DBRS Morningstar Places All Classes of Sage AR funding No.1 Plc Under Review with Negative Implications

DBRS Ratings Limited (DBRS Morningstar) placed its ratings on the following classes of commercial mortgage-backed floating-rate notes due November 2030 issued by Sage AR Funding No. 1 Plc (the Issuer) Under Review with Negative Implications (UR-Neg.):

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

The transaction is a 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 borrower onlent the senior loan to its parent, Sage Rented Limited (SRL), a for-profit registered provider of social housing, and SRL used the loan to finance its acquisition of properties 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. The portfolio was revalued by Savills in September 2021 to GBP 336.4 million, up from GBP 308.4 million (in terms of market value subject to tenancy), reducing the rated senior loan-to-value to 62.14% from 67.76%.

Sage Housing Limited (the sponsor) was established in May 2017 and is majority owned by Blackstone Inc. The portfolio is a mixture of new-build houses and flats in new purpose-built schemes dating from 2017. 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 let on starter leases and then transferred to periodic assured tenancy agreements 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.

The proceeds of the notes were advanced to a wholly owned, newly incorporated subsidiary of SRL, and onlent to SRL. SRL has in turn 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 to the borrower by way of a fixed charge over its segregated account into which rent is paid. The borrower will maintain full signing rights and full discretion over SRL’s segregated account.

The senior loan interest comprises two parts: (1) 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; and (2) the lower of excess cash flow and 9% fixed interest on the retention tranche (the Class R notes).

The underlying loan is performing in line with the terms of the senior facility agreement and all debt service requirements were met in full this quarter and for the previous three quarters. However, to hedge against increases in the interest payable under the loan resulting from fluctuations in Sonia, the borrower purchased an interest cap agreement from Merrill Lynch International, with a cap strike rate of 0.5% for the full notional amount of the rated notes. The current hedge arrangement expires in November 2022, at which point it must be renewed annually for the remaining term of the loan. If the hedge is not extended as described, there will be a loan event of default and a sequential payment trigger event on the notes. The loan has a five-year term.

DBRS Morningstar notes that there are certain hedging conditions in place, such that the interest rate cap(s) with a WA strike rate on any day must not be more than the higher of (1) 0.75% per year and (2) the rate that ensures that, as at the date on which the relevant hedging transaction is contracted, the hedged interest coverage ratio is not less than 1.5 times.

In today’s market, a hedge at this level is likely to be very difficult to procure and/or expensive and although the servicer has 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 loan event of default. Notwithstanding a loan event of default and in the instance where a hedge is not procured, the current net operating income would not be sufficient to cover the debt interest with respect to current one year swap rates and also in reference to DBRS Morningstar’s “Interest Rate Stresses for European Structured Finance Transactions” methodology. DBRS Morningstar has consequently placed its ratings on UR-Neg. until the hedging arrangements have been disclosed.

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 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’s liquidity reserve account on the closing date. The liquidity facility may be used to cover shortfalls on the Issuer’s payment of interest due to the Class A to Class C noteholders.

To satisfy risk retention requirements, an entity within 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.

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.

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 Situs Asset Management.

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 26 October 2021, when DBRS Morningstar confirmed its ratings on all classes of notes.

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

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

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

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

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

Class F Risk Sensitivity:
-- 10% decline in DBRS Morningstar NCF, expected rating of the Class E notes at CCC (sf)
-- 20% decline in DBRS Morningstar NCF, expected rating of the Class E notes at CC (sf)

These ratings 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: Mirco Iacobucci, Head of European CMBS
Initial Rating Date: 5 October 2020

DBRS Ratings Limited
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London EC3M 3BY United Kingdom
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 [email protected].