Morningstar DBRS Downgrades Credit Ratings on Emerald Italy 2019 S.r.l.; Maintains Negative Trends on the Class A and Class B Notes

DBRS Ratings GmbH (Morningstar DBRS) downgraded its credit ratings on the commercial mortgage-backed floating-rate notes due September 2030 issued by Emerald Italy 2019 SRL (the Issuer) as follows:

-- Class A notes to BB (high) (sf) from BBB (low) (sf)
-- Class B notes to B (low) (sf) from BB (low) (sf)
-- Class C notes to CC (sf) from CCC (sf)
-- Class D notes to C (sf) from CC (sf)

The trends on the Class A and Class B notes remain Negative. There are no trends applicable to the Class C and Class D notes.

CREDIT RATING RATIONALE
The downgrade is driven by the distressed performance of the underlying collateral, coupled with a lack of improvement in the forecast net rental income in the sponsor's business plan for the next three years. Illiquidity persists in the Italian secondary retail market and the transaction's refinancing risk remains high, notwithstanding the three-year maturity extension to the loan and the notes consented via an extraordinary resolution approved by the noteholders on 23 July 2024.

The transaction is a securitisation of a EUR 105.8 million Italian commercial real estate loan advanced to Investire Società Di Gestione Del Risparmio S.p.A., acting on behalf of an Italian real estate alternative closed-end fund (fondo comune di investimento immobiliare alternativo di tipo chiuso riservato) named Everest, which is ultimately owned by Kildare Partners. The loan comprised a EUR 100.4 million term facility and a EUR 5.4 million capital expenditure (capex) facility, arranged by J.P. Morgan Securities plc (JPM) and advanced by J.P. Morgan Chase Bank, N.A., Milan branch. The loan is amortising at the rate of 1.5% per annum (p.a.), along with an additional deferable 1.0% p.a. deleverage and bears a three-month Euribor variable rate over a 4.05% p.a. margin. The loan is secured by a portfolio of two retail malls and one shopping centre located in the Lombardy region of Northern Italy.

The loan was originated in July 2019, and it was transferred to special servicing in June 2020 following an uncured payment default. The noteholders, through an extraordinary resolution on 10 November 2021, approved the Issuer's entry into an agreement standstill on any enforcement action until the loan termination in September 2022, when the sequential payment was triggered as extension conditions, including appropriate in-place hedging, were not satisfied. Subsequently, the special servicer agreed to a standstill period with the borrower until 15 September 2023, during which the key terms of the loan continued to apply, with default interest of 2.0% accruing since the September 2022 interest payment date (IPD) on all overdue amounts. On the June 2023 IPD, the calculation agent determined that the loan default interest amounts distributed as pro rata default interest to Class A through Class D noteholders should have been used for sequential principal redemption of the notes. Therefore, certain adjustments were made to the distribution of interest available funds on the September 2023 IPD, which led to the redistribution of interest deferrals and a decrease in the Class A principal balance. The loan is currently under a standstill agreement terminating on 15 September 2024.

As of the June 2024 IPD, the outstanding loan amount is EUR 94.8 million. Available funds after Issuer expenses were sufficient to cover interest payments on the Class A to Class C notes and partial interest payments on the Class D notes. Pending deferred interest on Class D stands at EUR 906,703, of which EUR 45,337 has been allocated to the retention tranche D of the Class R notes whereas the Class R notes represent the 5.0% unrated vertical interest retained by JPM in the transaction. Also, the Class D notes carry forward EUR 95,527 deferred pro rata default interest amount, of which EUR 4,777 represents the portion on the retention tranche D of the Class R notes.

At closing, the collateral backing the loan was valued by Cushman & Wakefield Debenham Tie Leung Limited (C&W) at EUR 161.4 million as of 31 October 2021, resulting in a loan-to-value (LTV) of 65.5%. The transaction has suffered a substantial deterioration in the collateral value since. The LTV increased to 70.8% based on the EUR 134.0 million valuation prepared by Jones Lang LaSalle IP, Inc (JLL) on 30 June 2022. The latest available valuation report by Savills Advisory Services Limited (Savills) provided a market value of EUR 78,910,000 as of 27 April 2023, equivalent to a decrease of 51.1% on the C&W valuation at issuance and an increase in LTV to 120.2%.

