Morningstar DBRS Confirms Credit Ratings on Sage AR Funding No.1 Plc

DBRS Ratings Limited (Morningstar DBRS) confirmed its credit ratings on the bonds issued by Sage AR Funding No.1 Plc (the Issuer) as follows:

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

The trend on all ratings is Stable.

CREDIT RATING RATIONALE
The credit rating confirmations follow the transaction's stable performance over the last 12 months, with a modest increase in net rental income and no cash trap covenant breaches recorded to date.

The transaction is a securitisation of a GBP 220 million floating-rate senior social housing-backed loan (the senior loan) advanced by the Issuer to a single borrower, Sage Borrower AR1 Limited. The borrower onlent the senior loan to its parent, Sage Rented Limited (SRL), a for-profit registered provider of social housing, and SRL used the loan to finance its acquisition of properties and associated costs and expenses. The senior loan is backed by 1,609 residential units comprising mostly houses or apartments located across England. The loan term is for five years with an expected final repayment date on 15 November 2025.

Savills Advisory Services Limited (Savills) revalued the portfolio in September 2021 to GBP 336.4 million from GBP 308.4 million (market value at issuance), and Jones Lang LaSalle Limited (JLL) most recently valued the portfolio at GBP 322.1 million as of October 2023, indicating a 4.2% decline in value over the previous valuation of GBP 336.4 million. JLL valued 1,434 properties on the basis of market value subject to tenancies (MVSTT) and the remaining 175 properties on the basis of existing use value for social housing (EUVSH). The key difference between the two valuation approaches is that the EUVSH assumes that the property will be used for social housing only, whereas the MVSTT takes into account the existing tenancy agreement. As a result of the 4.2% decline in the value of the collateral, the rated loan-to-value ratio increased to 64.89% from 62.14% over the quarter ended November 2023 and remains at 64.89% as of the August 2024 Interest Payment Date.

Sage Housing Limited (the sponsor) was established in May 2017 and is majority owned by Blackstone Inc. The portfolio is a mixture of new-build houses and flats in new purpose-built schemes dating from 2017. Each scheme is generally in a good residential location close to transport links and amenities. Approximately 60% of the portfolio is in London, the South East, and the South West. Most of the rented units are let on starter leases and then transferred to periodic assured tenancy agreements after an initial probationary period of 12 months, which is extendable to 18 months. Tenants in social housing typically occupy the units for more than five years beyond the probationary period.

The proceeds of the notes were advanced to a wholly owned, newly incorporated subsidiary of SRL, and onlent to SRL. SRL in turn granted third-party security by way of mortgages and a share pledge over the shares in the borrower to secure the borrower's obligations under the facility agreement. SRL also granted security to the borrower by way of a fixed charge over its segregated account into which rent is paid. The borrower will maintain full signing rights and full discretion over SRL's segregated account.

The senior loan interest comprises two parts: (1) Sonia (subject to zero floor) plus a margin that is a function of the weighted average (WA) of the aggregate interest amounts payable on the rated notes; and (2) the lower of excess cash flow and 9% fixed interest on the retention tranche (the Class R notes).

The contracted annual rent (let units) for the portfolio stood at GBP 14.8 million as of August 2024. This represents a 9.7% increase over the contracted annual rent of GBP 13.5 million as of August 2023. Meanwhile, net rental income (NRI) increased to GBP 10.7 million as of August 2024 from GBP 10.1 million as of August 2023. The leases are indexed to the Consumer Price Index (CPI) plus 1% from years 1 to 6, and to CPI alone after year 7.

The rated debt yield slightly increased to 5.1% in August 2024 from 4.8% in August 2023 as a result of the increase in NRI. The occupancy rate of 98.9% as of August 2024 shows improvement over the occupancy rate of 91.0% at origination and is in line with the occupancy rate of 99.1% as of August 2023. Since the properties are new builds, Sage does not model any capital expenditure until at least year three onwards.

Sage's affordable rents business has an arrears level of 4.1% for tenants in occupancy for over 12 months and 3.2% for tenants in occupancy for over 18 months. For the purposes of calculating arrears levels, Sage takes the approach that any amount that is overdue, even by one day, is in arrears.

Morningstar DBRS increased its net cash flow (NCF) assumption to GBP 10.5 million to reflect its initial rental growth projections of 1.0% per annum. Morningstar DBRS maintained its stabilised cap rate assumption at 4.25% as at issuance, which results in a Morningstar DBRS value of GBP 215.1 million, thus reflecting a 33.2% haircut to JLL's valuation dated October 2023.

The borrower purchased an interest cap agreement from Merrill Lynch International, with a cap strike rate of 0.75% for the full notional amount of the rated notes to hedge against increases in the interest payable under the loan resulting from fluctuations in Sonia. The current hedge arrangement expires on 17 November 2024, at which point it must be renewed for the remaining term of the loan.

Morningstar DBRS notes that there are certain hedging conditions in place, such that the interest rate cap(s) with a WA strike rate on any day must not be more than the higher of (1) 0.75% per year and (2) the rate that ensures that, as at the date on which the relevant hedging transaction is contracted, the hedged interest coverage ratio is not less than 1.5 times. If the hedge is not extended as described, there will be a loan event of default and a sequential payment trigger event on the notes. Morningstar DBRS anticipates the current hedge arrangement to be renewed in accordance with the hedging conditions.

The transaction benefits from a liquidity reserve facility of GBP 6.5 million provided by Deutsche Bank AG London Branch. The liquidity facility may be used to cover shortfalls on the Issuer's payment of interest due to the Class A to Class C noteholders. Morningstar DBRS calculated that the liquidity reserve facility can cover interest payments on the covered notes up to 21 months, based on the interest cap strike rate of 0.75%, or 10 months, based on Sonia capped at 4.0% plus the respective notes' margin.

To satisfy risk retention requirements, an entity within Sage Group has retained a residual interest consisting of no less than 5% of the nominal and fair market value of the overall capital structure by subscribing to the unrated and junior-ranking GBP 11 million Class R notes. This retention note ranks junior in relation to interest and principal payments to all rated notes in the transaction.

The final legal maturity of the notes is expected to be 17 November 2030, five years after the expected loan maturity (15 November 2025). Given the security structure and jurisdiction of the underlying loan, Morningstar DBRS believes that this provides sufficient time to enforce on the loan collateral, if necessary, and repay the bondholders.

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 British 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 Credit 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 Situs Asset Management Limited and U.S. Bank Trustees Limited since issuance and valuation reports provided by Savills Advisory Services Limited and Jones Lang LaSalle 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 17 November 2023 when Morningstar DBRS confirmed its credit ratings on the Issuer with Stable trends.

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 (sf)
-- 20% decline in Morningstar DBRS NCF, expected credit rating on the Class B notes of A (high) (sf)

Class C Risk Sensitivity:
-- 10% decline in Morningstar DBRS NCF, expected credit rating on the Class C notes of A (sf)
-- 20% decline in Morningstar DBRS NCF, expected credit rating on the Class C notes of BBB (high) (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 E notes of B (high) (sf)
-- 20% decline in Morningstar DBRS NCF, expected credit rating on the Class E notes of CCC (sf)

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

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
Rating Committee Chair: David Lautier, Senior Vice President
Initial Rating Date: 5 October 2020

DBRS Ratings Limited
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Registered and incorporated under the laws of England and Wales: Company No. 7139960

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 (6 September 2024) ,
https://dbrs.morningstar.com/research/439043.
-- Interest Rate Stresses for European Structured Finance Transactions (24 September 2024),
https://dbrs.morningstar.com/research/439913.
--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/439604.

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