). Notwithstanding a senior loan EOD and if a hedge is not procured, the current NRI would not be sufficient to cover the debt interest with respect to current one-year swap rates as per DBRS Morningstar’s “Interest Rate Stresses for European Structured Finance Transactions” methodology.

Despite the relatively moderate increase in projected NRI and the longer WALTe since issuance, DBRS Morningstar notes that the office building’s vacancy rate remains consistently high compared with the submarket and with DBRS Morningstar’s expected letting assumptions at issuance. Moreover, DBRS Morningstar expects rising interest rates to lead to higher capitalisation rates in the next 12 months, therefore exposing the asset to a potential market value decline since the last valuation dated September 2021.

DBRS Morningstar consequently placed its ratings on Class B to Class D UR-Neg. until it receives more clarity on the new hedging arrangements as well as on the upcoming revaluation of the securitised asset.

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.

DBRS Morningstar is undertaking a review and will remove the rating from this status as soon as it is appropriate.

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 data from the servicer report published by Mount Street Mortgage Servicing Limited.

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 December 2021, when DBRS Morningstar confirmed its ratings on all classes of notes and changed the trends on Class B to Class D to Negative from Stable. The trend on Class A remained Stable.

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 of Class A notes to AAA (sf)
-- 20% decline in DBRS Morningstar NCF, expected rating of Class A notes to AA (low) (sf)

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

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

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

The ratings on Class B to Class D notes are Under Review with Negative Implications. Generally, the conditions that lead to the assignment of reviews are resolved within a 90-day period.

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.

This rating is endorsed by DBRS Ratings GmbH for use in the European Union.

Lead Analyst: Dinesh Thapar, Vice President
Rating Committee Chair: Christian Aufsatz, Managing Director
Initial Rating Date: 11 December 2018

DBRS Ratings Limited
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Tel. +44 (0) 20 7855 6600
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.
-- 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.
-- Derivative Criteria for European Structured Finance Transactions (20 September 2021), https://www.dbrsmorningstar.com/research/384624/derivative-criteria-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.