Scope Ratings has assigned a preliminary rating to the bearer bond to be issued by Herrenhausen Investment SA via its Compartment IV:

Inhaberschuldverschreibung EUR 10m, 4.5% fixed coupon, due 03/2022: new rating (P) BBB_SF

The EUR 10m bond, issued by Herrenhausen Investment SA – Compartment IV, represents the synthetic 10.9 % first-loss exposure to a EUR 97m syndicated portion of a EUR 347m commercial real estate loan. The loan was issued by a Landesbank, and syndicated with Deutsche Hypothekenbank AG and another German mortgage lender. It is exposed to the performance of 11 German properties, which represent a group of ‘good secondary property’ quality in ‘A’ locations. The assets are actively managed by a well-recognised asset manager with 24 years of experience in the German commercial real estate market. In addition to the loan, each property is financed by individual vehicles with 30.3% paid-in equity providing subordination to the loan. Herrenhausen Investment SA is a bankruptcy-remote SPV under Luxembourg law. The bond issuance is expected to close in early October with a legal final maturity on 31 March 2022.

RATING RATIONALE

The rating reflects the credit quality of loan and the underlying commercial real estate (CRE) assets in the context of the German macroeconomic environment. The rating factors in the capabilities and incentives of key agents in the transaction, in particular the asset manager and the loan syndicate banks. The rating reflects the exposure to Deutsche Hypothekenbank AG, which is the collateral account bank for the bond as well as the payer of transaction fees, taxes and promised interest. The rating also reflects the legal and financial integrity of the synthetic transaction.

The rating is supported by the credit quality and expected cash flows from the properties underlying the syndicated loan. The transaction benefits from the upside value potential of the properties resulting from: i) their active management, ii) the subordination available at each property’s ‘financing level’, and iii) the pooling of cash flows from all properties to service the syndicated loan. Scope’s stable outlook for the German CRE market, especially for ‘A’ locations, provides a solid environment for the underlying assets’ performance, sale, refinancing and potential work-out by legal maturity.

The rating is constrained by an excessive counterparty risk exposure to Deutsche Hypothekenbank AG, which acts as collateral account bank, guarantee-premium-paying counterparty and paying agent. The bond’s entire collateral is held in cash by the bank and there are no structural features to delink the bond’s performance from this counterparty. Under an insurance agreement with Herrenhausen Inv. – Compartment IV, the bank pays an insurance premium, which is used by the issuer to fund interest payments on the bond. Scope assessed the credit quality of Deutsche Hypothekenbank AG in the low investment grade range.

PROPERTY PORTFOLIO INFORMATION

Scope’s assessment of the properties considers their age, attractiveness for re-letting, tenant concentration, rent profile and individual micro markets. Office properties are the predominant asset type and are graded at ‘good secondary quality’. The grade assigned by Scope is driven by the:

- moderate property age of 13.2 years;
- moderate vacancy rate of 17.2% as of June 2015;
- high tenant concentrations with 72% of rental income attributable to the top ten tenants;
- low weighted average lease term of 5.5 years; and
- stable outlook for the CRE market in Germany for ‘A’-located properties, making up 85% of the portfolio.

The active involvement of the asset manager will support the performance of the bond. The manager has 24 years of sector experience and deep knowledge of the CRE assets financed by the loan, gained from managing the properties for its former owner. Moreover, the asset manager guarantees the rent for five properties, covering shortfalls for vacant spaces over the next two years. The rent guarantee lapses if the properties’ occupancy rate rises, providing the asset manager a strong incentive to rapidly reduce the vacancy rate in the portfolio.

LOAN CHARACTERISTICS

Covenants of the syndicated loan protect the transaction against a deterioration in the underlying properties’ performance. Covenants for loan-to-value (LTV) and interest coverage ratio (ICR) capture early the excess cash flows for the benefit of the loan and allow for early enforcement of the loan security if the assets perform poorly. The current property rent provides an ICR of 200% for the referenced loan, and an up-letting will improve the credit metrics of the CRE. The LTV of the loan is 69.7% using the purchase price of the properties, which were acquired at market value.

The rating also takes into account the oversight of the asset manager and of the SPVs owning each property, by Deutsche Hypothekenbank AG and the other German banks in the loan syndicate. In particular, these banks benefit from veto rights on the quality of new tenants identified by the asset manager, which helps to maintain a stable tenant quality. In addition, upon breach of loan covenants, the banks i) can exercise cash trapping rights, i.e. diverting property SPVs’ cash flows to senior lenders away from junior liabilities, and ii) have to approve the property SPVs' business plans.

MODELLING APPROACH AND ASSUMPTIONS

Scope assessed the expected loss and default likelihood on the bond by taking into account both the i) excessive counterparty risk exposure to Deutsche Hypothekenbank AG and ii) cash flow modelling results. The credit risk on the bond reflects the losses on the CRE loan according to the guarantee agreement, whereby Herrenhausen Inv. – Compartment IV pays protection payments to Deutsche Hypothekenbank AG, if the loan defaults.

To quantify the default probability of the bond and the loan, Scope considered the projected cash flows in relation to the scheduled debt service, tenant diversity, as well as the collateral value of the financed assets in relation to the loan amount and debt yields. Scope determined the property grade, sustainable rent level, and remaining residual life for each property to estimate i) the CRE loan’s servicing ability and ii) the development of the properties’ market value, which is based on external valuations of the portfolio and Scope’s assumptions on the German CRE market.

