Rating action

Scope Ratings has today affirmed its issuer rating of B+ on Stern Immobilien AG (STERN) as well as a rating of BB+ on STERN’s bond (ISIN: DE000A1TM8Z7 due in May 2018 with a coupon of 6.25%). The Outlook is Stable.

Rating rationale

The rating affirmation is primarily driven by reduced execution risk regarding the bond’s refinancing at the end of May 2018. According to STERN, the successful disposal of a project in Munich as well as equity repayments from its Istanbul development project will lead to cash inflows prior to the bond’s maturity covering an estimated 80% of the outstanding nominal.

Positive rating drivers include the company’s moderate leverage in line with Scope’s expectations as well as successful disposal activity in 2016 and 2017, thanks to a high-quality, liquid pipeline of development projects.

The rating is constrained, however, by persistently stretched and volatile liquidity due to STERN’s high proportion of shortterm debt, thereby increasing dependence on external financing. Furthermore, Scope has a negative view of STERN’s limited size and full exposure to the cyclical real estate development market, as these factors cause a higher sensitivity to unforeseen shocks and uneven cash flow.

The bond’s collateral consists of: i) shares in STERN’s subsidiary (Stern Real Estate AG); and ii) full recourse to STERN whose balance sheet includes high-quality liquid assets. This security significantly improves credit risk for the bond over that of the issuer.

Rating drivers

Business risk profile:

In comparison with its peers, STERN is ranked as a small developer due to its asset volume (EUR 103m including disclosed hidden reserves) and relatively low funds from operations of EUR 3.5m for the 12 months to 30 June 2017. This small size limits potential economies of scale and makes STERN vulnerable to market movements, especially as the
company is highly exposed to the inherent cyclicality in the real estate market, with almost 100% of its revenues linked to development activities. Scope judges this exposure to be credit-negative.

STERN has an international presence in three regions, with development projects in Germany (accounting for 67% of expected exit proceeds), Turkey (15%) and Romania (18%) as at April 2018. The spreading of activities across these different regions, with diverging demand patterns, should reduce overall execution risk and cash flow volatility going forward. In Scope’s view, STERN’s moderate geographical diversification is somewhat weakened by its concentrated development pipeline of only seven projects in H1 2018 down from nine at YE 2016. The number of sub-projects fell even more sharply from 15 to 11 within the same time period, following several disposals in 2017 and 2018. As a result, the top three projects’ contribution to targeted exit proceeds increased to 62%, up from 40%. However, this greater concentration is somewhat mitigated by reduced execution risk in Turkey – a country in which the application of the rule of law and political uncertainties are judged to be constraints (Scope: 22.09.2017) – following the finalisation of negotiations between STERN, together with its joint venture partner (Vartas), and Kiptas A.S. (a subsidiary of the Istanbul Metropolitan Municipality) to buy into the joint venture, acquiring a stake of 68% and taking over the financing of the project.

With an exposure to ‘A’ (Munich, Istanbul) and ‘C’ locations (Cluj) STERN’s assets are chiefly situated in mature and liquid markets. This enhances the fungibility of STERN’s properties and lowers potential price haircuts in a distressed sales scenario.

STERN’s profitability, as measured by its EBITDA margin, stands at a level of around 20% which Scope considers to be sustainable (last twelve months H1 2017: 18%; 2016: 20%). Scope expects continued volatility for this margin, albeit at around 20%.

Financial risk profile:

With the successful disposal of projects, STERN was able to keep debt protection (EBITDA interest cover) for the 12 months to 30 June 2017 at above 2.2x which supports the company’s financial risk profile. STERN’s ability to maintain this level in the future – as expected – may, however, be jeopardised by delayed or unsuccessful disposals from its development pipeline.

STERN’s cash flow generation has been very volatile in the past as a result of the company’s limited size and concentrated project pipeline. Free cash flow was starkly negative between 2013 and 2015 due to a sharp rise in the company’s working capital as it built up its development pipeline. These efforts bore fruit from 2016 onwards, as indicated by EUR 49m in sales in 2016 followed by EUR 9m in sales in H1 2017. As STERN is currently further divesting parts of its current project pipeline with an estimated sales volume of between EUR 25m and EUR 35m for the 12 months to 30 June 2018, free operating cash flow is expected to remain positive up to H1 2018. However, an expansion of STERN’s project pipeline, as anticipated by Scope, or slower than expected sales could put pressure on STERN’s free operating cash flow, potentially leading to deviations from Scope’s current expectation of a more stable financial risk profile.

STERN has a moderate loan/value ratio, standing at 50% as at 30 June 2017. This ratio remains within the rating-conditional range of 45-55% supported by the successful sale of parts of STERN’s project pipeline in 2016 and 2017 which led to a reduction in Scope-adjusted debt (SaD) by around EUR 40m up to YE 2017. The loan/value ratio is expected to stay at this level for the next two years, due to disclosed hidden reserves. However, highly levered acquisitions to expand STERN’s development pipeline could lead to increasing leverage with downside pressure on the issuer rating.

