Morningstar DBRS Downgrades DROP Mortgage Trust 2021-FILE, Changes Trends to Negative

On August 5, 2024, Morningstar DBRS updated the press release below to provide additional clarity.

DBRS, Inc. (Morningstar DBRS) downgraded the ratings on the Commercial Mortgage Pass-Through Certificates, Series 2021-FILE issued by DROP Mortgage Trust 2021-FILE as follows:

-- Class A to AA (sf) from AAA (sf)
-- Class A-IO to AA (sf) from AAA (sf)
-- Class A-Y to AA (sf) from AAA (sf)
-- Class A-Z to AA (sf) from AAA (sf)
-- Class B to BBB (sf) from AA (low) (sf)
-- Class C to BB (sf) from A (low) (sf)
-- Class X-NCP to B (high) (sf) from BBB (sf)
-- Class D to B (sf) from BBB (low) (sf)
-- Class E to CCC (sf) from BB (sf)
-- Class HRR to CCC (sf) from BB (sf)

There are no trends for Classes E and HRR, which are assigned credit ratings that do not typically carry trends in commercial mortgage-backed securities (CMBS). The trend for all other classes was changed to Negative.

All credit ratings have been removed from Under Review with Negative Implications where they had been placed on April 15, 2024, as part of Morningstar DBRS' review of transactions secured by office properties within its North American Commercial Mortgage Backed Securities Single-Asset/Single-Borrower (NA CMBS SASB) portfolio. The review was prompted by Morningstar DBRS' view that a shift in the use and demand for office space has been observed in the last few years. Amid the increase in remote work and hybrid schedules, tenant demand in urban markets, such as those most frequently represented in the NA CMBS SASB space, has been the most resilient for those higher-quality buildings that offer extensive amenity packages and are located close to transportation hubs with other nearby draws for commuters and city dwellers alike. These trends are expected to be sustained in the long term and their ripple effects of increased tenant improvement costs, capital improvement expectations, and decreased demand for some markets and neighborhoods will continue to influence investment activity for the office sector as a whole. For more information regarding the approach and analysis conducted, please refer to the press release titled "Morningstar DBRS Takes Rating Actions on North American Single-Asset/Single-Borrower Transactions Backed by Office Properties," published on April 15, 2024.

At the conclusion of the April 2024 review, several transactions, including the subject transaction, remained Under Review with Negative Implications. This generally reflected the existence of evolving factors for those credits for which Morningstar DBRS identified a need for more information to be gathered to inform the analysis. With this review of the subject transaction, Morningstar DBRS has resolved the Under Review with Negative Implications status. The full details of the credit rating actions and ratings rationale are outlined below.

The subject transaction's underlying mortgage is collateralized by the borrower's fee-simple interest in a 750,370-square foot (sf) office building in the Mission Bay submarket of San Francisco. The credit rating downgrades reflect Morningstar DBRS' expectation that the collateral property's occupancy will continue to decline, and vacant space will be a challenge to backfill, negatively affecting the property value and potentially, the sponsor's commitment to the asset. The occupancy challenges are primarily driven by the election of the largest tenant, Dropbox, to give back a significant portion of its space. Although the tenant has and will continue to remit termination fees with each option, the significant decline in demand within the submarket in recent years could undermine stabilization efforts significantly. In addition, the increased vacancy will be a detriment to efforts to refinance the debt on the property at the anticipated repayment date (ARD) in 2026. As part of this credit rating action, Morningstar DBRS completed an updated cash flow analysis as part of deriving an updated Morningstar DBRS value of $460.1 million for the property, which represents a -30.2% variance from the Morningstar DBRS value derived when the credit ratings were assigned in 2021.

The floating-rate loan is interest only (IO) and is structured with an ARD in April 2026 with 10 successive one-year extension options and one six-month option for a final maturity date in October 2033, one month before Dropbox Inc.'s (Dropbox) lease expiration. In addition to penalty interest due on the mortgage after the ARD, the loan will hyper-amortize to the extent of available excess cash flow. Morningstar DBRS notes the significant reserves that will ultimately be held following Dropbox's downsizing. Although the terms of the loan do not allow for the Dropbox termination funds being held to be applied to leasing costs nor to pay down the loan balance outside of a Trigger Period (which would result from the loan not repaying at the ARD, among other instances) or a default scenario, the funds may be used to cover lost revenues and to pay debt service in the event of a shortfall, however. Additionally, given the current interest rate environment and upcoming loss of rental income, it is unlikely there will be meaningful cash flow overage available in a sweep event to contribute to additional principal paydown. These factors contributed to the Negative trends.

The collateral asset, previously known as The Exchange, but since rebranded as Icona: Labs at Mission Bay, was completed in 2018 and is LEED Platinum certified. The largest tenant is Dropbox, which at issuance occupied 98.4% of the net rentable area (NRA) on a lease through November 2033. Dropbox has since given back 185,852 sf of space, 133,896 sf (17.8% of the NRA) of which was converted to a direct lease with former sublease tenant, Vir Biotechnology, through December 2033. However, the remaining 51,956 sf is still vacant. As of the March 2024 rent roll, the property was 92.6% occupied, with no significant rollover in the near term. However, Dropbox is expected to give back another 113,229 sf over the next year, which will reduce its footprint to 58.8% of the NRA by YE2025. Assuming no other leasing takes place by that time, the property's implied occupancy rate would be 76.6%. All leases in place are scheduled to expire within three months of the loan's fully extended maturity date in October 2033.

