Scope Ratings has assigned ratings to six credit protection agreement tranches issued by Red 1 Finance CLO 2017-1 DAC (Red 1) and entered into with Santander UK plc (Santander).

The assigned ratings are as follows:

Tranche A: EUR 696.7m (76.00%): assigned new AAA_SF
Tranche B: EUR 68.8m (7.50%): assigned new AA+_SF
Tranche C: EUR 41.3m (4.50%): assigned new A+_SF
Tranche D: EUR 22.9m (2.50%): assigned new BBB-_SF
Tranche E: EUR 25.2m (2.75%): assigned new BB_SF
Tranche F: EUR 22.9m (2.50%): assigned new B-_SF

The ratings assigned by Scope reflect the risk for the credit protection seller to make a payment with respect to a credit event under the credit protection deed’s terms. The ratings do not address potential losses resulting from the transaction’s early termination, nor any market risk associated with the transaction. Scope did not assign a rating to Tranche G. The transaction’s maturity is 20 June 2029.

Red 1 is a synthetic securitisation of a static GBP 916.8m portfolio of 25 commercial real estate loans, originated by Santander for the acquisition of 144 properties in the United Kingdom. Red 1 sells credit protection on the portfolio through seven strictly sequential, fully funded credit protection agreements – Tranches A to G – entered into with Santander. Red 1 covers 95% of the losses from the reference portfolio. The loss attachment points for the tranches, i.e. the respective credit enhancements, are: Tranche A, 24.00%; Tranche B, 16.50%; Tranche C, 12.00%; Tranche D, 9.50%; Tranche E, 6.75%; Tranche F, 4.25%; and Tranche G, 0.00%.

Under the credit protection agreements, Santander receives cash payments equal to the expected loss upon the default of a reference obligation, which is then adjusted for the actual loss during a maximum work-out period of seven years. Losses are allocated to the respective tranches in reverse order of seniority, i.e. from Tranche G to A.

The transaction defines loan default as i) a failure to pay with respect to the reference obligation; ii) a bankruptcy of the obligor or obligor group; or iii) a loss from the restructuring of a reference obligation. The credit protection agreements grant significant supervisory rights to the external verification agent, a reputable global accounting firm. This agent ensures that all loss claims are valid and the determination of the expected loss and final loss comply with Santander’s internal policies. Santander also must demonstrate to the verification agent that its servicing and work-out processes accord with the bank’s internal business principles and policies.

Rating rationale

The ratings reflect the legal and financial structure of the transaction as defined under the terms of the credit protection deed; the credit quality of the underlying portfolio in the context of macroeconomic conditions in the UK; the ability and incentives of Santander, servicer of the reference loans; and the supervision from the verification agent, a reputable global accounting firm.

The ratings account for the respective credit enhancement of the tranches, the strictly sequential release of risk coverage from reference portfolio amortisation. The ratings also reflect the credit risk of a concentrated reference portfolio, characterised by material default risk over the loans’ terms and at their refinancing.Tranche B’s relatively high sensitivity to changes in the loans’ expected recovery rate is reflected in its rating.

The ratings incorporate the macroeconomic dynamics in the UK. Scope’s market-value-decline assumptions for commercial real estate properties in the UK reflect rising uncertainties associated with Brexit. Scope expects heightened uncertainties to have an adverse impact on consumer and investment confidence, which, in turn, may have a knock-on effect on commercial real estate by reducing demand and the willingness to maintain the properties’ condition.

There is counterparty risk with Santander with respect to credit protection premiums and recovery proceeds. This is mitigated by i) the high credit quality of Santander; ii) the termination of the credit protection deed upon Santander’s default, which effectively cancels the exposure to the remaining reference portfolio; and iii) the netting of credit protection premiums and collected recoveries with new loss claims. Scope has a public rating on Banco Santander SA (AA-/Stable Outlook) and has also analysed the credit quality of Santander UK plc.

Key rating drivers

Low loan-to-value mortgages (positive). The commercial real estate loans have a low loan-to-value (LTV) of 48.7% (based on third-party valuations with an average of nine months since the last valuation), which reflects positively on recovery rates and the probability of successful refinancing at maturity.

Property quality (positive). The good average property quality increases the likelihood of re-letting and lessens foreclosure costs.

Static portfolio (positive). The portfolio is static and does not allow for loan extensions, refinancing and reference loan additions.

Experienced CRE lender (positive). Santander’s real estate lending activities in the UK date back to 1944 (Abbey National plc, bought by Santander Group in 2004).

Concentrations (negative). The reference portfolio is concentrated. The nine largest exposures account for 60% of the entire portfolio, and the property base (144) and tenancy base per property are relatively non-granular. Despite 1,480 tenants in total, the number of tenants differs significantly among properties. Several single properties are occupied by a single tenant. This reflects negatively on the level and stability of the interest coverage ratios.

