Morningstar DBRS Downgrades Credit Ratings on Haus (European Loan Conduit No. 39) DAC With Negative Trends, Removes All Classes from Under Review With Negative Implications

DBRS Ratings GmbH (Morningstar DBRS) downgraded its credit ratings on all classes of commercial mortgage-backed floating-rate notes due July 2051 issued by HAUS (European Loan Conduit No. 39) DAC (the Issuer) as follows:

-- Class A1 downgraded to AA (high) (sf) from AAA (sf)
-- Class A2 downgraded to A (high) (sf) from AA (high) (sf)
-- Class B downgraded to BBB (high) (sf) from A (high) (sf)
-- Class C downgraded to BB (high) (sf) from BBB (high) (sf)
-- Class D downgraded to B (high) (sf) from BB (high) (sf)

Morningstar DBRS also removed the notes from Under Review With Negative Implications where they were placed on 19 July 2024. The trends on all credit ratings are Negative.
The credit ratings downgrade reflects Morningstar DBRS' review of its underwriting assumptions on the overall occupancy and the achievable rental value, which has resulted in a lower Morningstar DBRS Stabilised Net Cash Flow (NCF) and value.

The transaction is a securitisation of a EUR 318.75 million loan arranged by Morgan Stanley & Co. International plc in July 2021. The loan is secured by a portfolio of 6,284 multifamily residential units across 92 sites (equivalent to 59 properties) in Germany. The loan refinanced the acquisition of the portfolio by eight German borrowers, ultimately controlled by the sponsor, Brookfield Property Group L.P. (Brookfield).

At issuance, Brookfield had a majority interest in the portfolio (approximately 90%) with the seller (a group of high-net-worth individuals) retaining a minority stake and the role of portfolio asset manager. Following the seller shareholder's exit in March 2023, the sponsor gained full control and appointed a new asset manager, MVGM Property Management Germany GmbH, to speed up the delivery of the initial business plan.

The initial business plan comprised a refurbishment program of the underinvested portfolio (60% occupied at issuance) with the aim to create significant reversionary upside. The target was to modernise 75% of 2,263 selected units in the first two years. To fund this, the seller provided a capital expenditure (capex) guarantee of EUR 39.5 million and a rent guarantee of EUR 23.3 million. The rental guarantee was fully utilised by the July 2022 interest payment date (IPD) and topped up by the sponsor via equity contribution until the seller's exit in March 2023 when the remaining funds (EUR 22.7 million) from the capex guarantee were transferred to the sponsor. An equity commitment letter replaced the guarantees. Based on the figures reported by the servicer, as of the July 2024 IPD, the sponsor's contribution towards capex works totaled EUR 41.7 million, greatly exceeding the amount left from the original capex guarantee. According to the servicer report as of July 2024, the number of refurbished units reached 1,293, of which 841 units belong to the initial 2,263 selected pool of units (approximately 50% of the initial target) and the remaining 452 units represent additional nonscheduled refurbishments. In Morningstar DBRS' view this represents a significant delay of the initial business plan. The lease-up is slowing progressing and creating some reversionary value, since refurbished units are let at an average of EUR 7.3 per square metre (sqm), against an overall portfolio average of EUR 5.9 per sqm. However, the occupancy rate decreased to 49.1% at July 2024, down from 56.9% at last year's review in August 2023. The decrease in occupancy is mainly due to the clearance of a legacy of leases that were not producing any income. As of the July 2024 IPD, the total operating costs, heavily burdened by void and irrecoverable costs, still exceeded the net rental income (NRI), producing negative net operating income (NOI). The interest coverage ratio stood at 0.52 times (x) as of the July 2024 IPD. The sponsor has continued to inject equity in lieu of the seller's guarantees to cover costs. In June 2023, Brookfield committed EUR 56.6 million to cover capex and debt service. As of the July 2024 IPD, EUR 71 million had already been contributed, the majority of which has been spent on operating costs and capex, and the remaining on servicing the debt. No financial shortfall is anticipated as the sponsor's top-up commitment runs until the end of December 2024. Morningstar DBRS' view is that the portfolio's cash flow will not be generating positive NOI by year end and that the sponsor's commitment to inject equity is essential for the transaction to keep servicing its debt.

