Scope Ratings has assigned a rating to the bond issued by Reditum SA, XS1257166956, EUR 200m bond, fixed coupon 6.25% p.a., due 2020; new rating B.

Upon issuance, the proceeds of the bond are transferred to Larmag Real Estate 2 BV (LRE2) under a loan agreement. The related loan with 6.3% fixed interest p.a. matures on 10 July 2020. LRE2 is a special purpose company, investing exclusively in commercial real estate in eurozone countries, with a special focus on the Netherlands. The bond and loan have the same redemption date; and the bond’s performance depends on LRE2’s property investments. LRE2 invested already EUR 4.65m of Dutch properties in provincial locations and will acquire real estate for up to the balance of the bond issue. The assets are actively managed by Larmag Realty Group BV (Larmag), a manager with 30 years of experience in the global market for commercial real estate (CRE). The bond has a legal final maturity on 15 July 2020. Reditum SA is an independent vehicle incorporated under Luxembourg law.

RATING RATIONALE

The rating reflects the i) credit quality of the bond driven by the performance of the underlying assets held by Larmag Real Estate 2 BV (LRE2), in the context of a recovering Dutch property market; ii) capabilities and incentives of Larmag, the asset manager and sponsor; and iii) the legal and financial integrity of the transaction.

The rating is supported by the credit quality and expected cash flows from properties underlying the loan to LRE2. The bond benefits from the properties’ upside-value potential under normal market conditions, which results from active management and the pooling of cash flows from all properties to service the loan. Scope believes that Larmag, as asset manager of the transaction, can maintain high tenancy retention and further ramp-up the portfolio with similar quality assets to reduce concentration risk. Scope also considers that Larmag is positively incentivised by its i) equity contribution of 20%, ii) an event-driven call option for the issuer to acquire LRE2 for EUR 1.00, and iii) asset management fees that depend on stable rental cash flows.

The rating is constrained, however, by a substantial exposure to the market value risk of the properties, for which refinancing or sales proceeds will be necessary to redeem the bond at maturity. The transaction is exposed to the risk that Larmag cannot adequately source new assets, as well as a lack of directly enforceable asset-performance triggers that could protect bondholders upon breach or upon the underlying assets' deterioration. In addition, the transaction does not feature the traditional structured finance characteristics of a bankruptcy remote issuer, or debt seniority and security.

KEY RATING DRIVERS

Non-ramped portfolio (negative): Only two assets have been included in the structure to date, exposing investors to uncertainty regarding the quality of assets acquired in the future. Investment criteria are flexible, and applying these depends on the performance of Larmag (the sponsor and asset manager) as the owner of LRE2. This is mitigated partly by Larmag’s asset management quality, with its 30-year track record in the European (especially Dutch) market. Larmag has already identified 47 CRE projects worth EUR 170m to ramp-up the portfolio and limit risks of negative carry.

Asset quality (negative): The two properties with an asset quality of ‘tertiary’ reflect the average in the Dutch market. This view is driven by the: (i) relatively short weighted average unexpired lease term (WAULT) to first break of 2.5 years; (ii) moderate average property age of 11.5 years; (iii) moderate occupancy rate of 90%; and (iv) the ‘C’ location quality for the cities of Deventer and Weert, where the properties are located. The quality and current geographical diversification of the assets reduces the fungibility/liquidity of the property portfolio, increasing potential price haircuts in a distressed sales scenario.

Asset concentration (negative): At closing, the high concentration of assets and tenants exposes the transaction to material disruptions of cash flows upon a tenant’s default or damage of the property. However, the quality of the current main tenant – the Dutch workers’ union – mitigates that risk. Portfolio diversification will improve after the ramp-up of the portfolio, which will likewise reduce concentration risk.

Market value risk (negative): At maturity, if the sponsor fails to promptly refinance the transaction, there will be limited flexibility to sell the assets because the transaction does not allow for additional time (or tail period) to liquidate the assets. The amortisation profile of the properties, with a large principal repayment at maturity and an expected loan-to-value (LTV) of around 80%, further increases the challenges to refinance and the exposure to market value risk. The rating, however, incorporates the recovering Dutch macroeconomic environment, which, to some extent, may reduce LTV at maturity, as well as downside risks.

Limited security (negative): The bond does not benefit from a standard security on the properties’ collateral, and only benefits from a pledge on the account LRE2 uses to collect excess cash. Investor protection is therefore weaker than on traditional secured debt because bondholders cannot enforce their rights on the assets upon an event of default. The issuer, however, benefits from a (i) call option to acquire 100% of LRE2’s shares for EUR 1.00 upon a default of LRE2, and (ii) a pledge on the rental income account. No covenant protects the bondholders if the transaction underperforms.

Lack of non-petition against the issuer (negative): The issuer does not benefit from a non-petition clause with its third-party providers. This risk is mitigated by the senior nature and limited size of costs paid to third-party providers. This limits the risk of actual petitions against the issuer if it does not meet contractual obligations toward third-party providers.

Limited financial counterparty risks (positive): The risk to financial counterparties which receive and hold moneys for and on behalf of the issuer is not material to the rating. This is due to either the: (i) very short time risk exposure to the paying agent, Caceis Bank Luxembourg SA, or (ii) the credit quality of the issuer and the rental income account bank, ING Luxembourg SA (A / S-1 / Stable Outlook).

