DBRS Morningstar Finalised Provisional Ratings on SAGE AR Funding 2021 PLC

DBRS Ratings Limited (DBRS Morningstar) finalised its provisional 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)

All trends are Stable.

The ratings are based on information provided to DBRS Morningstar by the Issuer and its agents as of the date of this press release.

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 loan was then on-lent by the borrower to its parent, Sage Rented Limited (Parent RP or SRL), a for-profit registered provider of social housing, and was used to finance the Parent RP’s acquisition of the properties as well as to cover the associated costs and expenses. The loan is backed by 1,712 residential units comprising mostly houses or apartments located across England (the portfolio).

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 rate to the prevailing open market and let only to people on local authority housing waiting lists who are in need of housing. The transaction represents the second securitisation by the Sponsor following Sage AR Funding No. 1 Plc, which was issued in October 2020 and rated by DBRS Morningstar.
 
The portfolio securing the loan consists of recently completed social housing units across 134 development sites in England, totalling 3,482 beds. The vast majority of the properties are located in the South East and the East of England, at 41.7% and 30.3% of the portfolio, respectively. 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.

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 200,000 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 facility has a loan-to-value (LTV) ratio of 72.9% (68.0% based on the rated notes), calculated using the Savills Advisory Services Limited (Savills) market value subject to tenancy (MVSTT) valuation of GBP 376.9 million, dated 14 October 2021. At the 30 September 2021 cut-off date, the borrower’s pro forma net operating income was GBP 10.9 million, resulting in a debt yield (DY) of 4.25% for the rated notes and 3.97% for the whole loan, including the subordinated Class R amount.

DBRS Morningstar’s value of GBP 239.0 million represents a DBRS Morningstar LTV of 115.0% for the whole loan and equates to a haircut of 36.6% to the Savills valuation. DBRS Morningstar based its valuation on an underwritten net cash flow (NCF) of approximately GBP 10.0 million and by applying a cap rate of 4.22%. The DBRS Morningstar DY at the cut-off date was 3.93% for the rated notes and 3.67% 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 (AR) housing has experienced a relatively limited impact compared with other asset types. Sage’s AR 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). DBRS Morningstar notes that such levels of arrears are in line with the sector’s benchmarks.

The proceeds of the notes were advanced to a wholly owned, newly incorporated, subsidiary of SRL, and then on-lent to SRL. SRL has in turn granted third-party security by way of mortgages over the properties and a share pledge over the shares in the borrower in order to secure the borrower’s obligations under the facility agreement. SRL also granted security to the borrower by way of a fixed charge over its segregated account into which rent is paid and over its right to receive rental income under the occupational leases. The borrower maintains full signing rights and full discretion over SRL’s segregated account.

The loan carries a floating rate of Sterling Overnight Index Average (Sonia) floored at 0% with a loan margin equal to the weighted-average margin of the rated notes. There is no interest payable on the portion corresponding to the Class R notes. The loan is interest only (with no scheduled amortisation) until the expected loan maturity on 15 November 2026. Following the initial five-year term, the loan may be extended on an annual basis until 15 November 2046, provided that no loan default for non-payment is continuing and satisfactory hedging is in place up to the relevant extended termination date. However, failure to repay the loan at the expected loan maturity is a cash sweep event and also triggers a minimum annual amortisation of 1.0% on the loan balance on the expected loan repayment date. A cash sweep event means that any excess funds available following the payment of interest and amortisation (together with the payment of certain senior costs including, inter alia, agent fees, corporate costs, asset management fees, and repair and maintenance costs) are used to repay the loan. If the loan is extended, there will also be a step-up in the margin payable on the rated notes (resulting in a step in the loan margin), on and from the first expected note maturity date on 17 November 2026.

The transaction does not have financial default covenants prior to a permitted change of control (CoC); however, there are cash trap covenants set at an LTV of 78.00% and DY of 3.56%, computed by reference to the aggregate balance of the Classes A to E.