The default likelihood of the loan reflects the failure to service the loan and the refinancing risk upon loan default or maturity. Scope considered the main drivers of refinancing risk to be the expected loan-to-value (LTV) at default or maturity, and the property grade. Scope tested the structure for failure-to-refinance probabilities from 9% to 25%, based on the average portfolio quality and the estimated sustained LTV ranging from 60% to 80%.

Scope estimates the properties’ values, which is required to assess the bond’s loss given default. The analysis incorporates assumptions on i) sustainable cash flows, ii) the expectations on market yield developments for the respective asset’s type (office, retail, industrial etc.), location and quality, and iii) the expected recovery costs. Scope estimates each property’s value by simulating their yields with a two-factor Monte Carlo simulation. The simulation includes a global factor and a location (city) factor, allowing for a maximum asset correlation of 55%. Results from the simulation feed into a cash flow model, which reflects the seniority of claims, priority of payments as defined in the respective transaction contracts, the guarantee agreement and bond characteristics. Scope assumed an average market yield of 7% based on external valuation reports for the portfolio assets. We applied a volatility to the yields of 25%. This volatility assumption reflects the peak-to-trough market development over the past ten years that applies to the assets’ property grade and location.

The model incorporates 3-month Euribor interest rate curves and inflation curves inferred from inflation-linked debt products. Scope performed a sensitivity analysis for these assumptions.

MARKET YIELDS, CORRELATION, REFINANCING AND MACROECONOMIC SENSITIVITIES

Scope tested the sensitivity of modelling results to assumptions for the market yield, asset correlation, refinancing probabilities and macroeconomic variables. Sensitivities, as listed below, show the deviation from the base case asset performance model results before taking into account the counterparty risk exposure to Deutsche Hypothekenbank AG.

Increasing the standard deviation of the average market yield simulation from the base case by 30% negatively affects the modelling result by two notches. A 0.5% increase of the average market yield negatively affects the modelling result by three notches.

Scope assumed a 55% asset correlation factor to simulate the properties’ value. Increasing the correlation from 55% to 75% negatively affects the model results by one notch.

Increasing the refinancing default probability to 25% from a base case average of 9% negatively affects the model results by three notches.

Adding one standard deviation to the interest forward curve negatively affects the model results by four notches.

Decreasing the inflation rate curve by one standard deviation negatively affects the model results by two notches.

For a reference of our rating approach, please see the General Structured Finance Rating Methodology, published August 2015. More detailed elements of the rating approach will be outlined in the rating report to follow.
 

REGULATORY AND LEGAL DISCLOSURES

Important information
Information pursuant to Regulation (EC) No 1060/2009 on credit rating agencies, as amended by Regulations (EU) No. 513/2011 and (EU) No. 462/2013

Responsibility
The party responsible for the dissemination of the financial analysis is Scope Ratings AG, Berlin, District Court for Berlin (Charlottenburg) HRB 161306 B, Executive Board: Torsten Hinrichs (CEO), Dr. Stefan Bund.

The rating analysis has been prepared by Sebastian Dietzsch, Lead Analyst. Guillaume Jolivet, Committee Chair, is the analyst responsible for approving the rating.

Rating history
The rating concerns newly-issued financial instrument, which were evaluated for the first time by Scope Ratings AG.

Information on interests and conflicts of interest
The rating was prepared independently by Scope Ratings but for a fee based on a mandate of the issuer of the investment, represented by the management company.

As at the time of the analysis, neither Scope Ratings AG nor companies affiliated with it hold any interests in the rated entity or in companies directly or indirectly affiliated to it. Likewise, neither the rated entity nor companies directly or indirectly affiliated with it hold any interests in Scope Ratings AG or any companies affiliated to it. Neither the rating agency, the rating analysts who participated in this rating, nor any other persons who participated in the provision of the rating and/or its approval hold, either directly or indirectly, any shares in the rated entity or in third parties affiliated to it. Notwithstanding this, it is permitted for the above-mentioned persons to hold interests through shares in diversified undertakings for collective investment, including managed funds such as pension funds or life insurance companies, pursuant to EU Rating Regulation (EC) No 1060/2009. Neither Scope Ratings nor companies affiliated with it are involved in the brokering or distribution of capital investment products. In principle, there is a possibility that family relationships may exist between the personnel of Scope Ratings and that of the rated entity. However, no persons for whom a conflict of interests could exist due to family relationships or other close relationships will participate in the preparation or approval of a rating.

Key sources of Information for the rating
Draft offering circular and draft contracts; final CRE loan documentation; individual property valuation reports and rent-role data; draft legal opinions related to the transaction documents.

Scope Ratings considers the quality of the available information on the evaluated entity to be satisfactory. Scope ensured as far as possible that the sources are reliable before drawing upon them, but did not verify each item of information specified in the sources independently.

Examination of the rating by the rated entity prior to publication
Prior to publication, the rated entity was given the opportunity to examine the rating and the rating drivers, including the principal grounds on which the credit rating or rating outlook is based. The rated entity was subsequently provided with at least one full working day, to point out any factual errors, use of confidential information, or to appeal the rating decision and deliver additional material information. Following that examination, the rating was not modified.

Methodology
The methodology applicable for this rating is “General Structured Finance Rating Methodology”, dated August 2015. Scope also applied the principles contained in the call-for-comments paper “Rating Methodology for Counterparty Risk in Structured Finance Transactions”, dated August 2015. Both files are available on www.scoperatings.com. The historical default rates of Scope Ratings can be viewed on 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 default rating, definitions of rating notations and further information on the analysis components of a rating can be found in the documents on methodologies on the rating agency’s website.

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