MODELLING ASSUMPTIONS

Scope assessed the expected loss and default likelihood on the bond by assessing the cash flow available to fulfil the promise on the bond. The credit risk on the bond reflects the expected losses on the loan to LRE2 and the performance of its CRE portfolio investments.

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 the i) CRE loan’s servicing ability and ii) development of the properties’ market value, which is based on external valuations of the portfolio and Scope’s assumptions on the Dutch 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 LTV at default or maturity, and the property grade.

Scope estimated the properties’ values, which is required to assess the bond’s loss given default. The analysis incorporates assumptions on i) sustainable cash flows, ii) expectations on market yield developments for the respective asset’s type (office, retail, industrial etc.), location and quality, and iii) 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 30%.

Results from the simulation are applied in a bespoke 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.

Key modelling parameters include:

i) yield or capitalisation rates and their volatility,

ii) refinancing default probability,

iii) tenancy retention rates, and

iv) rental growth prospects.

Capitalisation rates and volatility: Scope assumed an average yield of 11% based on the issuer’s indicative valuations on the current portfolio, reduced by 50% of the difference between the valuation and purchase price to account for the absence of a third-party valuation report on the assets. Scope applied a volatility of up to 55% for property yields. This volatility assumption reflects the peak-to-trough market development over the past 10 years that applies to the assets’ property grade and location, based on market data provided by Cushman & Wakefield, DTZ and CBRE.

Refinancing default probability: Given the average quality of the portfolio and the high LTV (80%) that Scope expects at the time of refinancing, refinancing default probability is judged to be high. Scope tested the structure for failure-to-refinance probabilities from 21% (LTV < 80%) to 70% (LTV > 80%).

Tenancy retention rate: The asset manager’s strategic goal is to focus on tenancy retention to avoid re-letting scenarios. Scope believes Larmag can achieve a 50% tenancy retention rate. This view is supported by the portfolio’s currently and relatively low rent of EUR 120/sq m p.a., which reduces competition for tenants on the local market, as well as the average level of Larmag’s asset management quality along with a strong footprint in the Dutch market.

Rental growth prospects: According to CBRE, the recent increase in occupier demand is not expected to affect headline rent because landlords still offer substantial incentives to attract new tenants. Thus Scope believes headline rents will not increase for the portfolio and the tenor of the bond. Additionally, the analysis includes a stress on rents by a maximum of 5% to address a downside risk because the portfolio is currently exposed to provincial cities, which are expected to suffer from a medium-term decline in demand according to Colliers.

Scope performed a sensitivity analysis on the main assumptions.

SENSITIVITY TO KEY ASSUMPTIONS

Scope tested the sensitivity of modelling results to property yield, tenancy retention rates, rental growth, refinancing default probabilities, asset correlation and portfolio ramp-up assumptions.

The credit risk of the bond, according to Scope’s model, is sensitive to the property yield. Shifting the yield from 11% by one percentage point to 12% negatively affects modelling results by one notch. The property yield should, however, remain stable in the short term because of the increasing investor appetite fuelled by low interest rates and the recovery of Dutch economy.

The tenancy retention rate needs to reduce to 30% from the base case level of 50% to negatively affect the modelling result by one notch. Nonetheless, the average asset management quality of Larmag and their strong footprint in the Dutch market supports our assumption of a 50% retention rate.

A steady negative rental growth rate of at least -2% p.a. negatively impacts model results by one notch. A significant drop in the rental growth rate is not envisaged, due to the stable macroeconomic environment.

An increase of refinancing default probability to 90% (LTV < 80%) and 100% (LTV > 80%) negatively affects the modelling results by one notch.

The model results are negatively affected by one notch under the assumption of 90% asset correlation.

The combined effect of: (i) an increase in property yield by one percentage point to 12%, (ii) a reduction of tenancy retention to 30% (iii) a decrease of rental growth to -2% and (iv) a refinancing default probability of at least 90% negatively affects the modelling result by three notches.

For a reference of Scope’s rating approach, please see the ‘General Structured Finance Rating Methodology’, published August 2015. Scope also took into account analytical elements reflected in the ‘Rating Methodology – European Real Estate Corporates’. More detailed elements of the rating approach will be outlined in the rating report to follow and will be freely available on www.scoperatings.com.

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 Philipp Wass, Lead Analyst. Guillaume Jolivet, Committee Chair, is the analyst responsible for approving the rating.

Rating history
Instrument ISIN; Date; Rating action; Rating

XS1257166956; 28.09.2015; new; (P) B

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
Bond prospectus and executed versions of the transaction contracts; final loan documentation; 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 the “General Structured Finance Rating Methodology”, dated August 2015. Scope also applied the principles contained in the “Rating Methodology – European Real Estate Corporates”, dated December 2014, and the “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.

The methodology used to assign the rating is the Structured Finance Instruments Methodology Guidelines (30 JULY 2014). The rated instrument does not exhibit the characteristics of a structured finance instrument according to the Regulation of the EUROPEAN PARLIAMENT AND OF THE COUNCIL (EC) No 1060/ 2009. Scope has therefore published the rating without adding a structured finance symbol (“SF”).”

Conditions of use / exclusion of liability
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