DBRS Morningstar Confirms Ratings on Salus (European Loan Conduit No. 33) with Stable Trends; Removes Ratings on Class B to Class D from Under Review with Negative Implications

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

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

All trends are Stable based on the senior loan’s performance metrics since DBRS Morningstar’s last review.

DBRS Morningstar also removed its ratings on Class B to Class D from Under Review with Negative Implications (UR-Neg.), where they were placed on 15 December 2022 and maintained on 14 March 2023. The UR-Neg. removal follows DBRS Morningstar’s receipt of the updated valuation report dated 1 March 2023, which showed only a moderate 9.5% market value decline to GBP 670.0 million compared with the previous valuation of GBP 740.0 million dated 1 September 2021. However, the market value decline had no impact on the ratings, as the DBRS Morningstar Value was maintained at GBP 486.5 million, thus resulting in a 27.4% haircut to the latest valuation, down from 34.3% haircut to the previous valuation. DBRS Morningstar believes that this value reduction was more driven by the uncertain macroeconomic environment with respect to inflationary pressure and rising interest rates, as we did not observe a deterioration in the underlying asset’s performance which, on the contrary, is showing improved rental income and stabilizing occupancy.

RATING RATIONALE
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 and located in the City of London. The asset is a 36-storey office tower that was originally built for British Petroleum Plc in 1967. The building offers 704,657 square feet (sf) of office space and more than 60,000 sf of retail space, including several restaurants and the largest health club in the square mile, Nuffield Health. It is one of the largest office buildings in the City of London, and was subject to a comprehensive reconstruction in 2001. Since then, the owner has maintained the property at high-quality standards with ongoing refurbishment works and, as such, the building does not show any significant signs of obsolescence. In particular, as part of the sponsor’s business plan to capture the asset’s reversionary value potential, during the course of 2020–21, levels five to eight (the podium floors) underwent a comprehensive refurbishment at a cost of around GBP 167 per sf to provide high-quality Grade A offices and an additional floor area and walkway. Landscaped terraces were also included and the dedicated podium reception was refurbished. However, these floors have remained substantially unoccupied throughout the course of last year, exceeding DBRS Morningstar’s anticipated letting time at issuance.

Nevertheless, according to the latest available servicer report, physical occupancy improved to 83.0% in April 2023 compared with 79.8% in January 2023. Annual contracted rent also increased slightly by GBP 1.4 million over the last quarter to GBP 31.8 million. According to the servicer report, increased occupancy and contractual rent stem from an existing tenant, Squarepoint Capital (Squarepoint), signing a new lease on level eight for a contracted rent of GBP 1.47 million for 24,867 sf and a starting date in December 2023. This represents the first letting of the refurbished levels. Squarepoint already occupies levels 33 to 36 of the building and is the third-largest tenant by contracted rent, with a weighted-average lease term to expiry (WALTe) of 3.7 years and no break clause in place. The remaining vacancy is concentrated mainly on level five (partially) and levels six and seven, plus some storage units in the basement. The servicer reported that there is interest from three different potential tenants and the borrower is having early-stage discussions with all interested parties.

The rental income stream continues to be highly concentrated in the largest five tenants, which account for 72.0% of total contracted rent. As of April 2023, 95.3% of rental income originated from office space while the remaining 4.7% originated from retail, including restaurants, coffee shops, bars, and a gym. The top two tenants by contracted rent are Simpson Thacher & Bartlett LLP (23.7%) and Simmons & Simmons (22.8%), two well-recognised international law firms with high covenant strength. The former occupies nine levels (11 to 14 and 17 to 22) in the building, the leases for which have been recently re-geared to expire in March 2034, while the latter occupies the first five floors and has agreed to 10-year reversionary leases expiring in March 2035 with a break option in March 2030.

