Scope Ratings has assigned a preliminary rating to the registered bond that will be issued by Ärztliche Beteiligungsgesellschaft SA (AEBG) via its Compartment 2:

Namensschuldverschreibung, EUR 52.0m: assigned new rating (P)BBB_SF

The rated instrument is a registered bond synthetically exposed to the 6% mezzanine credit risk of a EUR 865.4m commercial real estate loan portfolio originated by Deutsche Hypothekenbank Actien-Gesellschaft. The bond pays a quarterly coupon of three-month Euribor + 4.90% per annum and has its legal maturity in March 2052. The risk of the portfolio is structured into a senior tranche (93.3%), a mezzanine tranche (6%) and a junior (0.7%) tranche. The risk transfer is achieved through the issuer’s fully funded bilateral guarantee to Deutsche Hypothekenbank. At closing, the portfolio consists of 92 loans granted to 50 obligors to primarily finance retail, office, and multi-family properties in Germany, France and the Netherlands.The transaction features a portfolio ramp-up period until December 2018, financed with tap-issuances of further pari-passu bonds, which will be subject to a rating review.

Ärztliche Beteiligungsgesellschaft SA is a bankruptcy-remote special purpose vehicle under Luxembourg law. The bond issuance is expected to close on 25 October 2016 and has a legal final maturity on 25 March 2052.

Rating rationale

The (P)BBB_SF rating of the registered bond reflects the credit quality of the loan portfolio in combination with the credit enhancement of the referenced mezzanine tranche of 0.7% and the 0.12% portfolio excess spread per annum.

In addition, the rating is driven by Scope’s stable outlook on the commercial real estate business environment in Germany, France and the Netherlands, which reflect positively on property market values and refinancing conditions.

The rating considers the pro-rata amortisation mechanism implemented in the transaction. The mechanism reduces the credit enhancement available to the bond over time, exposing it to increasing portfolio concentration and single-asset risk. The risk from portfolio concentration is mitigated by the high credit quality of the largest exposures and those with the longest maturity. Credit enhancement more than offsets the expected loss contribution of the five assets with weaker credit quality, which partially mitigates the single-asset risk.

The rating also reflects the legal and financial integrity of the synthetic transaction.

The rating is directly linked to the credit quality of Deutsche Hypothekenbank because the bank holds the bond’s entire collateral in cash without risk-substitution triggers. Under an insurance agreement with AEBG SA - Compartment 2, the bank pays an insurance premium which is used by the issuer to fund interest payments on the bond. Scope has performed a private rating on Deutsche Hypothekenbank, which supports the rating at the current level.

Rating drivers

Portfolio credit quality (positive). Scope assumes that the portfolio’s credit quality is commensurate with a BBB+, which is primarily driven by the low loan-to-value of the loans. The weighted average loan-to-value ratio in the portfolio is low, at 52%, and supports the low probabilities of failure to refinance and high recoveries upon loan defaults.

Business environment (positive). Scope’s outlook on the commercial real estate business environment in Germany, France and the Netherlands is stable to positive, in particular for the property operations, financing, sale and loan work-out in ‘A’ locations.

Limited property information (negative). The information on the individual properties was limited. Scope has to taken a conservative view on property and tenant credit quality, both of which drive the relatively high probability of default over the individual loans’ terms.

Asset concentration risk (negative). The pro-rata amortisation of the structure prevents the reference tranche to benefit from credit enhancement build-up from portfolio amortisation. This is partially mitigated by the good credit quality of the assets with the longest maturities.

Counterparty risk (negative). Scope considers the exposure to Deutsche Hypothekenbank Actien-Gesellschaft to be excessive, and linked the rating to the credit quality of the bank. Scope has assigned a private rating to the bank.

Rating-change drivers

Prepayment of the largest and worst-quality assets in the portfolio would affect the rating positively.

The rating can be negatively affected if the commercial real estate business environments in Germany, France and the Netherlands deteriorate and refinancing conditions change adversely.

An erosion of credit enhancement from portfolio losses will also affect the rating negatively.

The rating can be negatively affected if systematic prepayments of the best assets in the portfolio leave the bond exposed to the remaining low-quality assets without sufficient credit protection.

Loan-by-loan analysis

The reference portfolio amounts to EUR 865.4m and consists of 92 loans granted to 50 obligors to finance commercial real estate properties in Germany (61%), France (32%) and the Netherlands (7%). The portfolio is well diversified across the different usage types: retail (33%), office (28%), multi-family (12%) and other (27%). The average loan-to-value of the assets is low at 52% and the average debt-service coverage ratio is moderate at 202%.