Bullet amortisation (negative). All loans in the portfolio have bullet or semi-bullet amortisation. This decreases the likelihood of refinancing at maturity, while increasing the volatility of expected recovery upon default.

UK macroeconomic uncertainty (negative). This may lead to lower demand for UK offices, a significant segment for the reference portfolio, especially if Brexit uncertainties prompt companies to relocate to continental Europe.

Key rating-change drivers

Positive. Increased credit enhancement from deleveraging accompanied by good performance may result in upgrades. An improvement of tenant granularity through up-letting may also help to stabilise the loans’ interest coverage ratios.

Negative. Worse-than-expected default and recovery performance of the assets will result in downgrades. Recovery rates and refinancing probabilities may reduce if Brexit negotiation outcomes lead to lower than expected demand for UK commercial real estate, reflecting negatively on property values.

Asset analysis

The reference loan portfolio is static and comprises 25 commercial real estate loans secured by 144 underlying properties. Nine loans represent more than 5% of the initial portfolio balance, and a combined weight of 60.2%. More than 1,800 lease contracts support the cash flows used to service the loans. However, tenancy per property differs significantly, up to several single properties occupied by only a single tenant. The portfolio benefits from a high interest coverage ratio of 3.9x and a low weighted average LTV of 48.7%, but both ratios exhibit significant volatility. On the other hand, Santander is an experienced lender in UK commercial real estate, with a prudent strategy and moderate risk appetite.

The portfolio is diversified across property sectors, with a focus on retail and office properties. Properties are predominantly offices, retail spaces and industrial buildings (67.7%, 8.5% and 3.2% of total collateral value respectively), while the remainder qualifies as mixed use or a hotel. Regarding regional diversification based on market value, 82% of the properties are located in London (whole loan market values, i.e. syndicated shares are included); this reduces to 19.4% if property number is used as a basis. The portfolio’s high concentration in the greater London area is natural, given that business activity and with that office demand in the UK centres on that region.

Scope believes the expected post-Brexit slowdown of the UK rental market will not immediately impact the portfolio. The agency expects the portfolio’s rental levels and the expected lease take-ups to be resilient, thanks to the properties’ good average quality and related lease contracts. The financed properties benefit from i) a weighted average unexpired lease term of 6.6 years – which is, however, volatile; and ii) lease contracts with below-market rents on average. Scope has assumed that the average tenant credit quality for this portfolio is BB. This reflects external credit assessments (available for 4.6% of the portfolio’s tenants) as well as the average credit quality of UK-based corporates over the past 10 years. Scope has chosen this approach given the overall granularity of the tenant base. Also, Scope has determined that the ratings are relatively insensitive to changes in tenant quality assumptions.

The portfolio is resilient against the expected short-term rise in yields, given the low weighted average LTV of 48.7%. This means property market values can decline by 24% on average before LTV covenants are breached, which would then trigger a default event at loan level.

Scope’s analysed i) term default probabilities on each loan (for all periods over its life; portfolio average of 4.9% per annum); ii) default probabilities at maturity (portfolio average of 14.8%); iii) and recovery rates upon default (88.4% expected under B-conditional stress). Stressed cash flows over the loan’s life drive the term default probability; while property market values drive refinancing risk, default probability at maturity, and severity of default. Refinancing risk is crucial to the analysis as commercial real estate loans typically do not amortise in full.

Scope has performed a fundamental analysis of the loans by using a bottom-up approach. The analysis started with an assessment of tenants and tenancy contracts, then properties and loans, and lastly of the overall portfolio. To assess a reference loan’s credit quality, Scope has considered the tenants’ quality, the property quality expressed as Scope’s property grade, and the loans’ LTV at maturity. The analysis also accounts for the amortisation profile, information on each loan and borrower, and available credit enhancement embedded in each of the loans. The analytical results reflect cash flows from both rent (net of operating expenses) and potential workout proceeds. The high interest coverage ratio and the low loan-to-value are credit-positive; whereas the low diversification of rental cash flow and the portfolio’s bullet nature are credit-negative. Cash available for loan repayments and the underlying properties’ market values were subjected to rating-conditional stresses, which Scope derived from previous commercial real estate cycles in the UK, incorporating additional haircuts which discount less-favourable post-Brexit scenarios.

Scope’s property grades account for a property’s distinct characteristics (type, location and attributes) to ascertain its condition and attractiveness to the market. Scope examines: i) maintenance costs and capex (historical and expected); ii) vacancy rates (historical and expected); iii) micro and macro location; iv) age; and v) the expiry of lease contracts. The analysis uses information from: i) on-site visits; ii) valuation reports from established industry experts; and iii) market studies from reputable sources. The highest property grade is PG1, e.g. a prime landmark building in a micro/macro location ideal for its usage type. The lowest is PG5, e.g. a property in poor condition in a degraded or undeveloped/unconsolidated location.

