DBRS Morningstar Finalises Provisional Ratings of Sage AR Funding No. 1 Plc

DBRS Ratings Limited (DBRS Morningstar) finalised its provisional ratings on the notes issued by Sage AR Funding No. 1 Plc (the Issuer) as follows:

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

All trends are Stable.

DBRS Morningstar does not rate the Class R Notes.

Sage AR Funding No. 1 Plc is the securitisation of a GBP 220 million floating-rate senior social housing backed loan (the senior loan) advanced by the Issuer to a single borrower, Sage Borrower AR1 Limited. The senior loan is on-lent by the borrower to its parent Sage Rented Limited (SRL), a for-profit registered provider of social housing, and was used to finance the acquisition of properties by SRL and associated costs and expenses. The senior loan is backed by 1,609 residential units comprising mostly houses or apartments located across England. The loan term is for five years with an expected final repayment date on 15 November 2025.

Sage Housing (the sponsor) was established in May 2017 and is majority-owned by Blackstone. Sage Housing has taken advantage of the recent changes to English legislation now allowing the presence of for-profit social housing providers, attracting private investors to a sector that was struggling to keep up with the fast-growing demand for affordable homes.

The portfolio is a mixture of new-build houses and flats in new purpose-built schemes dating from 2017. There are two sites in the portfolio consisting of 23 flats within high-rise buildings in London and both sites conform to fire safety regulations; however, DBRS Morningstar notes that external wall surveys may need to be carried out. Each scheme is generally in a good residential location close to transport links and amenities.

Approximately 60% of the portfolio is in London, the South East, and the South West. Most of the rented units are rented on what is called a starter lease and then transferred to a periodic assured 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.

SRL has appointed Places for People (PFP) for the day-to-day management of the units. PFP is a leading, nationwide-registered provider with a property portfolio of more than 197,000 units under management in diverse markets. It has a core social housing business with a G1/V1 rating from the regulator and more than 50 years of experience managing properties and tenants.

The senior facility represents a loan-to-value (LTV) of 71.3% (67.8% based on the rated notes) calculated on Savills Market-Value-Subject-To-Tenancy valuation of GBP 308.4 million dated 18 September 2020. Based on the borrower's proforma Net Operating Income of GBP 8.98 million, the debt yield (DY) at the 18 September 2020 cut-off date was 4.3% for the rated notes and was 4.1% for the whole loan, including the subordinated Class R amount.

DBRS Morningstar’s value of GBP 200.2 million represents an LTV of 109.9% (whole loan) and equates to a haircut of 35.1% to the Savills valuation. DBRS Morningstar deduced its valuation based on an underwritten net cash flow (NCF) of GBP 8.5 million and by applying a cap rate of 4.25%. The DBRS Morningstar DY at the cut-off date was 4.1% for the rated notes and was 3.9% for the whole loan.

Although the outbreak of the Coronavirus Disease (COVID-19) has negatively affected all commercial real estate sectors, the portfolio of affordable rented housing has experienced a relatively limited impact compared with other asset types. Collection data from August 2020 showed that during the lockdown period between March and June 2020 there was a slight increase in arrears; however, collections have recovered to normal levels following the easing of the lockdown restrictions.

The proceeds of the notes were advanced to a wholly owned, newly incorporated subsidiary of SRL, and on-lent to SRL. SRL in turn has granted third-party security by way of mortgages and a share pledge over the shares in the borrower to secure the borrower’s obligations under the facility agreement. SRL also granted security as a fixed charge over its bank account into which rent is paid. The borrower will maintain full signing rights and full discretion over operating the account.

The final legal maturity of the notes is expected to be 17 November 2030, five years after the expected loan maturity (15 November 2025). Given the security structure and jurisdiction of the underlying loan, DBRS Morningstar believes that this provides sufficient time to enforce on the loan collateral, if necessary, and repay the bondholders.

The senior loan interest comprises two parts: (1) Sterling Overnight Index Average (Sonia) (subject to zero floor) plus a margin that is a function of the weighted average (WA) of the aggregate interest amounts payable on the rated notes; (2) the lower of excess cash flow and 9% fixed interest on the retention tranche. As such, there is no excess spread in the transaction and ongoing costs are ultimately borne directly by the borrowers. To hedge against increases in the interest payable under the loan resulting from fluctuations in Sonia, the borrower has purchased an interest cap agreement from a hedge provider, with a rating, as at the cut-off date, commensurate to that of DBRS Morningstar’s rating criteria, with a cap strike rate of 0.5% for the full notional amount of the rated notes. The hedge will initially be in place for two years only; however, it must be renewed annually for the remaining term of the loan. DBRS Morningstar anticipates that the hedge will be extended for the full duration of the loan term. If the hedge is not extended as described, there will be a loan event of default and sequential payment trigger event on the notes.

There is no scheduled amortisation during the term of the loan; however, prepayments are permitted as voluntary prepayments and also with respect to property disposals. The borrower must prepay principal in an amount equal to the release price, which is 100% of the allocated loan amount of that disposal. The allocation of such principal prepayment to the notes will be pro rata prior to a sequential payment trigger, after which all principal will be applied sequentially. If a prepayment is made as a voluntary prepayment, such principal will be applied to the rated notes in reverse sequential order.