The value decline is driven by lower rental values of the properties that have experienced a decrease in footfall following the coronavirus pandemic and competition from new supply, as well as widening of yields due to higher reference rate and shortage of liquidity in the retail sector.

Based on the latest valuation, a Valuation Reduction Amount equal to EUR 24,425,621 has been determined and a Control Valuation Event has occurred with respect to the Class D notes on the June 2023 IPD. As such, the Class C noteholders became the controlling class and appointed an Operating Advisor via an ordinary resolution on 7 July 2023.

As of the June 2024 IPD, the contracted rent decreased to EUR 10.8 million from EUR 11.7 million at the last review conducted by Morningstar DBRS in September 2023. Vacancy increased to 17.1% in June 2024 from 13.0% in September 2023. Net rental income decreased to EUR 9.2 from EUR 9.8 million during this period. Arrears as of June 2024 were EUR 1.95 million, including receivables worth EUR 1.28 million that are 90 days past due. This level of arrears has remained stable over the past couple of years and has been accounted for as bad debts in the last revaluation, with a provision ranging from 1.5% to 2.0% of the passing rent. In addition, the valuer reported that the properties were overrented and tenant incentives have been compounded for circa 10% of the gross rental income on new leases. Forecast cash flows were published in a regulatory news service (RNS) notice dated 24 July 2024 and reflected a lack of improvement in the projected net operating income for the 2024 to 2027 period. In the absence of hedging, increased reference rate and default interest continue to further aggravate the transaction's cash flow position.

The loan's covenants are based on the debt service coverage ratio (DSCR), LTV, and debt yield (DY) derived from the ERV. The cash trap covenants are set at 1.55 times (x) the DSCR, 70% LTV for years one to two and 67.5% LTV thereafter, and 11.3% ERV DY, while the default covenants are set at 1.38x the DSCR, 75.0% LTV, and 10.7% ERV DY. The loan is in cash trap since March 2020 with a breach of the DSCR covenant ratio. A Class X diversion trigger event has occurred and is ongoing. As of June 2024 IPD, the Class X diversion ledger reports a credit of EUR 66,043, of which EUR 3,302 pertains to the retention tranche X of the Class R notes.

On 23 July 2024 the noteholders approved via an extraordinary resolution the extension of the final loan maturity to 15 September 2027 from September 2024 and extension of the notes' maturity date to 24 September 2033, from 24 September 2030. The business plan comprises a sales plan with marketing of the three properties starting in 18 months (i.e., January 2026). The restructuring provides for the unitholder parent of the borrower, Ticino Acquisitions Sarl, to grant 10% profit share of the proceeds (Contingent Value Rights) to the noteholders otherwise payable to the sponsor following the repayment of the loan. This will be allocated as final items in the pre and post enforcement waterfall.

The restructuring includes waivers of default interest, scheduled amortisation, hedging provision, and financial covenants, starting from the effective date, i.e., 16 September 2024. This would potentially improve the cash flow position to the benefit of the capex program and lease regearing, especially if the reference rate moves downwards. The loan margin capped at the current level of 4.05% will comprise two components named base and additional, whereas the latter represents the portion of the loan interest not applied to cover the Issuer's senior expenses and timely interest payments on the Class A and Class B notes and will be deferred until the earlier of the liquidation of the assets, or the final loan maturity date. The loan will remain in special servicing and principal repayment remains sequential. Outstanding interest deferrals, including accrued pro rata default interest will be crystalised, together with any potential Euribor excess amount. Following the redemption of the notes, deferrals will be paid as residual amounts.