As of July 2024 IPD, the outstanding whole-loan amount has remained unchanged at EUR 318.75 million since origination because the loan is interest only until the initial loan maturity in July 2026 when, if extended, a cash sweep will commence. The loan may be extended on an annual basis until July 2046, provided certain conditions precedent are met.

The loan carried a floating rate of Euribor plus a 1.98% per annum (p.a.) margin for the first two years after closing, after which the margin stepped down to 1.84% p.a. until the initial maturity date. Following a potential extension of the loan in July 2026, the margin would step up to 3.25% p.a. The loan is fully hedged until July 2025, with a cap strike rate of 2.0% p.a. The subsequent hedging arrangement until initial loan maturity in July 2026 is expected to have a strike rate of 2.0% p.a., necessitating sponsor support.

After the expected note maturity date, or in the occurrence of a loan hedge default, the Euribor component of the rate of interest payable on the notes will be capped at 4.0% p.a.

As of the July 2024 IPD, the loan-to-value (LTV) ratio was 63.8%, down from 75.2% at the last annual review in August 2023 and from 67.9% at the cut-off date in March 2021. The decrease is driven by the increase in portfolio value, appraised at EUR 500 million by Jones Lang LaSalle Limited (JLL) in December 2023. The last valuation represents a 18% increase from the previous EUR 423.7 million appraisal dated October 2022 prepared by Knight Frank UK Limited (KF) and a 6.5% increase from EUR 469.7 million at the cut-off date in March 2021 (also prepared by KF). Morningstar DBRS notes that the property yield implied in the latest valuation is lower than that in the previous valuation, contrary to market evidence of a widening in secondary multifamily yields in Germany over the last couple of years.

The loan does not have financial default covenants; however, there are cash trap covenants set at 77.9% for the LTV and 8.5% for the debt yield (DY) starting from the third year and increasing to 9.0% starting in October 2024. Following the initial maturity date, DY and LTV covenants are set at 7.0% and 75%, respectively, and will be tested on an annual basis to extend the loan. The DY in July 2024 was 2.0%, down from 3.8% at the last review and from 4.9% at issuance. A DY cash trap event has been ongoing since April 2022, although there has been no surplus cash to move to the cash trap account.

The property and tenancy profiles are granular, with the top 10 assets accounting for 39.3% of the portfolio's net cold rent as of July 2024. According to the most recent servicer report, the annual contractual rent as at July 2024 was EUR 15.8 million, down from EUR 18.5 million in August 2023, and the projected NRI was EUR 6.4 million, down from EUR 12.2 million last year. The significant decrease in projected NRI is because of both an increase in vacant units and irrecoverable costs over the last quarter, which annualisation has magnified.

Morningstar DBRS reviewed its underwriting assumptions for its long-term stabilised NCF by adjusting its initial estimated rental value and minimum occupancy rate. This has resulted in an average rent of EUR 6.0 per sqm, down from EUR 6.6 per sqm at initial underwriting and an average portfolio occupancy rate of approximately 78%, down from 81% as underwrote at inception. Morningstar DBRS' net cold rent resulted in EUR 26.4 million, down from EUR 28.3 million at initial underwriting. Following the deduction of operating costs, the NCF was EUR 19.0 million down from EUR 21.07 million at the cut-off date. Morningstar DBRS' long-term stabilised capitalisation rate remained unchanged at 5.75%. This results in a Morningstar DBRS Value of EUR 331.0 million, down from the previous assessment of EUR 336.4 million. The current Morningstar DBRS Value represents a haircut of 33.8% from the JLL appraised value.

