DBRS Morningstar Finalizes Provisional Ratings on BX Commercial Mortgage Trust 2023-VLT3

DBRS, Inc. (DBRS Morningstar) finalized its provisional ratings on the following classes of Commercial Mortgage Pass-Through Certificates, Series 2023-VLT3 (the Certificates) issued by BX Commercial Mortgage Trust 2023-VLT3 (BX 2023-VLT3):

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

All trends are Stable.

BX Commercial Mortgage Trust 2023-VLT3 (BX 2023-VLT3) is a single asset/single-borrower transaction collateralized by the borrower’s leasehold interest in one data center property in Phoenix, Arizona. DBRS Morningstar generally takes a positive view of the credit profile of the overall transaction based on the property’s long-term investment-grade tenancy, favorable market position, affordable power rates, and desirable efficiency metrics. The loan is unclosed but is expected to close on or before November 14, 2023, and terms of the loan are subject to change.

Data centers, while having existed in one form or another for many years, have become a key component in the modern global technology infrastructure. The advent of cloud computing, streaming media, file storage, and artificial intelligence applications has increased the need for these facilities over the last 10 years in order to manage, store, and transmit data globally. While previous incarnations of data centers were often constructed in existing buildings that were converted, the needs of the market require purpose-built facilities that are engineered for this single use.

From the standpoint of the physical plant, the data center asset is heavily powered with 42 megawatts (MW) of critical IT load and features N+1 redundancy for all building systems. DBRS Morningstar views data center collateral as strong assets with strong critical infrastructure, including power and redundancy, built to accommodate the technology needs not only of today, but also well into the future. QTS Realty Trust, Inc. (QTS), the sponsor and operator of the collateral, manages a data center portfolio consisting of 59 data centers located throughout the U.S. and Europe with more than 2,300 MW of critical IT load.

Data center operators have historically benefitted from high barriers to entry because of the complexity of their operations along with the specialized knowledge required to operate the facilities to extraordinarily demanding uptime and reliability standards. Furthermore, the high upfront capital costs and necessary power infrastructure also make speculative development more difficult than with other property types.

Data center operators benefit from strong clustering and network effects attributable to the complex IT environments of their tenants. For various reasons, larger tenants strongly prefer to scale within existing environments rather than add capacity at a facility with a different provider. Furthermore, value-add interconnection revenue from tenant and bandwidth provider crossconnects tends to grow with increasing facility scale.

The collateral is located in Phoenix, which is now the second largest data center market in the U.S. and is supported by favorable wholesale power costs. Phoenix’s wholesale power costs are approximately $0.069 per kilowatt hour (kWh), which compares favorably with other nearby markets where power costs can be higher, such as Los Angeles, Northern California, Las Vegas, and Austin, which exhibit power costs of $0.180/kWh, $0.146/kWh, $0.076/kWh, and $0.095/kWh, respectively. The collateral is designed with power utilization efficiency (PUE) ratio of less than 1.4, which indicates a relatively efficient delivery of power to critical IT infrastructure. Typical PUE ratios range from 1.2 to 3.0, depending on the facility. According to the Uptime Institute's 2022 Data Center Survey, average annual PUE across all data centers was 1.55. The PUE ratio is the measure of how much power is used to power the critical components versus the center itself. For example, a PUE of 1.0 indicates that all power consumed by the center is used for the data center’s mission, as opposed to components such as cooling and lights.

One AAA-rated confidential tenant occupies 100% of the subject. The tenant executed an approximately 15.4-year lease through February 2039, with annual rent escalations of 3.0% and one approximately 15.3-year extension option. The lease includes termination options with heavy penalties, which includes 100% of remaining base rent as termination payment during month 0 to125, 75% of remaining base rent as termination payment in months 126 to143 among others. Therefore, DBRS Morningstar believes that the tenant is materially motivated to remain in the center during the initial lease term.

The mortgage loan features a five-year anticipated repayment date (ARD). After the ARD, the assumed spread of the mortgage loan components will increase by 200 basis points and excess cash flow will be used to amortize the mortgage loan. DBRS Morningstar concluded ARD structure in this mortgage loan as credit positive with a single long-term investment-grade tenant occupying the property. As it would result in a paydown of approximately $18.1 million should the loan not be repaid at the ARD.

The $500.0 million mortgage loan represents 60.2% LTV based on the $831.0 million as-complete appraised value and 58.5% LTV based on $854.0 million as-stabilized appraised value. Based on DBRS Morningstar value of $673.5 million, the mortgage loan represents a 74.2% LTV, which is relatively modest compared with more fully leveraged single-asset/single-borrower transactions.

QTS is an experienced data center operator with a footprint of more than 2,300 MW of power capacity of owned mega scale data center space throughout North America and Europe. The company has established relationships with significant power users across various industries. Additionally, QTS has demonstrated commitment to sustainability and environmental, social, and governance (ESG), and is committed to having 100% of the portfolio powered by carbon-free energy sources by 2025.

The sponsor on the transaction is QualityTech, LP (an operating partnership of QTS), an affiliate of The Blackstone Group (Blackstone). The transaction benefits from the experienced institutional sponsorship of Blackstone, a global private equity firm with a team of approximately 900 real estate professionals across 12 offices. As of June 30, 2023, Blackstone had approximately $333 billion in real estate capital under management. DBRS Morningstar also views Blackstone's acquisition of QTS as a long-term thematic entrance into the data center space, and the acquisition was completed using several of the firm's permanent capital private equity vehicles (including Blackstone Infrastructure Partners L.P.).

