Scope Ratings has taken the following rating action on the credit linked notes issued by Herrenhausen Investment SA - Compartment 1:

Inhaberschuldverschreibung, EUR 21.3m: BBB-_SF review for downgrade

Scope used quarterly investor reporting up to 28 February 2018 and the annual loan-by-loan portfolio update as of February 2018.

Rating rationale

The review for downgrade reflects the continued uncertainty over the ongoing restructuring of one delinquent loan, as reported by the issuer on February 2018. Scope has taken into account that the operational restructuring and re-letting of the property underlying the delinquent exposure is in line with the restructuring plan. The debt service ability is almost restored and the re-letting resulted in a reduction of the vacancy rate to 15%. The tenant base is more granular than before the restructuring and has an average lease term beyond the maturity of the loan. In addition, an updated valuation from April 2018 shows an increase of the property value to 42.3m, up from 35.5m from last reporting. Scope will resolve the review as soon as possible, following the successful restructuring of the delinquent loan.

The action takes into account the performance of the overall transaction, which exhibits increased portfolio concentration through asset amortisation, partially mitigated by a marginal increase in credit enhancement of subordination to 1.45% from 1.22% at last monitoring.

Scope maintains a stable outlook on the German commercial real estate (CRE) market. The French and Dutch CRE market are also evolving positively. The later markets are however characterised by higher levels of price volatility, which Scope took into account.

The stable credit profile of Deutsche Hypothekenbank AG, the transaction’s account bank and holder of the notes’ cash collateral, supports the current rating.

Key rating drivers

The rating drivers remain unchanged from closing, including updates from previous monitorings.

Rating change drivers

The rating can be affected positively, if the largest-sized and worst-quality assets in the portfolio prepay or if their credit quality materially increase.

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

Stress testing

Stress testing was performed by applying rating-adjusted recovery assumptions.

Rating sensitivity

Scope tested the resilience of the ratings against deviations of the portfolio’s tenant quality and the portfolio recovery rate. 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.

The following shows how the quantitative results for the rated instrument changes when the portfolio’s tenant quality deteriorates by three notches, or the portfolio’s expected recovery rate reduces by 10%, respectively:

The CLNs sensitivity to tenant quality assumption is, one notch; sensitivity to recovery rates, four notches.

Quantitative assumptions and cash-flow analysis

Scope derived the default distribution of the reference portfolio loan-by-loan from a Monte Carlo simulation. For each loan, Scope estimated 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 resulting portfolio default distribution was then used to perform a cash flow analysis to compute the expected loss and expected life of the rated instrument, reflecting 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 14.4% for a weighted average life of 4.9 years. This assumption is the result of loan defaults associated with i) tenant defaults, and ii) the failure to renew property lease contracts that end before the maturity of the related loans. The portfolio default rate also accounts for high probabilities of refinancing failure for some loans, driven by Scope’s long-term market-value-decline assumptions.

Scope has assumed a rating-conditional average portfolio recovery rate of 92.3%. This considers a BBB rating-conditional stress for the assumptions on the properties’ market value declines and accounts for distressed-sale discounts of 12.5% to 15%, liquidation costs of 12.5% to 16%, and an absolute recovery-rate cap of 98% loan by 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.

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 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.

Scope considers the average property quality to be good, reflected in an average property grade of PG2. Scope’s property grades account for a property’s distinct characteristics (type, location and attributes) to ascertain its condition and attractiveness to the market. Scope examines: 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 of lease contracts. The analysis uses information from: i) on-site visits; ii) valuation reports from established industry experts; and iii) market studies from reputable sources. The highest property grade is PG1, e.g. a prime landmark building in a micro/macro location ideal for its usage type. The lowest is PG5, e.g. a property in poor condition in a degraded or undeveloped/unconsolidated location.

For the tenant quality, Scope made the assumption that the average tenant credit quality is commensurate with a BB rating. 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.

Scope assessed the contracted lease length based on weighted average underwritten lease terms (WAULT) reported for the different properties, either in the form of tenant lists or aggregated data. The portfolio shows an average WAULT of 10.5 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.

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 the market value declines for each loan, depending on the development of each regional market and the loan’s time to maturity. Scope’s rating conditional market-value-decline assumptions range from 12% to 32%, reflecting the current states and expected long-term developments of the property markets in the relevant countries. Scope compared a mean reversion of current property prices with the development of long-term historical prices.

About the transaction

Herrenhausen Investment SA is a bankruptcy-remote special-purpose vehicle under Luxembourg law. Its Compartment 1 currently has a EUR 21.3m credit-linked note outstanding, which is synthetically exposed to the mezzanine credit risk of a EUR 484.8m commercial real estate 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 major counterparty in this transaction as the servicer, the payer of the guarantee payment and most importantly the cash account provider. The role as cash account provider especially exposes the notes to the credit risk of Deutsche Hypothekenbank, which constrains the notes’ rating.

Since closing, the reference portfolio has amortised by 64.3%. The credit quality has remained relatively stable, however, concentrations increased significantly. German CRE loans currently comprise 93.0% of the portfolio.

Scope’s loan-by-loan credit estimates, based on information up to February 2018, suggest an average portfolio credit quality (considering default probabilities and expected recoveries) of BBB, in line with the level in July 2017, when Scope last monitored the transaction.

The reference portfolio includes one delinquent loan under restructuring. However Deutsche Hypothekenbank, the protection buyer, has not claimed a loss for the exposure. The share of assets classified as non-investment grade under Deutsche Hypothekenbank’s internal scale has increased slightly to 21.2%, from 19.7% as at the last monitoring date. The current portfolio shows a decreased weighted average loan-to-value (LTV) ratio of 60.2%, down from 65.7% as at the last monitoring date, and an increased weighted average debt service coverage ratio (DSCR) of 196%, up from 192% as at the last monitoring date.

For more detail, refer to the initial rating report for Herrenhausen Investment S.A. - Compartment 1 - Inhaberschuldverschreibung, published by Scope 16 May 2014 (link).

Methodology

The methodology used for these ratings is the General Structured Finance Methodology, dated August 2017. Scope also applied the principles contained in the Methodology for Counterparty Risk in Structured Finance, dated August 2017 is/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.

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, the rated entities’ agents, 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.

Scope Ratings GmbH has not relied on a third-party asset due diligence/asset audit. However, the protection buyer Deutsche Hypothekenbank would not be able to claim losses under guarantee agreement upon a material misrepresentation on a reference asset that gave rise to a loss claim.

Prior to the issuance of the rating or outlook action, the rated entity was given the opportunity to review the ratings and the principal grounds on which the credit ratings are based. Following that review, the ratings were not amended before being issued.

Regulatory Disclosures

This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Lead analyst Sebastian Dietzsch, Associate Director
Person responsible for approval of the rating: Guillaume Jolivet, Managing Director
The preliminary rating was released by Scope on 25.03.2014
The final rating was first released by Scope on 16.05.2014.
The last rating update was on 11.07.2017.

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
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