Scope Ratings has assigned ratings to six credit protection agreements issued by Red 2 Finance CLO 2018-1 DAC (Red 2) and entered into with Santander UK plc (Santander).

The assigned ratings are as follows:

Tranche A: GBP 2,283.7m (82.00%): assigned new AAA_SF

Tranche B: GBP 104.5m (3.75%): assigned new AA+_SF

Tranche C: GBP 118.3m (4.25%): assigned new A+_SF

Tranche D: GBP 55.7m (2.00%): assigned new A_SF

Tranche E: GBP 75.2m (2.70%): assigned new BBB-_SF

Tranche F: GBP 64.1m (2.3%): assigned new BB_SF

The ratings assigned by Scope reflect the risk for the credit protection seller to make a payment with respect to a credit event under the credit protection deed’s terms. The ratings do not address potential losses resulting from the transaction’s early termination, nor any market risk associated with the transaction. Scope did not assign a rating to Tranche G. The transaction’s maturity is 26 September 2027.

Transaction overview

Red 2 is a synthetic securitisation of a static GBP 2,785m portfolio of 837 commercial real estate loans, originated by Santander and secured by more than 2,800 properties in the United Kingdom. Red 2 sells credit protection on the portfolio through seven strictly sequential, fully funded credit protection agreements – Tranches A to G – entered into with Santander. Red 2 covers up to 95% of the losses from the reference portfolio. The loss protection for the tranches, i.e. the respective credit enhancements, are: 18.00% for Tranche A; 14.25% for Tranche B; 10.00% for Tranche C; 8.00% for Tranche D; 5.3% for Tranche E; 3.00% for Tranche F and 0.00% for Tranche G.

Under the credit protection agreements, Santander receives cash payments equal to 35% of the outstanding balance of a reference obligation upon its default. The amount is then adjusted for the actual loss during a maximum work-out period of 5.5 years. There will be make-up payments to account for the difference between initial loss claim and final loss after work-out. Losses are allocated to the respective tranches in reverse order of seniority, i.e. from Tranche G to A.

The transaction defines loan default as i) a failure to pay with respect to the reference obligation; ii) a bankruptcy of the obligor or obligor group; or iii) a loss from the restructuring of a reference obligation. The credit protection agreements grant significant supervisory rights to the external verification agent, a reputable global accounting firm. This agent ensures that all loss claims are valid, and the determination of the expected loss and final loss comply with Santander’s internal policies. Santander also must demonstrate to the verification agent that its servicing and work-out processes accord with the bank’s internal business principles and policies.

Rating rationale

The ratings reflect the legal and financial structure of the transaction as defined under the terms of the credit protection deed; the credit quality of the underlying portfolio in the context of macroeconomic conditions in the UK; the ability and incentives of Santander, servicer of the reference loans; and the supervision from the verification agent, a reputable global accounting firm.

The ratings account for the respective credit enhancement of the tranches and the strictly sequential release of risk coverage from reference portfolio amortisation. The ratings also reflect the credit risk of a relatively granular reference portfolio, characterised by material default risk at the loans’ maturity and substantial recovery rate upon default.

Tranche B’s sensitivity to changes in the loans’ expected recovery rate is reflected in its rating.

The ratings incorporate the macroeconomic dynamics in the UK. Scope’s market-value-decline assumptions for commercial real estate properties in the UK also reflect uncertainties associated with Brexit. Scope expects heightened uncertainties to have an adverse impact on consumer and investment confidence, which, in turn, may have a knock-on effect on commercial real estate by reducing demand and the willingness to maintain the properties’ condition.

The ratings also account for the flexibility granted to Santander to allocate losses associated with defaulted obligations that are not fully worked out at the termination of the credit protection deed. These losses will reflect Santander’s accounting provisions. The risk of inflated losses based on Santander’s accounting provisions is limited to obligations that default within the 5.5 years prior to the legal final termination date.

Premiums and recovery proceeds payments by Santander expose the issuer to limited credit counterparty risk. This is mitigated by i) the high credit quality of Santander; ii) the termination of the credit protection deed upon Santander’s default, which effectively cancels the exposure to the remaining reference portfolio; and iii) the netting of credit protection premiums and collected recoveries with new loss claims. Scope has a public rating on Banco Santander SA (AA- Stable/S-1+) and has also analysed the credit quality of Santander UK plc.

Key rating drivers

Low loan-to-value mortgages (positive). The commercial real estate loans have a low average loan-to-value ratio (LTV) of 47.6%, based on third-party valuations with an average of nine months since the last valuation. This LTV level supports high recovery rates expectations and helps the probability of successful refinancing at maturity.