The property is subject to a 99.5-year ground lease with an affiliate of the sponsor, composed of a 29.5-year initial term automatically extended for an additional period of 70 years. The ground lease includes rent provisions that escalate annually at 2.0% with initial payment of $1.0 million. There is a ground rent reserve of $19.0 million, which is designed to cover ground rent for the years 2 through 17 of the ground lease. The sponsor is required to pay the ground landlord the initial ground rent payment of $1.0 million. The ground lease was executed pending a subdivision of the larger parcel owned by an affiliate of the sponsor in accordance for other purposes. The sponsor intends to subdivide the land into multiple separate parcels subject to a declaration to be put in place after closing, and ownership of the ground fee title is expected to be acquired by the SPE borrower and subject the fee title to the Deed. DBRS Morningstar views the intent of the ground lease to be credit neutral compared to third-party ground leases and the inclusion of the reserve adds additional security to the loan.

The property is leased in its entirety to a single investment-grade tenant and is structured with 15.4-year total term with one 15.3-year renewal option. Also, the lease is fully NNN with 3.0% annual rest escalations. The lease termination options have significant termination penalties, which includes 100% of remaining base rent as a termination payment during month 0 to 125, 75% of remaining base rent as termination payment in months 126 to143 among others. Given the long-term nature of the tenancy and its AAA-rated credit profile, DBRS Morningstar concluded single tenant exposure risk is sufficiently mitigated.

Data center properties require specialized operational knowledge and expertise in order to operate to extremely high uptime and reliability standards set forth in various service-level agreements (SLAs) with tenants. Failure to meet the terms of the SLA may result in rent abatements and credits. Therefore, the pool of potential buyers may be more limited than other asset types such as warehouse/distribution properties. Furthermore, a substantial component of the collateral value is dependent on QTS's client roster and extensive industry relationships and technical expertise. The loan documents require that any replacement manager meet certain qualifications, including having managed at least five data center properties (not including the property) for at least the five years.

DBRS Morningstar views data center properties as significantly more capital-intensive beyond the identifiable shell building repairs captured by a typical engineering report. Data center properties typically have dedicated on-site utility substations, complex closed loop evaporative cooling systems, and substantial uninterruptible power supply (UPS) and backup generator systems that must be proactively maintained and replaced to ensure the highest level of uptime and reliability. Typically, DBRS Morningstar assesses significant capex reserves even with newer properties. However, given the long-term credit tenant (LTCT) treatment for the tenant, these reserves were waived in the analysis.

The phase I environmental site assessment recognized a large, contaminated groundwater plume. The subject property is located within the current boundary of the Motorola 52nd Street EPA Superfund site, which extends approximately seven miles from the former Motorola manufacturing facility where the original chemicals were released. No former or current owners or operators of the subject property have been identified as a responsible party associated with the release of chemicals, and the phase I report identified no data or information that would suggest current or historical operations on the property may have contributed to the identified contamination. The subject property was constructed with a vapor barrier and other mitigation measures to eliminate the potential for vapor intrusion from the subsurface into the buildings. The phase I report recommended a vapor intrusion survey to determine the efficiency of mitigation measures, but it required no further actions from the sponsor. Also, the in-place environmental liability coverage of the subject provides $75.0 million of total aggregate coverage with an expiration date of October 2028. As a result, DBRS Morningstar did not elect to apply any additional adjustment to the LTV sizing benchmark for the recognized environmental condition at the subject property.

DBRS Morningstar’s credit rating on the Certificates addresses the credit risk associated with the identified financial obligations in accordance with the relevant transaction documents. The associated financial obligations are listed at the end of this press release.

DBRS Morningstar’s credit rating does not address non-payment risk associated with contractual payment obligations contemplated in the applicable transaction document(s) that are not financial obligations. For example, Spread Maintenance Premium.

DBRS Morningstar’s long-term credit ratings provide opinions on risk of default. DBRS Morningstar considers risk of default to be the risk that an issuer will fail to satisfy the financial obligations in accordance with the terms under which a long-term obligation has been issued. The DBRS Morningstar short-term debt rating scale provides an opinion on the risk that an issuer will not meet its short-term financial obligations in a timely manner.

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/416784 (July 4, 2023).

All credit ratings are subject to surveillance, which could result in credit ratings being upgraded, downgraded, placed under review, confirmed, or discontinued by DBRS Morningstar.

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

The principal methodology is North American Single-Asset/Single-Borrower Ratings Methodology (October 19, 2023; https://www.dbrsmorningstar.com/research/422174).

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

With regard to due diligence services, DBRS Morningstar was provided with the Form ABS Due Diligence-15E (Form-15E), which contains a description of the information that a third party reviewed in conducting the due diligence services and a summary of the findings and conclusions. While due diligence services outlined in Form-15E do not constitute part of DBRS Morningstar’s methodology, DBRS Morningstar used the data file outlined in the independent accountant’s report in its analysis to determine the credit ratings referenced herein.

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.

The credit rating was initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for this credit rating action.

DBRS Morningstar had access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is a solicited credit rating.

Please see the related appendix for additional information regarding the sensitivity of assumptions used in the credit rating process.

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

Legal Criteria for U.S. Structured Finance (December 7, 2022; https://www.dbrsmorningstar.com/research/407008)

DBRS Morningstar North American Commercial Real Estate Property Analysis Criteria (September 22, 2023; https://www.dbrsmorningstar.com/research/420982)

Interest Rate Stresses for U.S. Structured Finance Transactions (June 9, 2023; https://www.dbrsmorningstar.com/research/415687)

North American Commercial Mortgage Servicer Rankings (August 23, 2023; https://www.dbrsmorningstar.com/research/419592)

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/417279.

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

Financial Obligations of the issuer are listed as follows:

-- Class A Principal Amount
-- Class A Interest Distribution Amount
-- Class B Principal Amount
-- Class B Interest Distribution Amount
-- Class C Principal Amount
-- Class C Interest Distribution Amount