Morningstar DBRS Finalises Provisional Credit Ratings on Classes A to F Notes of Hera Financing 2024-1 DAC

DBRS Ratings Limited (Morningstar DBRS) finalised its provisional credit ratings to the following classes of notes issued by Hera Financing 2024-1 DAC (the Issuer):

-- Class A notes at AAA (sf)
-- Class B notes at AA (high) (sf)
-- Class C notes at A (sf)
-- Class D notes at BBB (high) (sf)
-- Class E notes at BBB (low) (sf)
-- Class F notes at BB (sf)

CREDIT RATING RATIONALE
The transaction is the partial securitisation of a GBP 520.0 million senior commercial real estate (CRE) loan (the Facility A Loans) granted to refinance the acquisition of a portfolio of 19 freehold and long leasehold flexible office assets (the Initial Property Portfolio), owned and operated by Fora, the largest operator of high-quality flexible offices in central London. The portfolio totalling 721,000 square feet (sf) offers high quality amenities and collaborative workspaces in key sub-markets across London; with two additional office assets in Bristol and Oxford in the UK.

At closing, GBP 520 million were advanced to 12 borrowers through a GBP 220 million securitised Facility A2 Loan, representing 42.3% of the total Facility A Loans, whereas the remaining GBP 300 million Facility A1 Loan was advanced by third-party lenders. The borrower group comprises 10 borrowing entities incorporated in Guernsey and two entities registered in England and Wales. The portfolio was established in 2022 from the merger of The Office Group (TOG) and Fora and is now operated as the owned portfolio under the Fora brand, which is directly controlled by Blackstone (51%) and Brockton Capital (49%).

The portfolio securing the loan comprises 17 high-grade flexible office assets located in central London, with two additional properties in Bristol and Oxford. The Bristol asset operates as a fully flexible workspace whilst the Oxford asset is not operational and currently houses retail units. The London assets are all centrally located (Zone 1), in areas such as the West End, Soho, King Cross, Southbank, Shoreditch, and Farringdon.

The borrowers can make a delayed draw on additional funding (either through notes issued by the Issuer or a bank loan under the same facility agreement as the one used for the original senior loan) for the purposes of refinancing an additional property, Chancery House, Chancery Lane, London. Consequently, the Issuer may, after the closing date, issue additional notes [in each class], in each case subject to satisfaction of the further issuance conditions to fund all or a part of the Chancery House loan.

Valuations prepared for each property by Knight Frank in August 2024 concluded an aggregate portfolio market value (MV) of the collateral at GBP 867.0 million and with the inclusion of Chancery House, GBP 1.094 billion, based on the assumption of a corporate sale with no stamp duty land tax (SDLT) hence an assumption of 1.8% purchasers costs. The loan-to-value ratio (LTV) based on this value equals 60.0%; with the inclusion of the risk-retention Class R notes of GBP 11.58 million (see further below) the LTV is 61.3%.

The initial property portfolio has an occupancy rate of 75.1% (or 78% including Chancery House) as of 30 June 2024, the cut-off date. Occupancy is expected to increase to 79% in September 2024 pro forma. The in-place vacancy is largely concentrated in five properties, which are ramping up following an occupier vacating recently and some spaces requiring minor refurbishment. Following the merger of TOG and Fora the business has been able to realise synergies within the portfolio and benefits from a vertically integrated platform operating under a single brand, Fora. The sponsors have committed to a strategy of achieving an energy performance certificate (EPC) rating of at least C by 2027; as such, they have indicated a maintenance capex budget of GBP 14.5 million over the next five years to assist with incorporating these upgrades.

The portfolio including Chancery House generates revenue from license fees from 534 occupiers (or 456 occupiers excluding Chancery House) and rental income from full repairing and insuring (FRI) leases to more than 16 tenants (excluding The Silver Vaults and deposit boxes). The portfolio generates additional income from ancillary services and revenue streams, but the license revenue (flex office) and rental income (FRI) represent 90.2% of total revenues (excluding Chancery House from FY23 management accounts), with typical contracts ranging from three months to 24 months (and sometimes longer). The average contract length in the initial property portfolio is approximately 15.3 months (or 15.9 months including Chancery House) for the flexible office leases and the weighted-average (WA) unexpired lease term for the FRI leases for the FRI space is 9.1 years (or 8.3 years including Chancery House). In aggregate, the initial property portfolio occupier base is highly granular with the top 10 occupiers accounting for 22% of the flexible office revenue (or 18% including Chancery House).