The restructuring includes the principal amount of the Class X notes (and the related Retention Tranches) to be redeemed. The balance of the Class X account stands at EUR 1,053 as of the June 2024 IPD. Any amounts owing to the Class X notes and the related Retention Tranche will be cancelled and any amounts in any Class X diversion ledger will be applied as Interest Available Funds.

The loan seller also provided a liquidity facility of EUR 3.5 million (EUR 5.3 million at issuance) to the Issuer to cover any potential interest payment shortfalls on the Class A and Class B notes, including the corresponding retention tranches. According to Morningstar DBRS' analysis, the current commitment amount is equivalent to approximately nine months of interest payment shortfalls based on the 5% Euribor cap and the relevant margins for the Class A and Class B notes. Morningstar DBRS reference rate stress of 5.4%. exceeds the Euribor cap.
At origination, the Class D notes were subject to an available funds cap where the shortfall was attributable to interest due on the securitised loan not sufficient to pay senior costs and interest due on the notes. However, the cap will be removed after the restructuring effective date.

Morningstar DBRS updated its Net Cash Flow (NCF) assumptions and updated its cap rate assumption to 12%, from 11% at the September 2023 annual review and 9.5% at cut off. The Morningstar DBRS NCF declined to EUR 6.8 million from EUR 7.5 million at the last annual review in September 2023 mostly due to the decline in the contracted rent and increase in the vacancy rate. Morningstar DBRS value results in EUR 56.8 million, which translates to a haircut of 28.1% to the latest available valuation dated April 2023.

From the date the restructuring enters into force, the legal final maturity of the notes is extended to September 2033, from September 2030. The tail period is reduced to six years, from seven years at inception.

Morningstar DBRS' credit ratings on the Class A to Class D of the commercial mortgage-backed floating-rate notes issued by Emerald Italy 2019 SRL 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' credit rating does not address non-payment risk associated with contractual payment obligations contemplated in the applicable transaction documents that are not financial obligations. For example, pro-rata default interest, Euribor excess amount, 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.

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 https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings

Notes:
All figures are in euros 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 servicer reports and quarterly data provided by Banca Finint S.p.A. and CBRE Loan Services Limited; valuation reports provided by C&W, JLL, and Savills and RNS notices published on Euronext Direct as referenced above.

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 transaction took place on 15 September 2023, when Morningstar DBRS downgraded its credit ratings on the Class A notes to BBB (low) (sf) from A (low) (sf), on the Class B notes to BB (low) (sf) from BBB (low) (sf), on the Class C notes to CCC (sf) from B (high) (sf), and on the Class D notes to CC (sf) from B (low) (sf), while maintaining the Negative trends on all the classes. Morningstar DBRS also removed the Under Review with Negative Implications Status of the credit ratings where they were placed on 5 July 2023.

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 ratings, Morningstar DBRS considered the following stress scenarios as compared with the parameters used to determine the credit ratings (the base case):

Class A Risk Sensitivity:
-- 10% decline in Morningstar DBRS NCF, expected rating on the Class A notes of BB (sf)
-- 20% decline in Morningstar DBRS NCF, expected rating on the Class A notes of B (sf)

Class B Risk Sensitivity:
-- 10% decline in Morningstar DBRS NCF, expected credit rating on the Class B notes of below B (low) (sf)
-- 20% decline in Morningstar DBRS NCF, expected credit rating on the Class B notes of below B (low) (sf)

Class C Risk Sensitivity:
-- 10% decline in Morningstar DBRS NCF, expected credit rating on the Class C notes of below B (low) (sf)
-- 20% decline in Morningstar DBRS NCF, expected credit rating on the Class C notes of below B (low) (sf)

Class D Risk Sensitivity:
-- 10% decline in Morningstar DBRS NCF, expected credit rating on the Class D notes of below B (low) (sf)
-- 20% decline in Morningstar DBRS NCF, expected credit rating on the Class D notes of below 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 Limited for use in the United Kingdom.

Lead Analyst: Violetta Volovich, Assistant Vice President
Rating Committee Chair: David Lautier, Senior Vice President
Initial Rating Date: 9 October 2019

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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 (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.