Granularity (positive). The five largest exposures account for only 4.7% of the portfolio. Both, the property and the tenancy base are generally granular, which reflects positively on the stability of the loans’ interest coverages.

Experienced CRE lender (positive). Santander’s real estate lending activities in the UK date back to 1944 (Abbey National plc, bought by Santander Group in 2004).

Static portfolio (positive). The portfolio is static and does not allow for loan extensions, refinancing and reference loan additions.

Bullet amortisation (negative). All loans in the portfolio have bullet or semi-bullet amortisation. This decreases the likelihood of refinancing at maturity, while increasing the volatility of expected recovery upon default.

UK macroeconomic uncertainty (negative). This may lead to lower viability of UK commercial real estate in general, especially if Brexit uncertainties result in adverse impacts on tenant’s business models.

Key rating-change drivers

Positive. Increased credit enhancement from deleveraging accompanied by solid asset performance may result in upgrades.

Negative. Worse-than-expected default and recovery performance of the assets will result in downgrades. Recovery rates and refinancing probabilities may reduce if Brexit negotiation outcomes lead to lower than expected demand for UK commercial real estate, reflecting negatively on property values.

Asset analysis

The reference loan portfolio is static and comprises 837 loans secured by more than 2,800 underlying commercial and residential real estate properties. More than 5,500 lease and rent contracts support the cash flows used to service the loans. The portfolio benefits from a sound interest coverage ratio of 2.96x, and a currently low weighted average LTV of 47.6%. Scope assumes the LTV to rise over the transaction life, reflecting a regression of the currently high price level for commercial real estate in the UK and the bullet nature of the portfolio. On the other hand, Santander is an experienced lender in UK commercial real estate, with a prudent strategy and moderate risk appetite.

The portfolio is diversified across property sectors, with a focus on retail and office properties. Properties are predominantly residential, retail spaces and office buildings (33.3%, 26.4% and 25.3% of total collateral value respectively), while the remainder qualifies as industrial or mixed use. Regarding regional diversification based on market value, 29.3% of the properties are located in London (whole loan market values, i.e. syndicated shares are included). The portfolio’s good regional diversification across the UK is a reflection of Santander’s regional real estate lending, which shows a reduced share of offices in London.

Scope believes the expected post-Brexit slowdown of the UK rental market will not immediately impact the portfolio because of its business and credit characteristics. The agency assumes the portfolio’s rental levels and the expected lease take-ups to be resilient, thanks to the properties’ generally granular tenant base and related lease contracts. The financed properties benefit from i) a weighted average unexpired lease term of 3.9 years; and ii) lease contracts with below-market rents on average. The portfolio is resilient against an expected short-term rise in yields, given a portfolio weighted average LTV of 47.6%.

Quantitative analysis

Scope has analysed the reference portfolio loan by loan and simulated its performance using a single-step Monte Carlo simulation implementing a Gaussian-copula dependency framework. For each loan, Scope has assumed i) a specific default probability, inferred from the credit estimate assigned to the loan over its weighted average life; ii) a specific recovery upon default; and iii) asset correlations between the loans. The resulting rating-conditional loss distribution and default timing were then used to project tranche losses, reflecting the transaction’s collateral release and loss-allocation mechanisms as well as the credit enhancement of the respective tranche.

Scope’s analysis of commercial real estate loans consists of deriving: i) term default probabilities for all periods over a loan’s life ; ii) default probabilities at maturity; iii) and recovery rates upon default. Stressed cash flows over the loan’s life drive the term default probability; while property market values drive refinancing risk, default probability at maturity, and severity of default. Refinancing risk is crucial to the analysis as commercial real estate loans typically do not amortise in full.

Scope has also performed a fundamental analysis of the loans by using a bottom-up approach. The analysis starts with an assessment of tenants and tenancy contracts, then properties and loans, and lastly of the overall portfolio. To assess a reference loan’s credit quality, Scope considers the tenants’ quality, the property quality expressed as a property grade, and the loans’ LTV at maturity. The analysis also accounts for the amortisation profile, information on each loan and borrower, and available credit enhancement embedded in each of the loans.

Property grades account for a property’s distinct characteristics (type, location and attributes) to ascertain its condition and attractiveness to the market. Scope has examined: 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; and iv) information provided by Banco Santander. 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.

