Rating action

Scope Ratings has today affirmed the issuer rating of B+ for JSC Lisi Lake Development (LLD) and changed the Outlook to Positive. The agency has also assigned a first-time instrument rating of BB to the senior unsecured corporate bond issued in December 2019.

Rating rationale

The B+ issuer rating for LLD, a premium residential real estate developer based in Tbilisi, Georgia, is supported by its: i) conservative financing structure relying on equity and minimal net debt; ii) above-average cash profitability, minimising the need for external financing; and iii) strong local brand recognition and industry network, which enables off-market deals, particularly for new attractive plots, and thereby the development of larger residential projects.

The issuer rating is negatively affected by LLD’s current lack of size and scope, being a small residential property developer that relies fully on property and/or land sales to end-customers. The pure-play developer business model implies a lack of substantial recurring revenues, therefore bearing the risk of high cash flow volatility in the event of reduced property sales. Diversification is deemed low given the substantial cluster risk regarding the Lisi Lake projects, which will comprise more than 75% of the issuer’s investment properties in the next two years (balance sheet value). The issuer rating is also limited by the sole geographical exposure to Georgia, which bears additional risks regarding the country’s less resilient economy, inflationary and foreign exchange risks, and tight liquidity in premium real estate compared to the more mature markets in western Europe.

Key rating drivers

Business risk profile

Scope assesses LLD’s industry risk to be high. As a pure-play developer, it is exposed to the most cyclical segment in the real estate industry. The agency’s short-term credit view for the industry is stable but accompanied by increasing sensitivity against changes in political and economic conditions as well as in interest rates. In addition, the Georgian market is less mature and thus more volatile. The company’s core activity is to develop premium residential real estate in Tbilisi and other cities in Georgia. LLD currently has a very concentrated project pipeline focused on two projects: its largest project, Lisi Lake in Tbilisi, and a major early-stage project at the Black Sea shoreline, Buknari, starting in 2019. However, more projects are planned, targeting other regions in Georgia and further projects in Tbilisi.

LLD is a small company, with total assets of c. USD 170m at year-end 2017 and funds from operations of USD 11m in 2017. Even so, it exhibits strong growth in its home market. LLD’s average asset quality is strong as all residential units are newly built in premium quality and the company’s land bank consists of prime locations in Georgia.

Size is expected to grow further in the next two years thanks to an expanding project pipeline. However, the company’s limited size and market position also indicate heightened sensitivity to unforeseen shocks and stronger cash flow volatility as almost all revenues are currently linked to the highly cyclical development sector.

The very concentrated pipeline also heightens cash flow volatility. The pipeline can be divided into several sub-projects and phases that can be managed and timed separately to a certain extent, but the largest project represents most of the revenue expected for the next 30 months. As a result, project delays or cost overruns would have a major impact on cash flow. However, Scope, along with other third-party market observers, expect demand overhang for Tbilisi’s premium residential real estate in the coming years, provided there is no major external economic shock. Moreover, as mentioned above, management intends to improve geographical diversification.

LLD’s profitability has been above industry average and had relatively low volatility considering its business model. EBITDA margin exceeded 30% in the 2016 and 2017 business years, driven by significant sales volumes. Scope believes this margin will gradually decrease, as the significant competitive advantage of having acquired a land bank at low prices about 10 years ago is shrinking because new projects will have to be acquired at current prices. Nevertheless, a substantial volume of land at the main project, Lisi Lake, can be developed at later stages. Scope expects EBITDA and particularly FFO margin to remain above industry average for the next two to three business years despite the increased competition foreseen in the agency’s conservative scenario.

Financial risk profile

While the Scope-adjusted debt/EBITDA of around 0.4x (2017) provides a huge boost to the financial risk profile, the uncertainty over future sales, and thus EBITDA levels, limits the sub-score to BB. In addition, as recurring revenues rely almost entirely on property sales, the analytical value of leverage ratios based on projected operating income is reduced. Management is seeking to reduce this revenue dependency, by entering into asset classes that produce recurring rental income like hotels or offices, starting with the revenues from Tsikhisdziri/Buknari hotel project. However, development will remain the core activity, according to company. In any case, Scope considers high cash flow volatility to be typical for a developer, with projects not assessed and financed in annual tranches but over the whole period of development.

EBITDA interest cover is at very comfortable levels: c. 12x in 2016 and above 40x in 2017. This is unusually high and is due to more than 90% of the balance sheet being equity-financed, resulting in minimal debt. Even with the USD 12m senior unsecured corporate bond issued in December 2018, EBITDA interest coverage is forecast to stay at more than 3.5x. Nevertheless, Scope again points out the risks posed by EBITDA depending entirely on ongoing land/property sales.

Cash flow was sufficient in the last two to three business years as a good number of properties were sold for the first time. However, free operating cash flow turned negative in 2017, due to the company’s growth ambitions as well as the inherent nature of real estate development. Scope expects the sound operating cash flows to further grow, but negative free cash flows in the medium term and tighter liquidity in 2019 due to the aforementioned expansion plans. The credit rating is also constrained by the very clustered project pipeline caused by the issuer’s limited size and scope.

The loan/value ratio has stayed at single-digits in recent years, driven by the low Scope-adjusted debt of less than USD 10m. Scope expects the loan/value ratio to remain at these levels for the next two business years, even with the USD 12m bond issue.
Revenues significantly exceeded expectations, and the company has also proved its ability to access debt markets. There is also further credit upside via greater visibility on the funding of new projects as well as a diversification in funding sources.

USD 8% Bond 2018/21 I 12m I ISIN GE2700603717

Scope has assigned a BB rating to the USD 12m of senior unsecured notes at a coupon of 8%, issued on 17 December 2018. Proceeds will used for the Buknari and Lisi Green Town development projects. The bond rating reflects the significantly above-average expected recovery due to the high volume of investment properties. However, should senior secured debt that ranks senior to this unsecured bond be issued in future, the positive headroom may shrink.

Outlook

The rating Outlook has been upgraded from Stable to Positive, supported by the enlarged Lisi Lake development pipeline and improved visibility on the funding for the next stages of the two main projects. In Scope’s view, this increased visibility on future revenues outweighs the effect of the newly incurred debt. Demand in Georgia’s premium residential real estate market is also growing. The Outlook also incorporates expectations that i) cash profitability will remain above those of peers going forward; ii) group revenues will continue to grow; and iii) the project pipeline can be developed and sold without a major drop in demand and/or prices that negatively affects operating cash flows.

Rating-change drivers

A negative rating action is possible if sales slumped significantly or a serious deterioration in Georgia’s real estate market negatively affected LLD’s overall prospects.
Scope would consider a positive rating action if the business risk profile significantly improved via further diversification of the development portfolio and/or via a reduced reliance on continued asset sales for recurring cash flows, which would mitigate cash flow volatility and provide sufficient interest cover from recurring EBITDA.

Cash flow analysis & stress testing
Scope performed its standard cash flow forecasting for the company.No stress testing was performed.

Methodology
The methodologies used for this rating(s) and/or rating outlook(s), the Corporate Methodology 2018, and the Real Estate Methodology 2019 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.
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 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. 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: Denis Kuhn, Associate Director
Person responsible for approval of the rating: Olaf Tölke, Managing Director
The ratings/outlooks were first released by Scope on 10 July 2018
The ratings/outlooks concern a financial instrument, which has been rated by Scope for the first time.

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

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