Scope has assigned a credit estimate to every loan in the portfolio. Credit estimates reflect the probability of default over the loan term, the probability of failure to refinance at maturity, and the recovery upon default. Scope’s loan-by-loan credit estimates, based on information from June 2016, suggest an average credit quality of BBB+ in the portfolio, considering default probabilities and expected recoveries. The probability of default accounts for the property quality as represented by the property grade, the tenant credit quality and the loan-to-value at the time of default. The recovery rate is driven by the loan-to-value at the time of default, the property grade and the property liquidation costs.

The property grade combines Scope’s view on i) the property’s micro and macro location, ii) the property condition, iii) the vacancy rate and probability of remarketing, iv) lease terms and break options, and v) the tenant credit quality. The portfolio exposure focuses on ‘A’ locations (62% of the current portfolio) and properties with a low vacancy rate (mainly fully let). However, the weighted average unexpired lease term is only 4.4 years, and Scope makes the assumption that the average tenant credit quality is commensurate with a BB rating, which reflects negatively on the property grade. The assumption on tenant credit quality is based on the average default frequency observed in Germany, France and the Netherlands for corporates and households (based on the statistical offices of Germany, France and the Netherlands), and is stressed by one rating notch equivalent.

The recovery upon default of a single loan is driven by the outstanding loan balance at default and the corresponding market value of the property, net of recovery costs. Scope analysed in detail the market value declines for each loan, depending on the development of each regional market and the loan’s time to maturity. Scope’s market-value-decline assumptions range from 13% to 41%, reflecting the current states and expected long-term developments of the property markets in the relevant country. The approach is based on comparing a mean reversion of current property prices with the development of long-term historical prices.

Modelling and key assumptions

Scope modelled the default distribution of the reference portfolio loan by loan using a Monte Carlo simulation. For each loan, Scope modelled a default probability (taking into account the default over the loan’s term and at refinancing), a recovery upon default and asset correlations between the loans.

The distribution was then used for cash flow analysis to compute the expected loss and expected life of the rated instrument, reflecting the impact of pro-rata amortisation in the transaction.

To assess a single loan’s default probability, Scope considered the quality of tenants, the lease term, the property profile, and loan-to-value at maturity. The analysis also accounted for the amortisation profile, information on each loan and borrower, and the available credit enhancement embedded in each loan. Scope derived for the portfolio an average default probability of 26.6% over a weighted average life of 8.2 years. This high assumption results from the high probabilities of default over the loans’ terms, driven by Scope’s conservative assumptions concerning tenant credit quality and the property’s re-marketing upon vacancy.

Scope derived for the portfolio an average recovery rate of 96.5%, based on detailed assumptions on the properties’ market value declines. This rate also accounts for recovery costs of between 10% and 22.5%, depending on the property jurisdiction, and incorporates an absolute recovery-rate cap of 98% for each loan.

Scope has applied pairwise asset correlations between the loans, ranging from 45% to 65%, which consider the property type and location, as well as the exposure size. Scope also assumed perfect correlation for loans belonging to the same obligor group.

Scope also examined the structural protection against high-risk exposures and asset concentrations. The rating accounts for the three exposures that Scope considers to be non-investment grade quality, but that benefit from their good location, the stability of the commercial real estate business environment over their short weighted average life of 2.3 years, and credit enhancement from subordination and the cash reserve. In addition, Scope expects no impact on the rating from the build-up of asset concentrations during the life of the transaction. Scope considers that the large assets are of higher credit quality than the rating of the bond.

Sensitivity

Scope tested the resilience of the rating against deviations from main modelling parameters including tenant quality, average recovery rates, and prepayments. This analysis has the sole purpose of illustrating the sensitivity of the rating to input assumptions and is not indicative of expected or likely scenarios.

The rating would decrease by two notches if the average tenant quality decreased to B.

The rating would decrease by nine notches if the recovery rate assumption on the portfolio is reduced by 50%.

The rating would decrease by two notches if the assets with the best credit quality (17 loans accounting for EUR 223.5m) were prepaid immediately.

Methodology

The methodology applicable for this preliminary rating is Scope’s General Structured Finance Rating Methodology, published August 2016, and the Methodology for Counterparty Risk in Structured Finance Transactions, published August 2016.

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

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, Dr. Sven Janssen.
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 a newly issued financial instrument, which was 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 transaction documentation, individual underlying asset information (as of June 2016), draft legal opinions, third party valuation reports and expert opinions.
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 2016 in combination with the “Rating Methodology for Counterparty Risk in Structured Finance Transactions”, published August 2016, 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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