Quantitative assumptions

Scope has derived for the outstanding portfolio an average default probability of 28.4% for a weighted average life of 2.8 years. This assumption reflects i) the granularity of both the portfolio and the underlying tenant and property base; ii) tenant credit quality; and ii) the probabilities of refinancing failure, driven by Scope’s long-term market-value-decline assumptions and the limited amortisation of the reference portfolio’s loans.

The analytical results reflect cash flows from both rent (net of operating expenses) and potential workout proceeds. The sound interest coverage ratio and the low loan-to-value are credit-positive; whereas the portfolio’s bullet nature is credit-negative. Cash available for loan repayments and the underlying properties’ market values were subjected to rating-conditional stresses, which Scope derived from previous commercial real estate cycles in the UK, incorporating additional haircuts which discount less-favourable post-Brexit scenarios.

Scope assumes that the average tenant credit quality for this portfolio is BB-. This reflects the average credit quality of UK-based corporates over the past 10 years adjusted downwards by one notch. Scope has chosen this approach given the granularity of the tenant base. Also, Scope has determined that the ratings exhibit limited sensitivity to a change in tenant quality assumptions.

Scope has calculated the LTVs at loan maturity based on the long-term mean of the UK property index. These loan LTVs range from 14.0% to 90% with a weighted average of 62.6%. Scope has assumed that the market value of UK properties will decline by 21.3% from its current level over a horizon of 3.5 years, reflecting i) the loans’ time to maturity; ii) the current uncertainty of the UK commercial real estate market; and iii) current property prices above historical levels and expected to revert to their long-term historical levels. This affects the loans’ probability of refinancing and recovery upon default. To derive the recovery rates upon defaults, Scope added to this assumption i) an average distressed-sale discount of 18.2%; ii) average liquidation costs of 14.0%; and iii) a rating conditional haircut, ranging from 0% under the base case up to 28.7% for assigning the highest ratings.

Scope assumed a portfolio recovery rate of 95.0% for a B rating target and applied rating-conditional haircuts of 22.0% for AAA, 17.6% for AA, 13.2% for A, 8.8% for BBB, and 4.4% for BB. These haircuts consider rating-conditional stresses for the market-value-decline assumptions and absolute rating-conditional recovery-rate caps of 95% for AAA, 96% for AA, 97% for A, 98% for BBB and 99% for BB, loan by loan. Scope has also assumed a rating-conditional recovery haircut of up to 10% applicable to exposures that default within 5.5 years prior to transaction termination.
Scope has assumed pairwise asset correlations ranging from 50 to 70%, which reflect additive components including a general correlation factor of 15%, a location factor of 15% and a property type factor of 20%.

Additionally, Scope has considered a top-exposure stress, applicable to the largest obligors and to those obligors that contribute more than 1% to the portfolio’s expected loss. Scope applied a top-exposure correlation stress of 20 percentage points; stresses the probability of default for these obligors by one notch equivalent; and applies an additional 10% haircut to the recovery rate.

Rating sensitivity

Scope tested the resilience of the ratings against deviations of the main input parameters: tenant quality (as a driver of portfolio defaults) 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 results for each rated tranche change compared to the assigned ratings when the assumed tenant credit quality reduces by three notches, or the portfolio’s expected recovery rate reduces by 10%, respectively:

• Tranche A: sensitivity to lower tenant quality, zero notches; sensitivity to recovery rates, zero notches;
• Tranche B: sensitivity to lower tenant quality, zero notches; sensitivity to recovery rates, three notches;
• Tranche C: sensitivity to lower tenant quality, zero notches; sensitivity to recovery rates, five notches;
• Tranche D: sensitivity to lower tenant quality, zero notches; sensitivity to recovery rates, six notches;
• Tranche E: sensitivity to lower tenant quality, zero notches; sensitivity to recovery rates, four notches;
• Tranche F: sensitivity to lower tenant quality, one notch; sensitivity to recovery rates, six notches.

Methodology

The methodologies applied for this rating is the General Structured Finance Methodology. Scope also applied the principles contained in the Methodology for Counterparty Risk in Structured Finance. All documents 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 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 relied on a third-party asset due diligence/asset audit. The external due diligence/ asset audit has no impact on the credit rating.

Prior to the issuance of the rating, the rated entity was given the opportunity to review the rating and the principal grounds on which it is based. Following that review, the rating was not amended before being issued.

Regulatory and legal 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 ratings: Guillaume Jolivet, Managing Director
The ratings were first released by Scope on 15.10.2018
The ratings/outlooks concern a financial instrument, which has been rated by Scope for the first time. 

Potencial 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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