For the purpose of satisfying U.S., European Union, and UK risk retention requirements, the transaction includes a vertical risk retention (VRR) loan with the Issuer as the borrower of the VRR loan. At closing, the principal amount of the VRR loan was EUR 16.61 million, including EUR 657,895 as a portion to fund the liquidity reserve amount. The Issuer used EUR 12.5 million of the proceeds from the issuance of the Class A1 notes and the proportionate VRR loan amount to fund its liquidity reserve in an aggregate amount of EUR 13.157 million. The Issuer can use its liquidity reserve to cover interest shortfalls on the Class A1, Class A2, and Class B notes. As of July 2024, the liquidity facility balance stands at EUR 13.154 million. Morningstar DBRS estimates that the liquidity reserve amount can provide interest payments on the covered notes for up to 16 months or 10 months based on the interest rate cap strike rate of 2.0% or on the Euribor cap of 4.0%, respectively.

The transaction includes Class X notes of EUR 100,000, which are not rated by Morningstar DBRS. Interests due to Class X noteholders are subordinated to interest payments on all other classes of notes. The Class X interest diversion trigger event followed the loan's DY breach of 5.5% in August 2022 and Class X interests have not been distributed since. The Class X interest amount and the VRR loan proportion of that amount have been diverted to the Issuer's transaction account and credited to the Class X diversion ledger. The amount credited to the ledger was EUR 6.0 million on the July 2024 notes payment date. Once the trigger is cured, the held amount will be released to the Class X noteholders. Only following a sequential payment trigger event and enforcement of the note security, the funds can be applied as available funds to the transaction's waterfall.

The transaction is structured with a five-year tail period after the final loan repayment date in July 2046 to allow the special servicer to work out the loan by July 2051, which is the notes' final legal maturity.

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 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), https://dbrs.morningstar.com/research/437781 .

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 Regulatory Information Service notice, quarterly servicer reports, and the latest available tenancy schedules provided by Mount Street Mortgage Servicing Limited, quarterly cash manager reports prepared by U.S. Bank Global Corporate Trust Limited, the valuation reports prepared by JLL and KF.

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

At the time of the initial credit ratings, 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 19 July 2024, when Morningstar DBRS placed its credit ratings Under Review with Negative Implications.

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 A1 Risk Sensitivity:
-- a 10% decline in Morningstar DBRS' NCF would lead to an expected credit rating on the Class A1 notes at A (high) (sf)
-- a 20% decline in Morningstar DBRS' NCF would lead to an expected credit rating on the Class A1 notes at BBB (high) (sf)

Class A2 Risk Sensitivity:
-- a 10% decline in Morningstar DBRS' NCF would lead to an expected credit rating on the Class A2 notes at BBB (high) (sf)
-- a 20% decline in Morningstar DBRS' NCF would lead to an expected credit rating on the Class A2 notes at BBB (low) (sf)

Class B Risk Sensitivity:
-- a 10% decline in Morningstar DBRS' NCF would lead to an expected credit rating on the Class B notes at BBB (low) (sf)
-- a 20% decline in Morningstar DBRS' NCF would lead to an expected credit rating on the Class B notes at BB (sf)

Class C Risk Sensitivity:
-- a 10% decline in Morningstar DBRS' NCF would lead to an expected credit rating on the Class C notes at BB (low) (sf)
-- a 20% decline in Morningstar DBRS' NCF would lead to an expected credit rating on the Class C notes at B (low) (sf)

Class D Risk Sensitivity:
-- a 10% decline in Morningstar DBRS' NCF would lead to an expected credit rating on the Class D notes at B (low) (sf)
-- a 20% decline in Morningstar DBRS' NCF would lead to an expected credit rating on the Class D notes at 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: Patrizia Catanese, Assistant Vice President
Rating Committee Chair: David Lautier, Senior Vice President
Initial Rating Date: 29 July 2021

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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
-- Interest Rate Stresses for European Structured Finance Transactions (28 June 2024), https://dbrs.morningstar.com/research/435278
-- Derivative Criteria for European Structured Finance Transactions (06 September 2024), https://dbrs.morningstar.com/research/439043
-- Operational Risk Assessment for European Structured Finance Originators and Servicers (18 September 2024), https://dbrs.morningstar.com/research/439571

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.