To hedge against increases in the interest payable under the loan resulting from fluctuations in Sonia, the borrower is expected to enter into an interest rate cap agreement with Merrill Lynch International within 10 business days following the Closing Date. The expected hedge provider has a rating which, as at the cut-off date, is deemed to be commensurate with that of DBRS Morningstar’s rating criteria. The interest rate cap agreement is expected to cover the full notional amount of the rated notes. The hedge is expected to be in place for two years; 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 (EOD) and a sequential payment trigger event on the notes.

The initial interest rate cap is expected to have a strike rate of 0.75%. Generally, the interest rate cap agreements, prior to the expected loan maturity date, require an interest rate cap strike rate equal to the higher of 1.00% and the rate that provides a hedged interest coverage ratio (ICR) of 1.5 times (x). Following the expected maturity date, the interest rate cap agreements are expected to have an interest rate cap strike rate of the higher of 0.75% and the rate that provides an interest coverage ratio of 1.5x. This would result in 24 months of interest coverage on the notes.

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. The Issuer Liquidity Reserve can be used to cover interest shortfalls on the Class A, Class B, Class C, and Class D notes.

According to DBRS Morningstar’s analysis, the Issuer Liquidity Reserve amount, as at closing, could cover interest payments on the covered notes up to 12 months or five months based on the interest rate cap strike rate of 0.75% or the Sonia cap of 4.00%, respectively (the interest on the notes being capped at 4.00% plus their respective margins).

The final legal maturity of the notes is in November 2051, five years after the final loan termination date. DBRS Morningstar believes that this provides sufficient time to enforce the loan collateral and repay the bondholders, given the security structure and the jurisdiction of the underlying loan.

To satisfy EU, UK, and U.S. risk retention requirements, an entity within the Sage Group will retain a horizontal residual interest in the transaction 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 18.5 million Class R notes. This retention note ranks junior to interest and principal payments on all rated notes in the transaction.

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

The DBRS Morningstar Sovereign group releases baseline macroeconomic scenarios for rated sovereigns. These scenarios were last updated on 8 September 2021. DBRS Morningstar analysis considered impacts consistent with the baseline scenario in the below referenced report. For details, see the following commentaries: https://www.dbrsmorningstar.com/research/384150/baseline-macroeconomic-scenarios-for-rated-sovereigns and https://www.dbrsmorningstar.com/research/384482/baseline-macroeconomic-scenarios-application-to-credit-ratings.

ESG CONSIDERATIONS
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/373262.

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” (26 February 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 principal methodology.

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/381451/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 mainly include the data tape and portfolio stratification tables provided by the arrangers, a valuation report prepared by Savills, and additional reports and presentations prepared by the arrangers.

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 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 these financial instruments.

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

The last rating action on this transaction took place on 18 October 2021, when DBRS Morningstar assigned 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 ratings, DBRS Morningstar considered the following stress scenarios, as compared with the parameters used to determine the ratings (the Base Case):

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

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

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

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

Class E Risk Sensitivity:
-- 10% decline in DBRS Morningstar NCF, expected rating of Class E notes at BB (sf)
-- 20% decline in DBRS Morningstar NCF, expected rating of Class E notes at 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: Gareth Levington, 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 (26 February 2021), https://www.dbrsmorningstar.com/research/374399/european-cmbs-rating-and-surveillance-methodology.
-- Legal Criteria for European Structured Finance Transactions (29 July 2021), https://www.dbrsmorningstar.com/research/382171/legal-criteria-for-european-structured-finance-transactions.
-- Interest Rate Stresses for European Structured Finance Transactions (24 September 2021), https://www.dbrsmorningstar.com/research/384920/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.
-- Currency Stresses for Global Structured Finance Transactions (18 February 2021), https://www.dbrsmorningstar.com/research/373856/currency-stresses-for-global-structured-finance-transactions.
-- DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (3 February 2021), https://www.dbrsmorningstar.com/research/373262/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 [email protected].