As of the 30 June 2024 cut-off date, the portfolio (excluding Chancery House) generated GBP 60.3 million in flexible office revenue, which will likely increase to GBP 61.9 million in September 2024 pro forma, with an additional FRI income of GBP 2.9 million. Unless specified otherwise, portfolio data is based on the sponsor rent roll as at 30 June 2024 (the cut-off date) with a pro forma adjustment to September 2024 (taking into account license fee agreements signed but not yet started as 2024, churn of occupiers to 30 September 20024, and not the pipeline of potential occupiers.). The initial property portfolio will generate GBP 44.9 million in net operating income (NOI) in September 2024 pro forma, resulting in a day-one debt yield (DY) of 8.6%. Morningstar DBRS' long-term sustainable net cash flow (NCF) assumption for the initial property portfolio is GBP 42.5 million per annum, representing a haircut of 1.0% to in-place income and in line with the trailing 12-month NOI of the portfolio. The corresponding Morningstar DBRS value of GBP 582.0 million represents a haircut of 32.9% to the Knight Frank valuation. With the inclusion of the Chancery House property, the Morningstar DBRS cash flow would be GBP 54.0 million and the portfolio value would be GBP 734.0 million, implying a haircut of 32.4% to the Knight Frank valuation.

There are no senior loan financial covenants prior to a permitted change of control (PCOC); however, cash trap covenants are applicable with respect to LTV and DY both prior to and post PCOC. The cash trap event occurs if, on any loan payment date (15 February, 15 May, 15 August, and 15 November) the LTV ratio is greater than 60% or the DY is less than 12.5% and 13% following the additional funding of Chancery House. The financial covenants, following a PCOC on the LTV and the DY are set, respectively, at the LTV ratio being greater than 75% and the DY being less than 10.5% before the additional funding for the Chancery House property and 11.05% following the additional funding for the Chancery House property and will be tested on each interest payment date falling on or after the PCOC Date. At day-one the loan is not compliant with the cash trap covenant; however, this is largely because of the refurbishment of the five properties, which are yet to reach stabilisation.

The initial loan maturity date will be November 2027; however, two extension options are available and if the first extension option is exercised the loan maturity would extend to November 2028; the loan maturity would finally extend to November 2029 if the second extension option is exercised.

The senior loan is interest-only prior to a PCOC and carries a floating rate, which is referenced to the sterling overnight index average (Sonia; floored at 0%) plus a margin, which, with respect to the securitised Facility A2 loan, is a function of the WA of the aggregate interest amounts payable on the notes capped at 3.5% per annum, and in respect to the Facility A1 Loan, a margin of 3.5%. The borrowers must hedge against increases in the interest payable under the loan by purchasing an interest rate cap with a cap strike rate on any day of no more than the maximum hedging rate. The maximum hedging rate with respect to year one is 1.95% per annum; for year two it is 2.0% per annum; and for year three and thereafter the higher of 3.0% per annum and the rate that ensures that as at the date on which the relevant hedging transaction is contracted, the hedged interest coverage ratio (ICR) is not less than 1.5 times (x), until loan maturity.

The transaction is structured with a five-year tail period where the final note maturity date shall be automatically extended to ensure that the final note maturity date falls five years after the final loan repayment date.

On the closing date, the Issuer benefits from a liquidity facility provided by Bank of America. The liquidity facility covers the interest payments on the Class A, Class B, Class C, and Class D notes. No liquidity withdrawal can be made to cover shortfalls in funds available to the Issuer to pay any amounts in respect of the interest due on the Class E, Class F, and Class R notes. The Class F notes are subject to an available funds cap where the shortfall is attributable to an increase in the WA margin of the notes. Based on a WA cap strike rate of 2.7% and a Sonia cap of 5.0%, Morningstar DBRS understands that the liquidity facility covers no less than15 months and 11 months of interest payments, respectively, assuming standard senior-ranking Issuer costs and that the Issuer does not receive any revenue. Following the introduction of Chancery House, the liquidity facility will be upsized accordingly so there will be no loss of coverage with respect to interest payments on the notes.

