Morningstar DBRS Downgrades Credit Rating on First Mortgage Bonds Issued by SEC LP and ARCI Ltd. (Suncor Energy Centre), Removes from Under Review with Developing Implications

DBRS Limited (Morningstar DBRS) downgraded the rating on the first mortgage bonds (the Bonds) issued by SEC LP and ARCI Ltd. (Suncor Energy Centre) (the Issuer) as follows:

-- 5.188% Series 1 Senior Secured Bonds due August 29, 2033 to BBB (low) from A (low) (sf)

The trend is Stable.

With this review, Morningstar DBRS removed the Bonds from Under Review with Developing Implications, where they were placed on October 16, 2023, following the release of the Morningstar DBRS “Global Methodology for Rating Credit Tenant Leases.” The Bonds were placed Under Review with Developing Implications to determine potential impacts on the credit rating based on the new methodology. However, given the update to the asset’s tenant roster with varying lease expiries across multiple tenants, Morningstar DBRS does not consider the “Global Methodology for Rating Credit Tenant Leases” to be applicable and instead applied its “North American Single-Asset/Single-Borrower” methodology in conjunction with its “North American CMBS Surveillance Methodology” for the purposes of this credit rating action. Morningstar DBRS revised its loan-to-value ratio (LTV) sizing benchmarks using an updated cash flow and capitalization rate, which resulted in an LTV of 76.4% based on the current senior mortgage balance. While the current LTV is more favourable than the previous Morningstar DBRS LTV of 92.4%, there is now less reliance on the credit rating of the largest tenant, Suncor Energy Inc. (Suncor; rated A (low) with a Stable trend by DBRS Morningstar) to support the bond rating. This review focused solely on the asset’s performance without the credit tenant support, inclusive of leasing risk during the remaining term of the loan, therefore the results support the rating downgrade.

The Bonds are secured by the Issuer’s ownership interest in Suncor Energy Centre (the Property) and have a current outstanding balance of $408.4 million, with a maturity date of August 29, 2033. The Property is a 1.7 million square foot (sf) office complex in Calgary’s central business district. Built in 1984, the complex is a certified green building with LEED Gold certification. Suncor is the largest tenant at the Property, occupying 78.4% of the total net rentable area (NRA) on various leases and generating more than 85.0% of the in-place rents. Morningstar DBRS notes that, following a lease modification in September 2022, more than half of Suncor’s space is now leased beyond the term of the mortgage, which matures in August 2033. The remaining Suncor space is on a separate lease that is scheduled to roll at the original expiration date of November 30, 2028. Suncor has to provide notice of its intent to renew the leases expiring in 2028 by December 2025, giving the borrower three years to backfill the space, if necessary. Given the bifurcation of lease maturities, Morningstar DBRS notes that the Bonds are now less likely to be sensitive to changes to the credit rating of Suncor during its various lease terms.

The annualized net operating income (NOI), based on reporting for Q2 2023, was $63.9 million, reflecting a 5.5% increase compared with the YE2022 NOI figure of $60.6 million, primarily driven by increases in base rents, reimbursements, and parking income. According to the August 2023 rent roll, the property achieved an average rental rate of $32.61 per sf (psf), in line with the YE2021 average rental rate of $32.54 psf. The property’s occupancy rate was 86.4 % as per the rent roll dated August 2023, in line with the YE2021 rate of 88.6%, but a significant decline from the YE2019 rate of 98.0%. The decline is partially attributable to the departure of a previous investment-grade tenant, Cenovus Energy Inc. (rated BBB (high) with a Stable trend by Morningstar DBRS), that formerly occupied 8.1% of the NRA and did not renew its lease at expiration in May 2020. The second-largest tenant, PricewaterhouseCoopers International Limited (PwC; 5.5% of the NRA) has an upcoming lease expiry in January 2025. However, the property manager has indicated that PwC has renewed the lease on four of their five floors at the Property on a 10-year term, giving back approximately 20,000 sf (1.2% of the NRA), which would bring the occupancy rate down to 85.1%. The primary credit risk associated with the transaction is the term default risk: should Suncor elect not to renew its lease expiring in November 2028, the implied occupancy rate at the subject would decline further to 53.0%. Though the subject serves as Suncor’s headquarters, the tenant has historically subleased small portions of its space. Recent media reports have indicated that Suncor cut approximately 1,500 jobs in 2023, however, Morningstar DBRS is not aware of any current subleases at the property. The property is performing in line with other Class AA office properties in the Downtown Calgary Office submarket, which had a 13.4% vacancy rate as of Q3 2023, as per CBRE’s “Q3 2023 Calgary Downtown Office Report”.

Morningstar DBRS considered a conservative approach in its analysis and completed an updated sizing based on a stressed haircut to the YE2022 NOI that reflects market vacancy and significant below-the-line items, including re-leasing costs totalling $3.4 million ($1.96 psf). Morningstar DBRS’ concluded net cash flow is $44.1 million. Using a capitalization rate of 8.25%, supported by CBRE’s Q3 2023 “Canadian Cap Rates & Investment Insights” that reported the Calgary Downtown Office Q3 2023 cap rate of 8.0% to 8.5%, Morningstar DBRS derived a value of $534.3 million, resulting in an LTV of 76.4% based on the current senior mortgage balance. The resulting LTV Sizing Benchmarks supported the credit rating downgrade.

To further test the durability of the rating, Morningstar DBRS also conducted a stabilized value scenario wherein, if the Property were to be re-leased at market rent today and reflected current market occupancy, its net cash flow would decline to $33.4 million. Assuming the same capitalization rate of 8.25%, the resulting value is $404.5 million, which would be adequate to cover today’s outstanding debt and the transaction would also continue to benefit from planned amortization for the next four years prior to Suncor’s first lease expiry.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factors that had a significant or relevant 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 Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (January 23, 2024), https://dbrs.morningstar.com/research/427030.

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

Notes:
All figures are in Canadian dollars unless otherwise noted.

The principal methodology is the North American CMBS Surveillance Methodology (March 16, 2023), https://dbrs.morningstar.com/research/410912.

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

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link under Related Documents or by contacting us at [email protected].

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.

Morningstar DBRS 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 Limited
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Toronto, ON M5H 3M7 Canada
Tel. +1 416 593-5577

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

-- North American Single-Asset/Single-Borrower Ratings Methodology (October 19, 2023), https://dbrs.morningstar.com/research/422174

-- DBRS Morningstar North American Commercial Real Estate Property Analysis Criteria (September 22, 2023). https://dbrs.morningstar.com/research/420982

-- North American Commercial Mortgage Servicer Rankings (August 23, 2023), https://dbrs.morningstar.com/research/419592

-- Legal Criteria for Canadian Structured Finance (June 20, 2023), https://dbrs.morningstar.com/research/416101

A description of how DBRS Morningstar analyses structured finance transactions and how the methodologies are collectively applied can be found at: https://dbrs.morningstar.com/research/410863.

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