Morningstar DBRS Downgrades Notes Issued by Salus (European Loan Conduit No. 33) DAC With Negative Trends, Removes All Classes from Under Review With Negative Implications

DBRS Ratings Limited (Morningstar DBRS) downgraded the credit ratings of all notes issued by Salus (European Loan Conduit No.33) DAC as follows:

-- Class A downgraded to AA (high) (sf) from AAA (sf)
-- Class B downgraded to AA (low) (sf) from AA (sf)
-- Class C downgraded to BBB (high) (sf) from A (low) (sf)
-- Class D downgraded at BBB (low) (sf) from BBB (sf)

Morningstar DBRS also removed the notes from Under Review With Negative Implications where they were placed on 29 December 2023. The trends on all ratings are now Negative.

The rating actions reflect the increased refinancing risk related to the loan’s extended maturity date in January 2025 in light of the high vacancy rate of the asset, the reduction in the tail period to four years from five years following the amendment to the senior loan that came into effect on 15 December 2023 and the general negative outlook for the office sector, in line with Morningstar DBRS’s European CMBS 2024 Outlook (https://dbrs.morningstar.com/research/426333/european-cmbs-2024-outlook).

CREDIT 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 non-securitised 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 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 underwent 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. After the refurbishment, there was letting activity on level eight with the execution of a new lease that commenced on 1 March 2023. The contracted rent for the new lease is GBP 1.47 million per annum and the rent commencement date is 1 December 2023.

Negotiations with potential new tenants for levels five through seven are ongoing. Vacancy at the property was 17.6% as of the October 2023 Interest Payment Date (IPD). The loan is in cash trap with respect to its Debt Yield, which was reported at 7.9% as of October 2023, below the cash trap covenant of 8.0%. 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. The loan-to-value ratio (LTV) of the loan stands at 54.9% and is compliant with the cash trap covenant of 72.5%.

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 senior borrower then requested an additional 12 months’ maturity extension to 20 January 2025. The servicer agreed in December 2023 to the extension and in connection with the extension the senior borrower and the servicer agreed to additional amendments to the senior loan including, but not limited to, increasing the senior loan margin by 0.35% to 2.50% per annum for the period from 20 January 2024 to 20 January 2025 and a one-off maturity fee of 0.25% of the principal amount outstanding of the senior loan, both to be passed on to the noteholders and the VRR lender. The senior borrower also agreed to purchase hedging for 100% of the senior loan at a strike rate of 2.5% per annum for the period from 20 January 2024 to 20 January 2025.

DBRS Morningstar understands the final maturity date of the notes remains unchanged at 23 January 2029, thus reducing the tail period between the loan maturity and the final note maturity to four years from five years, which is shorter than what Morningstar DBRS would normally require for transactions secured by UK assets. The deal also faces higher refinancing risk particularly in light of the persisting high vacancy, especially at levels five through seven, which have remained unoccupied since the refurbishment. While Morningstar DBRS understands there are active leasing negotiations ongoing for levels five through seven, whether these spaces will be leased before the extended loan maturity date (20 January 2025) remains uncertain. Based on these risk factors, Morningstar DBRS took ratings actions by downgrading all classes by one notch and assigning a Negative trend to all classes of notes. Morningstar DBRS will continue to monitor the transaction, particularly on any relevant updates regarding new leasing activity and sponsor’s refinancing efforts.

The senior loan is interest only and currently accrues interest at the aggregate of compounded Sonia and a credit adjustment spread of 0.1193%, plus a margin of 2.15% per annum, which will increase to 2.50% on 20 January 2024. It is fully hedged to January 2025 with an interest rate cap provided by Wells Fargo Bank, N.A. with a strike rate of 2.5%.

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 liquidity facility support stands at GBP 20 million as of the October 2023 IPD, unchanged since issuance, and covers the Class A through Class D notes. Based on the cap strike rate of 2.5% and the amended note spreads, DBRS Morningstar estimated that the liquidity facility will cover 13.4 months of interest payments on the notes.

Morningstar DBRS' credit ratings on the notes issued by Salus (European Loan Conduit No. 33) address the credit risk associated with the identified financial obligations in accordance with the relevant transaction documents. The associated financial obligations are Initial Principal Amounts and Interest Amounts.

Morningstar DBRS' 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, Sonia Excess Amounts, Default Interest Amounts and Prepayment Fees.

Morningstar DBRS' long-term credit ratings provide opinions on risk of default. Morningstar DBRS 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 Morningstar DBRS 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, AND GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factors that had a relevant or significant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (4 July 2023) https://dbrs.morningstar.com/research/416784/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 credit ratings is European CMBS Rating and Surveillance Methodology (19 October 2023), https://dbrs.morningstar.com/research/422173.

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

A review of the transaction legal documents was not conducted as the legal documents have remained unchanged since the most recent credit rating action.

For a more detailed discussion of the sovereign risk impact on Structured Finance credit ratings, please refer to “Appendix C: The Impact of Sovereign Ratings on Other Morningstar DBRS Credit Ratings” of the “Global Methodology for Rating Sovereign Governments” at: https://dbrs.morningstar.com/research/421590.

The sources of data and information used for these credit ratings include the servicer reports published by Mount Street Mortgage Servicing Limited and the Regulatory Information Services (RIS) notification dated 20 December 2023.

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

At the time of the initial credit rating, Morningstar DBRS was not supplied with third-party assessments. However, this did not affect the credit rating analysis.

Morningstar DBRS considers the data and information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

Morningstar DBRS does not audit or independently verify the data or information it receives in connection with the credit rating process.

The last credit rating action on this issuer took place on 29 December 2023 when Morningstar DBRS placed all classes of notes Under Review with Negative Implications.

Information regarding Morningstar DBRS credit ratings, including definitions, policies, and methodologies, is available on dbrs.morningstar.com.

Sensitivity Analysis: To assess the impact of changing the transaction parameters on the credit rating, Morningstar DBRS considered the following stress scenarios as compared with the parameters used to determine the credit 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 (low) (sf)
-- 20% decline in DBRS Morningstar NCF, expected rating of Class B notes to BBB (sf)

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

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

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS' outlooks and credit ratings are monitored.

For further information on Morningstar DBRS historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication. For further information on Morningstar DBRS historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

These credit ratings are endorsed by DBRS Ratings GmbH for use in the European Union.

Lead Analyst: Deniz Gokce, Senior Analyst, Credit Ratings
Rating Committee Chair: David Lautier, Senior Vice President, Global Structured Finance
Initial Rating Date: 11 December 2018

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The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

-- Legal Criteria for European Structured Finance Transactions (30 June 2023),
https://dbrs.morningstar.com/research/416730
-- Interest Rate Stresses for European Structured Finance Transactions (15 September 2023),
https://dbrs.morningstar.com/research/420602
-- Derivative Criteria for European Structured Finance Transactions (18 September 2023),
https://dbrs.morningstar.com/research/420754
-- DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (4 July 2023), https://www.dbrsmorningstar.com/research/416784

A description of how Morningstar DBRS analyses structured finance transactions and how the methodologies are collectively applied can be found at: https://dbrs.morningstar.com/research/278375.

For more information on this credit or on this industry, visit dbrs.morningstar.com or contact us at [email protected].