To satisfy risk-retention requirements, The Office Group Securities Limited, an entity within the sponsor group, retains a residual interest consisting of no less than 5% of the nominal and fair MV of the overall capital structure by subscribing to the unrated and junior-ranking GBP 11.58 million Class R notes. This retention note ranks junior in relation to interest and principal payments to the senior-ranking loan facility and consequently all rated notes in the transaction.

Morningstar DBRS' credit ratings on the Class A, Class B, Class C, Class D, Class E, and Class F notes issued by the Issuer address the credit risk associated with the identified financial obligations in accordance with the relevant transaction documents. The associated financial obligations are the Stated Interest Amounts and Principal Amounts.

Morningstar DBRS' credit ratings do not address nonpayment risk associated with contractual payment obligations contemplated in the applicable transaction documents that are not financial obligations. For example, Prepayment Fees, Default Interest Amounts, and Sonia Excess Amounts.

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 Factors in Credit Ratings" (13 August 2024) at https://dbrs.morningstar.com/research/437781/.

Notes:
All figures are in GBP unless otherwise noted.

The principal methodology applicable to the credit rating 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 principal methodology.

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 a data tape with a cut-off date of 30 June 2024, valuation reports prepared by Knight Frank (with valuation date of 7 August 2024; technical and environmental due-diligence reports prepared by Botley Byrne Chartered Surveyors and Ramboll UK limited, respectively with issue dates throughout 2024); transaction documentation and related legal opinions, all provided by BNP Paribas.

Morningstar DBRS did not rely upon third-party due diligence in order to conduct its analysis.

Morningstar DBRS was not supplied with one or more 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.

These credit ratings concern newly issued financial instrument. These are the first Morningstar DBRS credit ratings on this financial instrument.

This is the first credit rating action since the Initial Rating Date.

Information regarding Morningstar DBRS credit ratings, including definitions, policies, and methodologies, is available on https://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 credit rating on the Class A Notes of AAA (sf)
-- 20% decline in Morningstar DBRS NCF, expected credit rating on the Class A Notes of AAA (sf)
Class B Risk Sensitivity:
-- 10% decline in Morningstar DBRS NCF, expected credit rating on the Class B Notes of AA (low) (sf)
-- 20% decline in Morningstar DBRS NCF, expected credit rating on the Class B Notes of A (low) (sf)
Class C Risk Sensitivity:
-- 10% decline in Morningstar DBRS NCF, expected credit rating on the Class C Notes of A (low) (sf)
-- 20% decline in Morningstar DBRS NCF, expected credit rating on the Class C Notes of BBB (sf)
Class D Risk Sensitivity:
-- 10% decline in Morningstar DBRS NCF, expected credit rating on the Class D Notes of BBB (sf)
-- 20% decline in Morningstar DBRS NCF, expected credit rating on the Class D Notes of BB (high) (sf)
Class E Risk Sensitivity:
-- 10% decline in Morningstar DBRS NCF, expected credit rating on the Class D Notes of BB (high) (sf)
-- 20% decline in Morningstar DBRS NCF, expected credit rating on the Class D Notes of BB (low) (sf)
Class F Risk Sensitivity:
-- 10% decline in Morningstar DBRS NCF, expected credit rating on the Class D Notes of B (high) (sf)
-- 20% decline in Morningstar DBRS NCF, expected credit rating on the Class D Notes of NR
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: Dinesh Thapar, Vice President
Rating Committee Chair: David Lautier, Senior Vice President
Initial Rating Date: 4 September 2024

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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 Factors in Credit Ratings (13 August 2024), 
https://dbrs.morningstar.com/research/437781

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 https://dbrs.morningstar.com or contact us at info-DBRS@morningstar.com.