Scope Ratings upgrades to BBB+_SF from BBB_SF the rating of the bearer bond issued by Herrenhausen Investment SA via its Compartment IV:

Inhaberschuldverschreibung (ISIN DE000A1Z9LJ3) EUR 4.3m, 4.5% fixed coupon, due 03/2022: rating upgrade to BBB+_SF

Rating rationale

Today’s upgrade reflects both the solid performance of the syndicated commercial real estate loan referenced in the transaction, and the strengthened view on counterparty risk, following the private rating Scope conducted on Deutsche Hypothekenbank (Actien-Gesellschaft).

Based on reporting from October 2016, the syndicated loan’s interest coverage ratio has increased to 4.7x, from 2.0x at the transaction’s inception; the loan-to-value ratio has reduced to 59.0% from 69.7% at inception. These improvements result from the amortisation from property sales; scheduled loan amortisation; and the successful up-letting, at market rents, of the properties underlying the loan. The positive effects of loan amortisation are partly offset by the higher tenant concentration.

The bond rating reflects the credit quality of the loan referenced in the transaction, which benefits from the increased subordination and solid performance of the underlying commercial real estate assets in the context of German macroeconomic conditions. Scope’s outlook for the German commercial real estate market remains stable, especially for ‘A’ locations, which represent 73.5% of contractual rental cash flow from the financed properties.

The rating also factors in the capabilities and incentives of key agents in the transaction, in particular the asset manager and the loan-syndicate banks. Covenants under the syndicated loan protect the transaction upon a deterioration in the underlying properties’ performance. The loan-syndicate’s supervision over the asset manager and over the special purpose vehicles owning each property provides additional protection.

The rating reflects a link to the credit quality of Deutsche Hypothekenbank, as the bank performs the roles of collateral account bank, paying agent and guarantee-premium-paying counterparty, exposing the transaction to counterparty risk to the bank. The bond’s entire collateral is held in cash by the bank and there are no structural features in the transaction to delink the bond’s performance from this counterparty. Under an guarantee agreement with Herrenhausen Investment SA - Compartment IV, the bank pays a guarantee premium, which the issuer uses to fund interest payments on the bond.

Analysis of underlying properties

Scope received information on valuations, sales and rent rolls as of October 2016 for the properties underlying the referenced loan.

The debt-service capacity of the portfolio has remained stable, even after five properties were sold. These sales have resulted in higher tenant concentration, a higher exposure to ‘B’ locations, and less absolute cash flow from properties to service the loan. This is offset by the senior-loan amortisation and the improved cash flow from the up-letting of remaining properties.

Office properties are the predominant asset type, which Scope has scored at property grade PG2, i.e. good secondary quality. Scope assigns property grades on a scale from PG1 (best) to PG5 (worst). Property grades reflect the properties’ condition and attractiveness to the market by examining: 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 profile of lease contracts.

Scope’s property grade assessment for this portfolio is driven by the:

• moderate property age of 13.8 years, up from 13.2 years at closing;
• improved vacancy rate of 14.5% (October 2016), down from 17.2% at inception (June 2015);
• increased tenant concentration, i.e. 76.1% of rental income is attributed to the top-ten tenants, up from 72% at inception;
• reduced weighted average unexpired lease term of 4.7 years, down from 5.5 years at inception;
• lower share of properties located in ‘A’ locations, currently at 73.5%, down from 85.0% at inception; and
• weaker tenant credit quality due to the sale of properties with tenants that have an above-average credit quality (especially the three large tenants with mid- to high-investment grade quality that accounted for 38% of the contractual rental cash flow).

The asset manager’s active involvement will continue to support the performance of the bond. The manager has 25 years of experience in the sector, as well as a deep knowledge of the commercial real estate assets financed by the loan, gained from managing the properties for its former owner. Moreover, the asset manager guarantees the rent for three properties, covering shortfalls for vacant spaces over the next years. The rental guarantee lapses if the properties’ occupancy rate rises, providing the asset manager a strong incentive to rapidly reduce the vacancy rate in the portfolio.

Key quantitative assumptions

An outline of the full transaction modelling and a summary of modelling assumptions can be found in the rating report published by Scope at the closing of this transaction.

Compared to the analysis performed at closing, Scope has adjusted its assumptions for refinancing default probabilities, distressed sale discounts and liquidation costs, based on updated information relating to the European commercial real estate market.

Scope has assumed refinancing default probabilities for a PG2 property, depending on the expected loan-to-value ratio at maturity, as follows:

• 0.5% (refinancing default probability) at 40-60% (expected loan-to-value)
• 0.9% at 70%
• 3.6% at 80%
• 26.1% at 90%
• 100% at 100%

For PG2 properties, Scope has considered a distressed-sale discount of 15% of the market value at the time of sale, down from 20% for the closing analysis. The liquidation-cost assumptions for ‘secondary quality’ properties are now 10% of the outstanding loan balance plus 2.5% of the market value after the distressed-sale discount is applied at the property’s liquidation. Scope’s analysis has considered liquidation costs of 15% of the outstanding loan balance at closing.

The transaction

The EUR 4.3m (closing EUR 10m) bond, issued by Herrenhausen Investment SA - Compartment IV, represents the synthetic 10.9% first-loss exposure to a EUR 41.4m (closing EUR 97m) syndicated portion of a EUR 148.0m (closing EUR 347m) commercial real estate loan. The loan was issued by a Landesbank, and syndicated with Deutsche Hypothekenbank (Actien-Gesellschaft) and another German mortgage lender. It is exposed to the performance of six German commercial real estate properties (eleven properties at closing), which represent properties of ‘good secondary quality’, mainly in ‘A’ locations. The assets are actively managed by an established asset manager with 25 years of experience in the German commercial real estate market. In addition to the loan, each of the remaining properties are financed by individual vehicles, with 41.0% equity providing subordination to the loan. Herrenhausen Investment SA is a bankruptcy-remote special purpose vehicle under Luxembourg law. The bond issuance closed on 5 November 2015.

Scope received bond-payment information as of September 2016.

Methodology

The methodology applicable for this rating is Scope’s General Structured Finance Rating Methodology, published August 2016, and the Methodology for Counterparty Risk in Structured Finance, 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
Instrument; ISIN; Date; Rating action; Rating
DE000A1Z9LJ3; 06.10.2015; Preliminary; (P) BBB_SF
DE000A1Z9LJ3; 05.11.2015; Definitive; BBB_SF

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
Offering circular and executed versions of the transaction contracts; final commercial real estate loan documentation; updated individual property valuation reports and updated rent-role data; final 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 2016. Scope also applied the principles contained in the “Methodology for Counterparty Risk in Structured Finance”, dated August 2016. 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.

Conditions of use / exclusion of liability
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