The loan structure does not include financial default covenants prior to a permitted change of control, but provides other standard events of default, including among others: (1) nonpayment, including failure to repay the loan at the maturity date; (2) noncompliance, where the borrower does not comply with its obligations under the senior facility agreement; (3) misrepresentation, where any representation or statement made or deemed to be made by the borrower under or in connection with any senior finance document or hedge document is or proves to have been incorrect or misleading; (4) cross-default, where any financial indebtedness or commitment of the borrower is not paid when due or within any originally applicable grace period; (5) insolvency and insolvency proceedings. In DBRS Morningstar’s view, potential performance deteriorations would be captured and mitigated by the presence of cash trap covenants: (1) a rated LTV cash trap covenant set at 78% and (2) a rated DY cash trap covenant set at 3.75%.

The transaction benefits from a liquidity reserve facility of GBP 6.5 million, which is provided by Deutsche Bank AG London Branch. The initial liquidity reserve amount will be drawn in full by the Issuer and deposited in the issuer liquidity reserve account on the closing date. The liquidity facility may be used to cover shortfalls on the payment of interest due by the issuer to the holders of the Class A to Class C notes. According to DBRS Morningstar’s analysis, the liquidity reserve amount will be equal to approximately 23 months’ interest coverage on the covered notes, based on the interest rate cap strike rate of 0.5% per year, and approximately nine months of interest coverage, based on the Sonia cap after loan maturity of 4.0% per year.

To satisfy risk retention requirements, an entity within the Sage Group has retained a residual interest consisting of no less than 5% of the nominal and fair market value of the overall capital structure by subscribing to the unrated and junior-ranking GBP 11 million Class R Notes. This retention note ranks junior in relation to interest and principal payments to all rated notes in the transaction.

COVID-19 CONSIDERATIONS
The Coronavirus Disease (COVID-19) and the resulting isolation measures have caused an economic contraction, leading to sharp increases in unemployment rates and income reductions for many tenants and borrowers. DBRS Morningstar anticipates that vacancy rate increases and cash flow reductions may arise for many CMBS borrowers, some meaningfully. In addition, commercial real estate values will be negatively affected, at least in the short-term, impacting refinancing prospects for maturing loans and expected recoveries for defaulted loans. The ratings are based on additional analysis as a result of the global efforts to contain the spread of the coronavirus.

On 16 April 2020, the DBRS Morningstar Sovereign group released a set of macroeconomic scenarios for the 2020-22 period in select economies. These scenarios were last updated on 10 September 2020. For details, see the following commentaries: https://www.dbrsmorningstar.com/research/366542/global-macroeconomic-scenarios-september-update and https://www.dbrsmorningstar.com/research/359903/global-macroeconomic-scenarios-application-to-credit-ratings. The DBRS Morningstar analysis considered impacts consistent with the moderate scenario in the referenced reports.

On 16 June 2020, DBRS Morningstar published a commentary outlining how the coronavirus crisis is likely to affect DBRS Morningstar-rated CMBS transactions in Europe. For more details, please see: https://www.dbrsmorningstar.com/research/362693/european-cmbs-transactions-risk-exposure-to-coronavirus-covid-19-effect and https://www.dbrsmorningstar.com/research/362712/european-structured-finance-covid-19-credit-risk-exposure-roadmap.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

For more information regarding structured finance rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/358308.

ESG CONSIDERATIONS

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

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” (13 December 2019).

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

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.

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/364527/global-methodology-for-rating-sovereign-governments.

The sources of data and information used for these ratings include the data tape provided by Deutsche Bank AG London Branch, various due diligence reports prepared by the delegates of Deutsche Bank AG London Branch, and a valuation report prepared by Savills.

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

DBRS Morningstar was 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.

These ratings concern a newly issued financial instrument. These are the first DBRS Morningstar ratings on this financial instrument.

This is the first rating action since the Initial Rating Date.

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

To assess the impact of changing the transaction parameters on the ratings, DBRS Morningstar considered the following stress scenarios, as compared to the parameters used to determine the ratings (the Base Case):

Class A Notes 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 (sf)

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

Class D Notes 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 (low) (sf)

Class E Notes Risk Sensitivity:
--10% decline in DBRS Morningstar NCF, expected rating of Class E Notes to B (low) (sf)
--20% decline in DBRS Morningstar NCF, expected rating of Class E Notes to lower than B (low) (sf)

Class F Notes Risk Sensitivity:
--10% decline in DBRS Morningstar NCF, expected rating of Class F Notes to lower than B (low) (sf)
--20% decline in DBRS Morningstar NCF, expected rating of Class F Notes to lower than B (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.

Ratings assigned by DBRS Ratings Limited are subject to EU and U.S. regulations only.

Lead Analyst: Dinesh Thapar, Assistant Vice President
Rating Committee Chair: Christian Aufsatz, Managing Director
Initial Rating Date: 5 October 2020

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 (13 December 2019), https://www.dbrsmorningstar.com/research/354637/european-cmbs-rating-and-surveillance-methodology.
-- Legal Criteria for European Structured Finance Transactions (11 September 2019), https://www.dbrsmorningstar.com/research/350234/legal-criteria-for-european-structured-finance-transactions.
-- Interest Rate Stresses for European Structured Finance Transactions (28 September 2020), https://www.dbrsmorningstar.com/research/367292/interest-rate-stresses-for-european-structured-finance-transactions.
-- Derivative Criteria for European Structured Finance Transactions (24 September 2020), https://www.dbrsmorningstar.com/research/367092/derivative-criteria-for-european-structured-finance-transactions.

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 [email protected].