Scope Ratings places under review for downgrade the BBB-_SF rating of the credit-linked note (Inhaberschuldverschreibung) issued by Herrenhausen Investment SA via its Compartment I.

Rating rationale

The review for downgrade reflects uncertainty over the restructuring of one delinquent loan, as reported by the issuer on 31 May 2017. The restructuring of the delinquent loan and active re-letting of the underlying property are in process. The review also factors in increased portfolio concentration through asset amortisation, accompanied by a marginal increase in credit enhancement from subordination. Scope will resolve this review as soon as possible by analysing the progress of the loan’s restructuring.

The rating also reflects the recent repayment of an exposure identified as highly likely to default by Deutsche Hypothekenbank, the loans’ originator.

Scope has taken into account the solid German commercial real estate (CRE) market, on which Scope has a stable outlook, and the more volatile French and Dutch CRE markets.

The stable credit profile of Deutsche Hypothekenbank Actien-Gesellschaft, also the account bank and holder of the notes’ cash collateral, supports the current rating.

Collateral performance and portfolio loan-by-loan analysis

Since closing, the reference portfolio has amortised by 58.1% to EUR 569.3m. This was driven by EUR 411.2m of prepayments, most of which related to loans with the best credit quality in the pool. German CRE loans currently comprise 94.0% of the portfolio.

Scope’s loan-by-loan analysis, based on information up to June 2017, suggest an average portfolio credit quality of BBB considering default probabilities and expected recoveries. During the monitoring process of the transaction, Deutsche Hypothekenbank has provided Scope with additional detailed information on 16 loans representing the highest default risk. Following the recent repayment of an exposure identified as highly likely to default by the bank, the share of assets classified as non-investment grade under Deutsche Hypothekenbank’s internal scale has decreased slightly to 19.7%, from 25.6% as at the last monitoring date. The remaining portfolio exhibits a weighted average loan-to-value (LTV) ratio of 62.5%, down from 65.7% as at the last monitoring date, and a weighted average debt service coverage ratio (DSCR) of 192%, up from 185% on the same date. Deutsche Hypothekenbank, as protection buyer, has not yet claimed a loss for the delinquent exposure.

Portfolio analysis

For each loan in the portfolio, Scope analysed the probability of default over the loan’s term, the probability of failure to refinance at maturity, and the recovery upon default. The approach outlined below explains how Scope has incorporated the additional information provided by Deutsche Hypothekenbank on loans, properties and tenants.

The probability of default accounts for the property quality as represented by Scope’s property grade, the tenant credit quality, the contracted lease length, and the LTV at default. The recovery rate is driven by the LTV at default, the property grade and the property liquidation costs. Scope analysed the quality of the properties securing the loans by assessing the properties’ micro and macro location, condition, vacancy rate, probability of re-marketing, lease terms, break options, and the tenants’ credit quality.

Scope has assumed a portfolio average tenant credit quality equivalent to a BB rating. This assumption is based on the average default frequency observed in Germany, France and the Netherlands for corporates and households based on the statistical offices’ data of the respective countries, and stressed by one rating notch.

Scope assessed the contracted lease length using the weighted average underwritten lease term (WAULT) reported for the different properties, either in the form of tenant lists or aggregated data. The portfolio’s average WAULT is six years. Scope assumes a 50% probability of default in the year of lease expiry for loans, where the WAULT for the related property is shorter than the maturity of the loan. Scope assumes that a property will not be re-let at a debt-servicing rent level.

A loan’s recovery upon default is driven by the outstanding loan balance at default and the corresponding market value of the property, net of recovery costs. Scope analysed the decline in market value for each loan, which depends on the development of each regional market and the loan’s time to maturity. Scope’s market-value-decline assumptions in this transaction range from 5% to 34%, reflecting the current state and expected long-term development of the property markets in the relevant country. Scope compared a mean reversion of current property prices with the development of long-term historical prices.

Asset assumptions

Scope modelled the default distribution of the reference portfolio loan-by-loan using a Monte Carlo simulation. For each loan, Scope assumed 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 portfolio default distribution produced by the simulation was used to project portfolio cash flows to compute the expected loss and expected life of the rated instrument, taking into account the transaction’s amortisation and loss-allocation mechanisms, as well as the credit enhancement of the credit-linked note.

Scope has assumed for the outstanding portfolio an average default probability of 14.6% for a weighted average life of 5.2 years. This is based on defaults caused by a failure to renew property leases that end before the related loan matures. Additionally, the portfolio default rate accounts for the high probability of refinancing failure for a number of loans, reflecting Scope’s long-term market-value-decline assumptions.

Scope has assumed for the portfolio an average rating-conditional recovery rate of 93.2%. This considers a BBB rating-conditional stress for the market-value-decline assumptions as well as distressed-sale discounts of 10% to 15%, liquidation costs of 10% to 12.5%, and an absolute recovery-rate cap of 98% for each loan.

Scope has applied pairwise asset correlations ranging from 5% to 45%, which incorporate a common factor, the property type and location, and the exposure size to reflect a more concentrated portfolio than at closing.

Rating sensitivity

Scope tested the resilience of the current rating against deviations of the portfolio’s tenant quality and the expected recovery rate: when tenant quality deteriorates by three notches, the rating’s sensitivity is one notch; when the recovery rate reduces by 10%, the sensitivity is five notches.

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.

Rating-change drivers

The rating may be positively affected if the largest-sized and worst-quality assets in the portfolio prepay or if credit quality of these assets materially increases.

The rating may be negatively affected if the German CRE market deteriorates and refinancing conditions change adversely, leading to a lower-than-anticipated recovery rate upon a loan’s default. In addition, an erosion of credit enhancement due to portfolio losses will also reflect negatively on the rating.

About the issuer

Herrenhausen Investment SA is a bankruptcy-remote special-purpose vehicle under Luxembourg law. Its Compartment I currently has a EUR 25.1m credit-linked note outstanding, which is synthetically exposed to the mezzanine credit risk of a EUR 569.3m CRE portfolio originated by Deutsche Hypothekenbank. The risk transfer is achieved by means of the issuer’s fully funded bilateral guarantee to Deutsche Hypothekenbank. The bank is the transaction’s main counterparty as its servicer, guarantee payer and, most importantly, the cash account provider. The latter role especially exposes the notes to the credit risk of Deutsche Hypothekenbank, which constrains the rating.

For more detail, refer to the initial rating report for Herrenhausen Investment S.A. - Compartment I - Inhaberschuldverschreibung, published by Scope 16 May 2014, in conjunction with the Scope’s General Structured Finance Rating Methodology, published August 2016, and the Methodology for Counterparty Risk in Structured Finance, published August 2016.
 
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
Instrument; ISIN; Date; Rating action; Rating
DE000A1ZFBA0; 25.03.2014; Preliminary; (P) BBB_SF
DE000A1ZFBA0; 16.05.2014; Initial; BBB_SF
DE000A1ZFBA0; 29.01.2015; Affirmation; BBB_SF
DE000A1ZFBA0; 22.05.2015; Affirmation; BBB_SF
DE000A1ZFBA0; 25.05.2016; Downgrade; 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. The issuer participated in the rating process.
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
Quarterly performance reporting (latest February 2017), individual underlying asset information (latest February 2017), legal transaction documentation, 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 “Methodology for Counterparty Risk in Structured Finance”, 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.

Conditions of use / exclusion of liability
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