STERN’s SaD/EBITDA stood at below 8x for the twelve months to 30 June 2017, representing a sharp drop from levels prior to 2016 when it exceeded 15.0x by far. This considerable decrease was primarily driven by STERN’s success in reducing its debt position which goes hand in hand with the successful disposal of projects in 2016 and H1 2017. Scope believes that SaD/EBITDA will remain at a level below 8.0x in H2 2017 and 2018. The rating agency judges the overall volatility of SaD/EBITDA to be typical for a developer, as these generally consider and finance projects over the whole development period rather than in annual tranches. Thus, it should be noted that STERN’s debt in the project special purpose vehicle: i) is interest only, which Scope views as credit-positive; but ii) just partially matches the expected lifetime of the project, which Scope views as credit-negative as it increases refinancing risk (see also liquidity).

Given the above, especially STERN’s interest-bearing liabilities at the holding level of EUR 20m at YE 2017 (EUR 3m in rolling credit lines or overdrafts; EUR 17m corporate bond) depend upon STERN’s ability to generate stable and, above all, sufficient cash flows from its project special purpose vehicle to cover related obligations. Due to the volatility of cash flows, Scope sees higher risks connected to a delay in developments and respective disposals within the project special purpose vehicle as described below.

Liquidity

Scope evaluates STERN’s liquidity as weak based on its expectation that sources of liquidity will only cover uses by about 0.1x in the 12 months to YE 2018 following volatile liquidity in the past.

100% of STERN’s debt matures at YE 2018. Of the EUR 35m of debt due in 2018 (EUR 15m for project financing; EUR 3m in rolling credit lines and overdrafts and a EUR 17m corporate bond) EUR 7m are expected to be repaid out of the exit proceeds from projects already sold in 2018. Uncertainties with regard to timely disposals pose the risk that the remainder may depend on the extension of overdrafts. At the same time, Scope believes that STERN would be able to manage any risk connected to the extension of overdrafts, as evidenced by its track record.

However, in Scope’s view, the refinancing of the EUR 17m bond in May 2018 is heavily dependent on the cash expected from the disposal of the Tulbeckstr. project in Munich as well as the repayment of equity related to the dilution of the company’s share in the Istanbul project. According to STERN, contractual preconditions for the disposal of the Tulbeckstr. project have been met and the purchase price is due. STERN’s management has stated that the equity repayment from the Turkish project will be received prior to the bond’s maturity. These cash inflows cover an estimated 80% of the outstanding nominal. According to the company, the remaining 20% will be financed either by private placements or external funding. Scope believes both to be possible given STERN’s relatively low leverage, unencumbered assets (Cluj) and reasonably diverse funding structure including nine different banks.

Bond

The bond’s credit quality is closely linked to STERN’s own credit quality and performance, which limits the likelihood of the bond’s rating substantially exceeding the company’s issuer rating. However, given STERN’s disclosed hidden reserves and well-located development portfolio, Scope considers a potential recovery to be well above market average, ultimately allowing for a bond rating of BB+.

Outlook

The Outlook is Stable, based on Scope’s expectation that STERN’s short-term credit lines/bank overdraft will continue to be extended or that successful refinancing will be achieved, including the EUR17m bond maturing at the end of May 2018. Furthermore, Scope expects current leverage, as measured by the loan/ value ratio, to remain between 45% and 55%, with disposal activities supporting a recurring EBITDA of above EUR 5m p.a. over the coming years. Scope’s rating case scenario further incorporates the deferral of dividend payouts to main shareholders until the successful repayment or refinancing of the bond.

Rating-change drivers

A negative rating action would be considered if the company’s activities and financial metrics did not adhere to Scope’s rating case scenario, particularly if access to external financing weakens.

A positive rating action might be warranted if STERN manages to significantly grow in size leading to enhanced diversification while maintaining financial metrics which adhere to Scope’s rating scenario and achieving adequate liquidity.

Stress testing & cash flow analysis
No stress testing was performed. Scope produced its standard cash flow forecast for the company.

Methodology
The methodologies used for this rating and rating outlook (Corporate Rating Methodology; Rating Methodology: European Real Estate Corporates) are available on www.scoperatings.com.
Historical default rates of Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA Please also refer to 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 definition of default as well as definitions of rating notations can be found in Scope’s public credit rating methodologies on www.scoperatings.com.
The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The rated entity and/or its agents participated in the rating process.
The following substantially material sources of information were used to prepare the credit rating: public domain, the rated entity, third parties and Scope internal sources.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the rating or outlook action, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds on which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Lead analyst: Philipp Wass, Director
Person responsible for approval of the rating: Olaf Tölke, Managing Director
The ratings/outlooks were first released by Scope on 30.04.2013. The ratings/outlooks were last updated on 11.04.2017.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
© 2018 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstrasse 5 D-10785 Berlin.

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