The transaction is comprised of the following instruments:

A1 loan debenture GBP 2,631.8m (75.00%): affirmed AAA_SF

A2 loan debenture GBP 473.7m (13.50%): affirmed AA+_SF

A3 loan debenture GBP 74.8m (2.13%): affirmed A_SF

B1 note GBP 122.8m (3.50%): rating withdrawn, from BBB_SF

B2 note GBP 205.9m (5.87%): rating withdrawn, from B+_SF

Scope Ratings has reviewed the performance of Griffon Funding Ltd. and affirms the ratings on the A loan debentures.

The affirmation incorporates the issuer’s proposal to restructure the transaction and add 79 new exposures to the transaction portfolio. The combined size of the debt instruments will increase accordingly and the respective instruments’ credit enhancements will change. After restructuring, the credit enhancement available to protect the rated instruments against portfolio losses will amount to 25.2%, 11.7% and 9.5% for the A1, A2 and A3 tranches, respectively. The restructuring will also change the transaction’s cash flow mechanisms and the amortisation scheme for the debt instruments. The issuer will terminate the senior interest-only instrument and transform the junior interest-only instrument into an excess spread capturing mechanism. From the effective date of the restructuring, the debt instruments will start to amortise pro-rata, subject to effective termination triggers. The pro-rata amortisation of the structure will change to sequential amortisation upon the first asset default, or when the outstanding portfolio amortises to 75% of the increased portfolio. Elavon Financial Services DAC (Elavon) will replace Barclays Bank plc as issuer account bank.

All the elements highlighted in the above paragraph are collectively referred to as the ‘proposal’. This proposal will become effective on 15 November 2018. Scope determined that the proposal will not in and of itself and at this time negatively affect Scope’s current ratings of the debt instruments. The rating agency does not express an opinion as to whether this proposal could have other non-credit-related effects.

Rationale

The ratings reflect the legal and financial structure of the transaction as defined in the revised transaction documents; the credit quality of the underlying portfolio in the context of macroeconomic conditions in the UK; as well as the ability and incentives of Barclays, the originator and servicer of the portfolio loans.

The ratings are primarily driven by the respective credit enhancement of the tranches and the effective protection of the senior tranches against the release of credit enhancement from pro-rata amortisation. The ratings also reflect the credit risk of a relatively concentrated portfolio composed of mainly bullet-amortising loans, characterised by material default risk at the loans’ maturity and substantial recovery rates expected upon default. The good property quality and the high granularity of the property and tenant base reflect positively on default and recovery rates.

The ratings on the A2 loan debenture and A3 loan debenture reflect the instruments’ sensitivities to changes in the recovery rate, as well as risks associated with possible loan maturity extensions at the discretion of Barclays.

The ratings incorporate the macroeconomic dynamics in the UK. Scope’s market-value-decline assumptions for commercial real estate properties in the UK reflect uncertainties associated with Brexit. Scope expects heightened uncertainties to have an adverse impact on consumer and investment confidence, which 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 transaction’s counterparty risk exposure to Barclays as portfolio servicer and Elavon as account bank and paying agent. The high credit quality of the two counterparties and effective replacement mechanisms partially mitigate this risk. The roles of Barclays (A+ Stable Outlook/ S-1) or Elavon would have to be transferred if the respective counterparty’s issuer rating falls below BBB, if available. Scope assessed the credit quality of Elavon based on public information and public credit ratings.

Scope also withdraws its ratings on the B1 note and the B2 note for business reasons.

Key rating drivers

Credit enhancement (positive). The A loan debenture benefits from excess spread and credit enhancement from overcollateralisation (A1 25.2%, A2 11.7%, A3 9.5%).

Low loan-to-value mortgages (positive). The commercial real estate loans have a low average loan-to-value ratio (LTV) of 50.5%, based on third-party valuations with an average of 15 months since the last valuation. This LTV level supports recovery rate expectations and raises the likelihood of successful refinancing at maturity.

Property and tenant base granularity (positive): The loans finance more than 4,700 properties with more than 15,400 tenants, which reflects positively on the stability of the loans’ interest and debt service coverages.

Strong liquidity coverage (positive). The structure provides strong liquidity protection to the tranches via a fully interconnected set of rules on distributing interest, principal and recovery collections from the assets. Additionally, the structure features a GBP 120m liquidity facility, which would cover 1.5 years of interest on the A loan, including other more senior items.

Bullet loan 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 the expected recovery upon default.

Pro-rata structure (negative). The pro-rata amortisation of liabilities will lead to a reduction in absolute credit enhancement. Effective triggers (0% defaults, 25% amortisation) partially protect the senior instruments from this effect.

Macroeconomic uncertainties in the UK (negative). These may lead to the lower viability of UK commercial real estate in general, especially if Brexit uncertainties adversely affect tenants’ business models.

Loan extensions (negative). The transaction allows for loan extensions up to three years, which increases uncertainty regarding refinancing and recovery conditions.

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 deteriorate if Brexit negotiation outcomes lead to lower-than-expected demand for UK commercial real estate, reflecting negatively on property values.

Collateral performance and asset portfolio update

The transaction’s performance since inception has been solid, without any loan defaults to date. As of October 2018, the 26 remaining loans accounted for GBP 771.6m and will form part of the increased portfolio.

The increased portfolio is static and comprises 105 loans granted by Barclays to finance more than 4,700 properties in the United Kingdom. Over 15,400 leases and rent contracts support the servicing of the portfolio loans. The increased portfolio has a high interest coverage ratio of 4.0x and an LTV of 50.5%, which incorporates all undrawn amounts up to the respective loans’ covenanted maximum LTV. Scope assumes that the LTV will rise over the life of the transaction, reflecting a fall in the high commercial real estate prices in the UK and the bullet nature of the portfolio.