Further, Winston and Strawn LLP is vacating levels 29 and part of level 30 at lease expiry in June 2023. Leases have been agreed with two existing tenants, Willkie Farr & Gallagher LLP (Willkie Farr) and United Trust Bank, to take these floors at rates of GBP 72.50 per sf and GBP 68.90 per sf for levels 29 and 30, respectively. Willkie Farr has also signed reversionary leases on its already-occupied levels (25, 26, and 27), expiring in December 2030.

The significant tenant activity and the number of lease extensions/reversionary leases signed for this property confirm the current general trend for corporate occupiers to commit to longer-term leases in better-quality Grade A and more sustainable assets, as DBRS Morningstar anticipated in its recent commentary “CMBS: European Net-Zero Targets and the Rising Demand for Green Office Space” at https://www.dbrsmorningstar.com/research/408726/cmbs-european-net-zero-targets-and-the-rising-demand-for-green-office-space. As of April 2023, the WALTe for the whole building was 7.1 years, thus still providing for a robust lease maturity profile.

Projected net rental income increased by 5.4% over the last quarter to GBP 29.9 million in April 2023 from GBP 28.3 million in January 2023 and by 17.8% 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 April 2023, the senior loan’s debt yield ratio increased above the 8.00% cash-trap trigger to 8.13%.

In March 2023, Savills Plc revalued the single asset at GBP 670.0 million, which is 9.5% lower than the previous valuation of GBP 740.0 million that Knight Frank LLP conducted in September 2021 but still 11.6% higher than the initial valuation of GBP 600.0 million that Jones Lang LaSalle Inc. conducted in October 2018. As a result of the decreased value, the senior loan’s loan-to-value (LTV) ratio increased to 54.8% in April 2023 from 49.7% in January 2023, though it remains below the LTV of 61.3% at closing and comfortably below the cash-trap trigger of 72.5%.

DBRS Morningstar’s assumptions remained unchanged since its initial analysis, with DBRS Morningstar’s Stabilised Net Cash Flow (NCF) at GBP 25.3 million and DBRS Morningstar’s Cap Rate at 5.2%. This results in a DBRS Morningstar Value of GBP 486.5 million, which represents a 27.4% haircut to the latest valuation as of March 2023.

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. 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 fully extended maturity date.

The liquidity facility support stands at GBP 20 million as of April 2023, unchanged since issuance, and covers the Class A through Class D notes. Based on the cap strike rate of 2.5%, DBRS Morningstar estimated that the liquidity facility will cover 14.8 months of interest payments on the notes.

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 these options, thus extending the senior loan’s maturity to 22 January 2024. The servicer anticipated that updates to the sponsor’s plans for the senior loan beyond final loan maturity will be provided in the servicer report for the next interest payment date (July 2023).

Refinancing the senior loan at the final loan maturity date in a rising interest rate environment with higher refinancing costs could be challenging. However, DBRS Morningstar believes that the sponsor’s strength, the asset’s prime location, the transaction’s cash flow stabilization, as well as the building’s high-quality and Grade-A specifications will positively influence the borrower’s ability to fully redeem the senior loan at final maturity.

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 British pound sterling unless otherwise noted.

The principal methodology applicable to the ratings is: European CMBS Rating and Surveillance Methodology (14 December 2022), https://www.dbrsmorningstar.com/research/407379/european-cmbs-rating-and-surveillance-methodology.

Other methodologies referenced in this transaction are listed at the end of this press release.

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 data from the servicer reports 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 14 March 2023, when DBRS Morningstar confirmed its rating on the Class A notes with a Stable trend and maintained the UR-Neg. status on the remaining classes of notes, which was initially assigned on 15 December 2022.

The lead analyst responsibilities for this transaction have been transferred to Deniz Gokce.

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)

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. For further information on DBRS Morningstar historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

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

Lead Analyst: Deniz Gokce, Senior Analyst
Rating Committee Chair: Mark Wilder, Senior Vice President
Initial Rating Date: 11 December 2018

DBRS Ratings Limited
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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 (14 December 2022), https://www.dbrsmorningstar.com/research/407379/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.