Morningstar DBRS Downgrades and Confirms Credit Ratings on Notes Issued by Salus (European Loan Conduit No. 33) DAC with Negative Trend

DBRS Ratings Limited (Morningstar DBRS) took the following credit rating actions on the notes issued by Salus (European Loan Conduit No.33) DAC (the issuer) as follows:

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

The trends on all ratings are Negative.

The credit rating actions result from the increase in Morningstar DBRS' Cap Rate for the underlying property by 55 basis points (bp) to 5.75% from 5.20%. This reflects the increased refinancing risk of the securitised loan with its upcoming extended maturity scheduled on 20 January 2025, the transaction's reduced tail period, and the aged property valuation, despite overall stable cash flow metrics.

In particular, the most recent valuation conducted on the property is dated 1 March 2023. Since then, prime yields for office buildings in the City of London have continued to widen as a result of the increase in interest rates. Coupled with the rise of hybrid work arrangements, this poses a substantial refinancing risk for loans secured by large office buildings that are proving very difficult to sell.

The credit rating actions also reflect the uncertainty as to whether the securitised loan will be refinanced or fully paid down through the sale of the property within the upcoming maturity in six months. If the loan fails to repay before maturity, any further loan extension request would be subject to the borrower obtaining consent from noteholders.

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. For the purposes of complying with the applicable risk retention requirements, Morgan Stanley also advanced a GBP 18.4 million vertical risk retention (VRR) loan to the issuer.

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 to an already occupying tenant (Squarepoint Capital LLP) that commenced on 1 March 2023. The contracted rent for the new lease is GBP 1.47 million per annum and the lease commenced on 1 December 2023. Based on the April 2024 Interest Payment Date (IPD) servicer report, Morningstar DBRS understands that terms have been agreed for the tenant to enter a 4-year reversionary leases of its existing space and that they will also take new leases on levels 9 and 10 (which are currently fully let to London CityPoint Centre Limited).

Negotiations with potential new tenants for levels five through seven are still ongoing. Physical vacancy increased by 2.5 percentage points to 20.1% in January 2024 from 17.6% in October 2023 as four tenants vacated: two tenants on levels 15-16 following their lease expiries, and another two tenants with storage/car space units. However, a new retail tenant joined the podium floors. In addition, in March 2024 Simpson Thacher & Bartlett LLP (already the largest tenant by annual contracted rent at the property) entered into a 10-year lease on level 15 with a rent of GBP 77.5 per square foot (sf). As a result, the tenant now occupies 123,566 sf of space over 10 different floors on co-terminus leases all expiring 24 March 2034. As of April 2024 IPD the property's weighted-average unexpired lease terms to break and to expiry were 6.1 years and 7.4 years, respectively.

The loan is in cash trap with respect to its debt yield, which was reported at 7.96% as of April 2024, slightly below the cash trap covenant of 8.00%. In March 2023, Savills Plc revalued the property 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 remained constant at 54.9%, in compliance 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 borrower then requested an additional 12 months' maturity extension to 20 January 2025. In December 2023, the servicer agreed to the extension conditional to certain amendments to the senior loan including, but not limited to, increasing 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 loan is interest only and currently accrues quarterly interest at the aggregate of compounded Sonia and a credit adjustment spread of 0.1193%, plus the 2.5% annual margin. It is fully hedged up until January 2025 with an interest rate cap provided by Wells Fargo Bank, N.A. with a strike rate of 2.5%.

Morningstar DBRS did not change any of its underwriting assumptions since issuance, thus maintaining its stabilised net cash flow (NCF) assumption constant at GBP 25.3 million. In addition, Morningstar DBRS increased its cap rate assumption by 55 bp to 5.75% from 5.20% to account for transaction-specific weaknesses (the aged valuation and refinancing risk) as well as the further widening of market yields 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). The increased cap rate translates into an updated Morningstar DBRS value of GBP 439.9 million, which represents a 34.3% haircut to Savills' valuation dated March 2023. At the previous review, Morningstar DBRS' value was equal to GBP 486.5 million, thus reflecting a 27.4% haircut to the same most recent valuation.

The liquidity facility outstanding balance stood at GBP 20.0 million as of the April 2024 IPD, unchanged since issuance, and covers the Class A through Class D notes.

According to Morningstar DBRS' analysis, the outstanding amount of the liquidity facility provides coverage of 13.7 months based on the interest rate cap strike rate of 2.5%, or 9.1 months based on the 5.0% Sonia cap payable on the notes after the expected note maturity date.

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.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

There were no Environmental/Social/Governance factor(s) 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 (23 January 2024) https://dbrs.morningstar.com/research/427030 .

Notes:
All figures are in Pound Sterling unless otherwise noted.

The principal methodology applicable to the credit ratings is

European CMBS Rating and Surveillance Methodology (17 January 2024)
https://dbrs.morningstar.com/research/426818

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

Morningstar DBRS has applied the principal methodology consistently and conducted a review of the transaction in accordance with the surveillance section of the principal methodology.

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/436000.

The sources of data and information used for these credit ratings include the servicer reports and the Q1 tenancy schedule received by Mount Street Mortgage Servicing Limited.

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 18 January 2024, when Morningstar DBRS downgraded all classes of notes and resolved the Under Review with Negative Implications status of the notes.

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 Morningstar DBRS NCF, expected rating of Class A notes to A (high) (sf)
-- 20% decline in Morningstar DBRS NCF, expected rating of Class A notes to A (low) (sf)

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

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

Class D Risk Sensitivity:
-- 10% decline in Morningstar DBRS NCF, expected rating of Class D notes to B (high) (sf)
-- 20% decline in Morningstar DBRS NCF, expected rating of Class D notes to B (low) (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, European Real Estate Ratings
Rating Committee Chair: Mirco Iacobucci, Senior Vice President, European Real Estate Ratings
Initial Rating Date: 11 December 2018

DBRS Ratings Limited
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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.

European CMBS Rating and Surveillance Methodology (17 January 2024)
https://dbrs.morningstar.com/research/426818

Legal Criteria for European Structured Finance Transactions (28 June 2024)
https://dbrs.morningstar.com/research/435165

Derivative Criteria for European Structured Finance Transactions (28 June 2024)
https://dbrs.morningstar.com/research/435260

Interest Rate Stresses for European Structured Finance Transactions (28 June 2024) https://dbrs.morningstar.com/research/435278

Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (23 January 2024), https://dbrs.morningstar.com/research/427030

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 info-DBRS@morningstar.com.