Only one loan accounts for more than 5% of the increased portfolio.

The portfolio is diversified across property sectors, with a focus on retail and office properties. The properties are predominantly retail spaces, office buildings or residential properties (34.9%, 32.3% and 13.3% of the total collateral value respectively), while the remainder qualifies as industrial or mixed use. Regarding regional diversification based on market value, 55.8% of the properties are located in London (whole loan market values, i.e. syndicated shares are included).

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 that the portfolio’s rental levels and expected lease take-ups will prove resilient, thanks to the properties’ generally granular tenant base and related lease contracts with a long weighted average unexpired lease term of over 10 years. Tenant credit quality is average, which Scope considers non-investment grade.

Quantitative and cash flow analysis

Scope 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 assumed: i) a specific default probability attributed to each loan over its weighted average life; ii) a specific recovery upon default; and iii) asset correlations between the loans. The resulting default distribution, default timing and rating-conditional recovery rates were used to project cash flows, reflecting the transaction’s amortisation mechanics, as well as the instruments’ credit enhancements.
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; and iii) recovery rates upon default. Stressed cash flows over a loan’s life drive the term default probability. 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 performed a fundamental analysis of the loans using a bottom-up approach. The analysis starts with an assessment of tenants and tenancy contracts, followed by properties and loans, and finally the overall portfolio. To assess a reference loan’s credit quality, Scope considers the tenant quality, the property quality expressed as a property grade, and the loan LTV at maturity. The analysis also accounts for undrawn amounts, 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 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; iii) market studies from reputable sources; and iv) information provided by Barclays. The highest property grade is one (PG1), e.g. a prime landmark building in a micro/macro location ideal for its usage type. The lowest is five (PG5), e.g. a property in poor condition in a degraded or undeveloped/unconsolidated location.

Quantitative assumptions

Scope derived an average default probability of 10.5% for the outstanding portfolio for a weighted average life of 2.3 years. This assumption reflects: i) the granularity of both the portfolio and the underlying tenant and property base; ii) tenant credit quality; iii) property quality; and iv) 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 analysis reflects cash flows from both rent (net of operating expenses) and potential workout proceeds. The sound interest coverage ratio and the low LTV are credit positive, whereas the portfolio’s bullet nature is credit negative. Scope applied rating-conditional stresses to the cash available for loan repayments and the underlying properties’ market values. Scope derived these stresses from previous commercial real estate cycles in the UK, incorporating 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 chose this approach given the granularity of the tenant base. The ratings exhibit limited sensitivity to a change in tenant quality assumptions. Scope assessed the average property quality of the financed properties as good (PG 1.8), based on valuation reports and information provided by Barclays.

Scope calculated the LTVs at loan maturity based on the long-term mean of the UK property index. These loan LTVs range from 8.2% to 86.7% with a weighted average of 60.9%. Scope assumed that the market values of the properties will decline by 30% from their current level over a horizon of about six years, reflecting: i) the loans’ time to maturity; ii) uncertainty in the UK commercial real estate market; and iii) current property prices above historical levels which are 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 default, Scope incorporated: i) an average distressed-sale discount of 14.2%; ii) average liquidation costs of 11.7%; and iii) a rating-conditional haircut, ranging from 0% under the base case to 28.7% for the highest ratings.

Scope’s pairwise asset correlations remain unchanged from closing. 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%.

Scope also 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; stressed the probability of default for these obligors by a one-notch equivalent; and applied an additional 10% haircut to the recovery rate.

Stress testing 

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

Rating sensitivity

Scope tested the resilience of the ratings to deviations in 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 is reduced by three notches, the portfolio’s expected recovery rate is decreased by 10%, or the maturity of the portfolio loans is extended by three years, respectively:

• A1 loan debenture: sensitivity to lower tenant quality, zero notches; sensitivity to recovery rates, zero notches; sensitivity to maturity extensions, zero notches;
• A2 loan debenture: sensitivity to lower tenant quality, zero notches; sensitivity to recovery rates, three notches; sensitivity to maturity extensions, three notches;
• A3 loan debenture: sensitivity to lower tenant quality, zero notches; sensitivity to recovery rates, two notches; sensitivity to maturity extensions, three notches.

About the transaction

After restructuring, Griffon Funding Ltd. will be a securitisation of a static GBP 3,509.0m commercial real estate loan portfolio, comprising 105 loans granted by Barclays in its normal course of business. Barclays is an experienced originator in the UK market with a prudent strategy and moderate to low risk appetite which is reflected in the quality of the portfolio.

Methodology
The methodology 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 the entities rated by 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.

Scope analysts are available to discuss all the details of the rating analysis and the risks to which this transaction is exposed.

Solicitation, key sources and quality of information
The rated instruments' issuer 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.
Prior to publication, the issuer and/or its agents were given the opportunity to review the rating and the principal grounds on which the credit rating is based. Following that review, the rating was not amended before being issued.
Scope Ratings GmbH has not relied on a third-party asset due diligence/asset audit. Scope has performed its own analysis of the asset, based on information received from the rated entity or related third parties, which is not and should be not deemed equivalent to a due diligence or an audit.
The analysis has no negative impact on the credit rating.

Regulatory and legal disclosures
These credit ratings are issued by Scope Ratings GmbH.
Lead analyst Sebastian Dietzsch, Associate Director.
Person responsible for approving the rating: Guillaume Jolivet, Managing Director.
The ratings were first released by Scope on 27.09.2016. The ratings were last updated on 02.11.2018.

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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