Quantitative analysis and assumptions

Scope has analysed the reference portfolio loan by loan using a Monte Carlo simulation. For each loan, Scope has assumed i) a specific default probability, inferred from the credit estimate assigned to a loan over its weighted average life; ii) a specific recovery upon default; and iii) asset correlations between the loans. The resulting rating-conditional loss distribution and default timing were then used to project tranche losses, reflecting the transaction’s amortisation and loss-allocation mechanisms as well as the credit enhancement of the respective tranche.

Scope has derived for the outstanding portfolio an average default probability of 30.2% for a weighted average life of 3.1 years. This assumption reflects i) the low granularity of both the portfolio and the underlying tenant and property base; ii) tenant credit quality; and ii) the high probabilities of refinancing failure, driven by Scope’s long-term market-value-decline assumptions and the non-amortising nature of the reference portfolio’s loans.

Scope has assumed pairwise asset correlations of 50-70%, which account for a general factor (factor loading 15%), a location factor (factor loading 15%) and a property type factor (factor loading 20%). Additionally, Scope considers a top-obligor factor (factor loading 20%) for obligors representing more than 5% of the portfolio.

Scope has assumed a base case portfolio recovery rate of 88.4%, to which rating-conditional haircuts were applied: 16% for AAA, 13% for AA, 10% for A, 6% for BBB, and 3% for BB. These consider rating-conditional stresses for the market-value-decline assumptions and absolute rating-conditional recovery-rate caps of 95% for AAA, 96% for AA, 97% for A, 98% for BBB and 99% for BB, loan by loan.

The LTVs at loan maturity, which Scope has calculated based on the long-term mean of the UK property index, range from 30.6% to 83.8% with a weighted average of 61.7%. Scope has also assumed that the market value of UK properties will decline by 45.3%, which affects the loans’ probability of refinancing and recovery upon default. This assumption incorporates i) an average distressed-sale discount of 18.5%; ii) average liquidation costs of 14.0%; iii) a loan’s time to maturity; iv) the current uncertainty of the UK commercial real estate market; and v) current property prices, which are above historical levels and expected to revert to long-term historical prices.

Rating sensitivity

Scope tested the resilience of the ratings against deviations of the main input parameters: tenant quality (as a driver of portfolio defaults) and the portfolio recovery rate. This analysis has the sole purpose of illustrating the sensitivity of the ratings to input assumptions and is not indicative of expected or likely scenarios. The following shows how the ratings for each rated tranche change when tenant credit quality reduces by three notches, or the portfolio’s expected recovery rate reduces by 10%, respectively:

• Tranche A: sensitivity to lower tenant quality, zero notches; sensitivity to recovery rates, zero notches;
• Tranche B: sensitivity to lower tenant quality, zero notches; sensitivity to recovery rates, six notches;
• Tranche C: sensitivity to lower tenant quality, two notches; sensitivity to recovery rates, seven notches;
• Tranche D: sensitivity to lower tenant quality, one notch; sensitivity to recovery rates, five notches;
• Tranche E: sensitivity to lower tenant quality, two notches; sensitivity to recovery rates, six notches;
• Tranche F: sensitivity to lower tenant quality, one notch; sensitivity to recovery rates, two notches.

Methodology

The methodologies applied for this rating is the General Structured Finance Methodology, dated August 2017. Scope also applied the principles contained in the Methodology for Counterparty Risk in Structured Finance, dated August 2017. All documents are available on www.scoperatings.com.

Scope analysts are available to discuss all the details of the rating analysis and the risks to which this transaction is exposed. 

Regulatory and legal disclosures

This credit rating is issued by Scope Ratings AG. The rating analysis was prepared by Sebastian Dietzsch. Responsible for approving the rating: Guillaume Jolivet. The ratings were first assigned as final ratings by Scope on 22.12.2017. The ratings were last updated on 22.12.2017.

Methodology
The methodology used for these ratings is the ‘General Structured Finance Rating Methodology’ and the 'Methodology for Counterparty Risk in Structured Finance', both dated August 2017. Available on www.scoperatings.com.
Historical default rates of Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default as well as definitions of rating notations can be found in Scope’s public credit rating methodologies on www.scoperatings.com.

Solicitation, key sources and quality of information
The rated entity and/or its agents participated in the rating process.
The following substantially material sources of information were used to prepare the credit rating: the rated entity, the rated entities’ agents, third parties, public domain, and Scope internal sources. Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.
Scope has not undertaken any assessment of Agreed Upon procedures carried out at the level of underlying financial instruments or other assets of structured finance instruments. Scope relied on a third-party assessment for the ratings at issuance. Prior to publication, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds on which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

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