Dropbox is required to pay termination fees with each termination option. Based on the servicer's description of how termination fees are held, those may be returned to the borrower if the entirety of the give-back space is backfilled. Morningstar DBRS thus assumes the termination fee that was paid for the space that has since been direct-leased to Vir Biotechnology is no longer being held in escrow. As of the June 2024 remittance, the termination fee paid on the still-vacant 51,596 sf in the amount of $26 million remains in reserve. An additional $50.9 million is expected to be deposited following the execution of Dropbox's future termination options.

The updated Morningstar DBRS NCF of $34.5 million derived with this review assumed all of Dropbox's future give-back space as vacant, and assumed an office market rent of $66 psf, in line with recent leases in the submarket. Morningstar DBRS' vacancy adjustment of 21.2% is based on the likely vacancy after Dropbox executes its final termination option. Expenses were primarily based on the historical figures. Morningstar DBRS based its tenant improvement assumptions on $60 (per square foot) psf for new leases and $15 psf for renewals, assuming a 10-year lease term. Leasing costs were based on 3.3% for new leases and 2.9% for renewals across all spaces. Morningstar DBRS concluded a renewal probability of 65.0% across all spaces.

Morningstar DBRS also elected to increase its cap rate to 7.5% (up from its previous cap rate of 6.5%), given recent changes in user demand in the submarket. The concluded Morningstar DBRS value of $460.1 million represents a loan-to-value ratio (LTV) of 130.4%. Morningstar DBRS made qualitative adjustments to the LTV Benchmarks totaling 4% to account for the high property quality and favorable location. A positive adjustment previously made to reflect the low cash flow volatility was removed, given the recent developments with Dropbox's space. Additionally, Morningstar DBRS removed an amortization credit that was previously applied to reflect the potential for deleveraging during the loan's tail period. Given the Dropbox termination and increase in the loan's floating rate since issuance, Morningstar DBRS no longer expects there will be significant excess cash flow to amortize the loan following its April 2026 ARD.

Morningstar DBRS remains concerned regarding the increased default risk following a major tenant, which contributed approximately 99% of the property's base rent at issuance, executing several consecutive termination options on large portions of space. This risk is exacerbated by the challenged leasing environment as office users across all markets have reduced their needs for physical space, and liquidity for biotech companies has diminished.

The ratings on Classes A, B, C, and D are higher than the results implied by the LTV sizing benchmarks. The variances are warranted given structural features, which outweigh the quantitative model output and uncertain loan-level event risk. As noted above, deposits related to Dropbox's termination are expected to accumulate to approximately $79.0 million by YE2025. Although these funds cannot be applied toward re-tenanting the space, they may offset rent interruptions or serve as added collateral should the loan default. In addition, the high property quality and location of the asset proximate to several large hubs, including UCSF's Mission Bay campus and medical center as well as the Kaiser Permanente campus, help to mitigate the increased risks and provide support for the variance rationale. It is also worthy to note that all classes, with the exception of Classes E and HRR, which were downgraded to CCC (sf), carry Negative trends.

Morningstar DBRS' credit ratings on the applicable classes address the credit risk associated with the identified financial obligations in accordance with the relevant transaction documents. Where applicable, a description of these financial obligations can be found in the transactions' respective press releases at issuance.

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, or 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).

Class X-NCP is an interest-only (IO) certificate that references a single rated tranche or multiple rated tranches. The IO rating mirrors the lowest-rated applicable reference obligation tranche adjusted upward by one notch if senior in the waterfall.

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 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. Please note a sensitivity analysis is not performed for CMBS bonds rated CCC or lower. The Morningstar DBRS Long-Term Obligation Rating Scale definition indicates that credit ratings of CCC or lower are assigned when the bond is highly likely to default or default is imminent, thereby prevailing over a sensitivity analysis.

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.

DBRS, Inc.
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Chicago, IL 60602 USA
Tel. +1 312 332-3429

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 (July 11, 2024; https://dbrs.morningstar.com/research/436004)
-- Rating North American CMBS Interest-Only Certificates (June 28, 2024), https://dbrs.morningstar.com/research/435294
-- Interest Rate Stresses for U.S. Structured Finance Transactions (February 26, 2024), https://dbrs.morningstar.com/research/428623
-- Morningstar DBRS North American Commercial Real Estate Property Analysis Criteria (June 28, 2024), https://dbrs.morningstar.com/research/435293
-- North American Commercial Mortgage Servicer Rankings (August 23, 2023), https://dbrs.morningstar.com/research/419592
-- Legal Criteria for U.S. Structured Finance (April 15, 2024), https://dbrs.morningstar.com/research/431205

For more information on this credit or on this industry, visit dbrs.morningstar.com or contact us at info-DBRS@morningstar.com.