Tranche A: GBP 404.5m (64.8%): affirmed AAA_SF

Tranche B: GBP 68.8m (11.0%): upgrade AAA_SF from previously AA+_SF

Tranche C: GBP 41.3m (6.6%): upgrade AA_SF from previously A+_SF

Tranche D: GBP 22.9m (3.7%): upgrade A_SF from previously BBB-_SF

Tranche E: GBP 25.2m (4.0%): upgrade BBB-_SF from previously BB_SF

Tranche F: GBP 22.9m (3.7%): upgrade BB-_SF from previously B-_SF

The review considers the information and tranche balances available as of the 20 September 2018.

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 Ratings has assigned ratings to six credit protection agreements issued by Red 1 Finance CLO 2017-1 (Red 1) and entered into with Santander UK plc (Santander). Scope did not assign a rating to Tranche G. The transaction’s legal maturity is 20 June 2029.

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 rating actions are primarily driven by the significant increase of credit enhancement for the respective tranches, as a result of faster than expected amortisation of the reference portfolio, without defaults. The tranche reduction in size follows a 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’ term and at their refinancing.

Tranche C and Tranche D’s relatively high sensitivity to changes in the loans’ expected recovery rate is reflected in the respective ratings.

The ratings incorporate the macroeconomic dynamics in the UK. Scope’s market-value-decline assumptions for commercial real estate properties in the UK reflect uncertainties associated with Brexit. Scope remains cautious regarding potential adverse impacts 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.

Credit protection premiums and recovery proceeds expose the transaction to the credit quality of Santander. 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

Prepayments (positive). The credit enhancement of the rated tranches has significantly increased, as a result of faster than expected repayments without defaults.

Low loan-to-value mortgages (positive). The commercial real estate loans have a low weighted average loan-to-value (LTV) of 50.0% (based on third-party valuations with an average of 22 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 highly concentrated. The ten largest exposures account for 76.6% of the entire portfolio, and the property base (109) and tenancy base per property are relatively non-granular. Despite 875 tenants in total, the number of tenants differs significantly among properties, including several single properties are occupied by a single tenant. This reflects negatively on the level and stability of the interest coverage ratio, which is provided by cash flows from the financed properties.

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.

Collateral performance and asset portfolio update

The transaction’s performance since inception has been solid, without any loan defaults to date.

As of September 2018, the static reference loan portfolio comprises 20 commercial real estate loans secured by 109 underlying properties. Ten loans represent more than 5% of the outstanding portfolio balance, and a combined weight of 76.6%%. More than 875 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 4.2x and a low weighted average LTV of 50.0%, 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. The properties are well distributed across the UK. However, in terms of property market value, 77.3% is located in London.

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 7.6 years – which is, however, volatile; and ii) lease contracts with at market level rents on average. The tenant credit quality is average, which Scope considers non-investment grade.

Quantitative and risk-cover-release analysis

Scope analysed the reference portfolio loan by loan and simulated its performance using a single-step Monte Carlo simulation implementing a Gaussian-copula dependency framework. For each loan, Scope assumed: i) a specific default probability attributed to each loan over its weighted average life; ii) a specific recovery upon default; and iii) asset correlations between the loans. The resulting default distribution, default timing and rating-conditional recovery rates were used to project the risk cover release of the tranches, reflecting the transaction’s amortisation mechanics, as well as the instruments’ credit enhancements.

Scope’s analysis of commercial real estate loans consists of deriving: i) term default probabilities for all periods over a loan’s life; ii) default probabilities at maturity; and iii) recovery rates upon default. Stressed cash flows over a loan’s life drive the term default probability. 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 performed a fundamental analysis of the loans using a bottom-up approach. The analysis starts with an assessment of tenants and tenancy contracts, followed by properties and loans, and finally the overall portfolio. To assess a reference loan’s credit quality, Scope considers the tenant quality, the property quality expressed as a property grade, and the loan LTV at maturity. The analysis also accounts for undrawn amounts, the amortisation profile, information on each loan and borrower, and available credit enhancement embedded in each of the loans.

