Morningstar DBRS Changes Trends on Two Classes of A10 Permanent Asset Financing 2017-II, LLC, to Negative From Stable; Confirms All Credit Ratings

DBRS Limited (Morningstar DBRS) confirmed its credit ratings on the following classes of A10 Permanent Asset Financing 2017-II, LLC:

-- Class A Notes at AAA (sf)
-- Class B Notes at AA (low) (sf)
-- Class C Notes at BBB (sf)

Morningstar DBRS changed the trends on Classes B and C to Negative from Stable. The trend on Class A is Stable.

The trend changes reflect Morningstar DBRS’ increased concerns for the pool, driven primarily by loans secured by office properties. Although the most recently reported credit metrics indicate the overall pool is generally performing in line with issuance expectations, several loans secured by office collateral have exhibited increased credit risk in recent months. In total, there are nine loans, representing 29.2% of the current pool, that are secured by office properties; a majority being Class B properties in nonprimary markets. Seven are on the servicer’s watchlist, having reported dark tenants and/or confirmation of major tenant departures, which will likely pressure cash flow declines. The increased default risk noted for these loans contributed to the Negative trends.

Given the shift in demand for office space following the coronavirus pandemic, Morningstar DBRS anticipates upward pressure on vacancy rates in the broader office market, presenting an additional challenge in retenanting these properties and increasing the potential for value declines. In the analysis for this review, Morningstar DBRS increased the probability of default (POD) for loans with confirmed tenant departures to reflect their current risk profile and, in certain cases, applied stressed loan-to-value (LTV) ratios. Following these adjustments, the modeled expected losses (ELs) for loans secured by office properties were among the highest in the pool, with a weighted-average (WA) EL 90.7% greater than the WA pool EL. Three of the loans receiving these adjustments are detailed below. Although the concentration of office loans is concerning, this is partially mitigated by the presence of eight loans, representing more than 26.0% of the current pool and secured by self-storage, industrial, or multifamily properties, which have historically performed well. In addition, there has been meaningful paydown with approximately 20.8% of collateral reduction since issuance. There has been no realized loss to the trust to date, and there are no loans currently in special servicing.

As of the March 2024 remittance, the transaction consists of 32 loans with an aggregate principal balance of approximately $235.3 million. Seven loans have repaid from the trust since issuance, including one loan, EZ Cheyenne Fountains 2018 (Prospectus ID#32; previously 1.2% of the pool) that paid off since the last credit rating action. While there are no specially serviced loans, six loans, representing 19.8% of the current pool balance, are on the servicer’s watchlist, including one loan, Village Square (Prospectus ID#1; 1.0% of the current pool), that is being monitored for its upcoming maturity in April 2024.

The largest loan of concern, PacCorp Center (Prospectus ID#38; 7.3% of the current pool), is secured by a Class B office property in Bellevue, Washington. The property was 89.6% occupied as of July 2023; however, the loan has been added to the servicer’s watchlist with the March 2024 remittance following the departure of the fourth and fifth largest tenants, Isola Homes (Isola; 10.7% of net rentable area (NRA), lease expired July 2023) and Ford Motor Credit Company (Ford; 8.7% of NRA, lease expired November 2023). Per LoopNet, there is approximately 29.4% of the NRA available for lease, implying an occupancy rate of 70.6%. With the aforementioned departures, a reduced performance period was triggered, initiating a cash flow sweep of $33,000 per month. The property has historically performed below market in terms of average effective rent, suggesting any replacement tenants may also pay a below-market rate. Per Reis, the YE2023 Bellevue/Issaquah submarket’s asking rent was $48.20 per square foot (psf). Although servicer commentary indicates there has been some leasing activity, two additional tenants, (11.7% of NRA) have leases expiring in 2024.

The annualized debt service coverage ratio (DSCR) for the trailing six months ended June 30, 2023, was 1.10 times (x), in comparison with the YE2022 and YE2021 DSCR of 1.32x and 1.65x, respectively. Given the tenant departures and the below-submarket rates historically reported for the asset, Morningstar DBRS analyzed this loan with an elevated POD and applied a stressed LTV adjustment, resulting in an EL more than 150.0% higher than the pool’s WA EL.

The second largest loan of concern, 500 S Sepulveda Blvd (Prospectus ID#35; 4.0% of the current pool), is secured by a Class B office property in Los Angeles. The loan was added to the servicer’s watchlist in July 2021 after the property’s largest tenant, Media Services (72.0% of NRA, lease expires December 2027), went dark but continues to pay rent according to its lease terms. Media Services is reportedly marketing one of its leased suites for sublease at a rental rate of $36.00 psf. In the absence of Media Services’ rent, the DSCR would fall well below 1.0x. With Media Services remaining current on its rent payments; however, the most recent DSCR remains in line with issuance expectations at 1.47x as of September 2023, compared with the YE2022 and YE2021 DSCR of 1.55x and 1.54x, respectively. According to the servicer commentary, other leased spaces within the building are being underused. To reflect concerns with dark space and high submarket availability, Morningstar DBRS maintained an elevated POD and applied a stressed LTV in its analysis of this loan, resulting in an EL nearly 130.0% higher than the pool’s WA EL.

Finally, the Clover Building loan (Prospectus ID#17; 3.9% of the current pool), also secured by a Class B office property in Bellevue, has experienced increased vacancy following the departure of its largest tenant, AIM Consulting (AIM; formerly 29.8% of NRA) at its lease expiration in August 2023. Occupancy reportedly dropped to 58.8% as of December 2023; although, Morningstar DBRS expects the current figure is lower given the third largest tenant RICOH USA, Inc. (RICOH, 9.2% of the NRA) recently vacated. Furthermore, there are four tenants (10.1% of NRA) with lease expirations in 2024. The loan reported a DSCR of 1.64x as of the trailing nine-month period ended September 30, 2023, of less than the YE2022 DSCR of 1.73x. Because of the departure of AIM and RICOH, as well as additional potential rollover in 2024, Morningstar DSCR expects the DSCR to drop well below breakeven over the next year. Morningstar DBRS analyzed this loan with an elevated POD and a stressed LTV, resulting in an EL more than 157.0% higher than the pool’s WA EL.

The transaction originally had a potential maximum funded balance of $400.0 million with a funding period that expired in December 2020. At that time, the transaction consisted of 38 loans with an aggregate balance of $292.4 million. The transaction reached its maximum funded balance of $297.2 million in December 2019 and began amortizing with the November 2020 Payment Date.

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 at (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 U.S. dollars unless otherwise noted.

The principal methodology is North American CMBS Surveillance Methodology (March 1, 2024; https://dbrs.morningstar.com/research/428798).

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 ratings were initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for these credit rating actions.

Morningstar DBRS had access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with these credit rating actions.

These are solicited credit ratings.

Please see the related appendix for additional information regarding the sensitivity of assumptions used in the credit rating process.

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.

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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.

-- North American CMBS Multi-Borrower Rating Methodology (March 1, 2024)/North American CMBS Insight Model v 1.2.0.0, https://dbrs.morningstar.com/research/428797
-- 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 U.S. Structured Finance (December 7, 2023),
https://dbrs.morningstar.com/research/425081

A description of how Morningstar DBRS analyzes structured finance transactions and how the methodologies are collectively applied can be found at: https://dbrs.morningstar.com/research/417279.

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