Property grades account for a property’s distinct characteristics (type, location and attributes) to ascertain its condition and attractiveness to the market. Scope examined: 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; iii) market studies from reputable sources; and iv) information provided by Santander. The highest property grade is one (PG1), e.g. a prime landmark building in a micro/macro location ideal for its usage type. The lowest is five (PG5), e.g. a property in poor condition in a degraded or undeveloped/unconsolidated location.

Quantitative assumptions

Scope has derived for the outstanding portfolio an average default probability of 27.4% for a weighted average life of 1.74 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.

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 assumes that the average tenant credit quality for this portfolio is BB-. This reflects 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 LTVs at loan maturity, which Scope has calculated based on the long-term mean of the UK property index, range from 28.1% to 81.0% with a weighted average of 60.0%. Scope assumed that the market values of the properties will decline by 30% from their current level over a horizon of about six years, reflecting: i) the loans’ time to maturity; ii) uncertainty in the UK commercial real estate market; and iii) current property prices above historical levels which are expected to revert to their long-term historical levels. This affects the loans’ probability of refinancing and recovery upon default. To derive the recovery rates upon default, Scope incorporated: i) an average distressed-sale discount of 17.2%; ii) average liquidation costs of 13.1%; and iii) a rating-conditional haircut, ranging from 0% under the base case to 28.7% for the highest ratings.

Scope has applied pairwise asset correlations assumptions unchanged from closing ranging from 50 to 70%, which reflect additive components including a general correlation factor of 15%, a location factor of 15% and a property type factor of 20%.

Scope also considered a top-exposure stress, applicable to the largest obligors and to those obligors that contribute more than 1% to the portfolio’s expected loss. Scope applied a top-exposure correlation stress of 20 percentage points; stressed the probability of default for these obligors by a one-notch equivalent; and applied an additional 10% haircut to the recovery rate.

Scope has assumed a base case portfolio recovery rate of 89.8%, to which rating-conditional haircuts were applied: 19.2% for AAA, 15.4% for AA, 11.5% for A, 7.7% for BBB, and 3.8% 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.

Stress testing

Stress testing was performed by applying rating-adjusted recovery rate assumptions.

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 results for each rated tranche change when the 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, one notch;
• Tranche C: sensitivity to lower tenant quality, zero notches; sensitivity to recovery rates, five notches;
• Tranche D: sensitivity to lower tenant quality, zero notches; sensitivity to recovery rates, five notches;
• Tranche E: sensitivity to lower tenant quality, one notch; sensitivity to recovery rates, four notches;
• Tranche F: sensitivity to lower tenant quality, one notch; sensitivity to recovery rates, four notches.

About the transaction

Red 1 is now a GBP 624.5m synthetic securitisation of a static portfolio of 20 commercial real estate loans, originated by Santander for the acquisition of 109 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 current loss attachment points for the tranches, i.e. the respective credit enhancements, are: Tranche A, 35.2%; Tranche B, 24.2%; Tranche C, 17.6%; Tranche D, 14.0%; Tranche E, 9.9%; Tranche F, 6.2%; 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.

Methodology
The methodologies applied for this rating is the General Structured Finance Methodology. Scope also applied the principles contained in the Methodology for Counterparty Risk in Structured Finance. 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.

Solicitation, key sources and quality of information
The rated instruments' issuer and/or its agents participated in the rating process.
The following substantially material sources of information were used to prepare the credit rating: public domain, the rated entity, the rated entities’ agents, third parties and Scope internal sources.
Scope Ratings GmbH has relied on a third-party asset due diligence/asset audit provided at closing of the transaction upon initial assignment of the ratings. The analysis has no negative impact on the credit rating.
Prior to publication, the issuer and/or its agents were given the opportunity to review the rating and the principal grounds on which the credit rating is based. Following that review, the rating was not amended before being issued.

Regulatory and legal disclosures
These credit ratings are issued by Scope Ratings GmbH.
Lead analyst Sebastian Dietzsch, Associate Director.
Person responsible for approving the rating: Guillaume Jolivet, Managing Director.
The ratings were first released by Scope on 22.12.2017. The ratings were last updated on 21.12.2018.

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

Conditions of use / exclusion of liability
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