Rating action

Scope Ratings upgrades issuer rating of Deutsche Konsum REIT-AG (DKR) to BB+. Senior secured debt (ISIN: DE000A2G8WQ9) affirmed at BBB and senior unsecured debt upgraded to BBB-. The Outlook is Stable.

Rating rationale

The issuer rating of BB+ for Deutsche Konsum REIT-AG (DKR) is supported by the size the company has achieved in the niche market of commercial real estate with a focus on non-cyclical retail. Its portfolio is diversified across Germany, with stable occupancy and a weighted average unexpired lease term of over five years, leading to predictable and steady cash flows. Relatively high profitability, implicit caps on leverage and floors on revenue diversification afford good debt protection measures and moderate leverage.

However, the rating is limited by DKR’s size which is expected to burden the company’s access to capital markets in times of economic turmoil. DKR’s focus on a niche market leads to a heavy reliance on single tenants and weak tenant diversification, with the top three accounting for 42% of gross rental income. Furthermore, Scope sees high downside volatility for the company’s property portfolio as a consequence of relatively small ticket sizes and rather weak macro locations, both resulting in limited fungibility. Scope’s overall assessment of DKR’s financial risk profile is negatively affected by the company’s ambitious growth plans for the next few years.

Scope’s rating scenario assumes the following:

• like-for-like rental growth reflecting CPI linkage (80%)
• increase in operational expenses in line with inflation rate forecasts for Germany as published in the European Commission’s Autumn Forecast (11/2018) – 2019: 1.9%, 2020: 1.6%
• fair value adjustments reflecting growth in like-for-like rents with no further occupancy increases assumed
• new borrowings at interest rates increasing by 50 bp per annum
• exclusion of EUR 7.5m invested in short-term loans via Creditshelf from calculation of credit metrics
• capital expenditure of EUR 100m per year
• additional increase in rents from new acquisitions reflecting a net initial yield of below 9.5%
• mandatory dividend distribution of 90% of German GAAP result
• no tax applicable due to the company’s German real estate investment trust (G-REIT) status
• capital issuance (equity and debt) in line to keep loan/value ratio at around 50%

Rating drivers

Credit positive

• DKR is the largest pure-play commercial property company in Germany with a focus on non-cyclical retail supporting stable cash flows throughout the cycle. With an estimated market share of 5% in German retail parks, DKR benefits from high visibility towards its tenants and vendors. Scope believes the company’s consolidation in the sector will further improve its visibility to potential tenants, lower tenancy fluctuation and thus reduce maintenance capex requirements.
• The company has moderate geographical diversification. Its property portfolio is spread across Germany with a focus on the east (90% of the gross lease area as at end-September 2018). DKR is consequently able to benefit from slightly different demand patterns, influenced by different industry exposures helping to mitigate cyclical swings.
• Stable occupancy of around 85% (end-September 2018: 90%) and a moderate weighted average unexpired lease term of over five years support visibility and the stability of cash flows in the short to medium term. Scope does not expect a material reduction in occupancy as a result of DKR’s acquisition strategy, thus limiting the company’s upside potential for its business risk profile.
• Despite the limited upside potential of the portfolio’s occupancy, which weighs heavily on the company’s profitability, DKR has EBITDA margins of around 70%. Thus, profitability is almost in line with larger peers, benefitting from economies of scale and very lean overheads. Scope expects the company’s profitability to remain at around 70% going forward with limited downside volatility, given its resilient cash streams that seem to be well protected.
• DKR benefits from a sufficiently high EBITDA interest cover of over 5x (FY 2017/18: 5.2x). Debt protection is expected to remain at this level going forward protected by a relatively low weighted average cost of debt of 1.88%, a reasonably long weighted average maturity of debt of 5.5 years (both as at end-December 2018) and a weighted average unexpired lease term of above 5 years; all at end-September 2018.
• DKR’s loan/value ratio increased to above 50% by end-September (53%). However, Scope expects leverage to remain below 55% as a consequence of implicit covenants in accordance with DKR’s G-REIT status as well as the successful equity increase of EUR 30m (November 2018). Thus, the current rating is judged to be at risk only in the event of a sudden slump in prices that could not be swiftly addressed by deleveraging measures.

Credit negative

• Company of limited size with total assets of EUR 453m and funds from operations of EUR 17m (both for FY 2017/18) limiting access to capital markets, as evidenced by a very homogeneous debt and equity investor base. This poses a threat to the availability of funding to finance further growth or to properly address liquidity shortages on capital markets. However, Scope expects DKR’s portfolio to continue to grow dynamically, reaching EUR 500m in total assets and EUR 25m in funds from operations in FY 2018/19. Size gains should improve the company’s access to capital markets.
• Modest diversification across sales formats with a high exposure to hypermarkets (11% of gross rental income at end-September 2018) – with negative future prospects – and discounters (12%), which tend to be more cyclical and thus more prone to defaults than other sales formats. As a result, DKR’s cash flows and portfolio values are negatively exposed to the development of both sales formats.
• DKR has a highly concentrated tenant portfolio with the top three accounting for 42% of gross rental income as at end-September 2018, making the company highly vulnerable to single tenant defaults and/or restructuring. However, Scope judges the associated risk to be partially mitigated by the majority’s good credit quality.
• The properties’ macro locations, predominantly in ‘D’ or worse cities, towns, villages (82% of fair value as at end-September) is expected to lead to higher downside volatility for fair values, thus putting pressure on the company’s ability to keep its G-REIT status in a cyclical downturn. This pressure is amplified by the company’s still relatively limited size. However, cash flows are better protected as micro locations are good and benefit from limited competition which should support tenant demand.
• DKR has negative free operating cash flows as a consequence of ongoing portfolio expansion and mandatory dividend payments. Both point to the company’s dependence on external financing to fund future growth. However, as 95% of capex is of a discretionary nature, DKR could halt its dynamic growth if access to external financing weakens, thus turning free operating cash flows positive.

Liquidity

DKR’s liquidity is judged to be adequate. In detail (Position: YE 2017/18 I 2018/19E):

Unrestricted cash: EUR -0.2m I EUR 0.6m
Open committed credit lines: EUR 0.0m I EUR 0.0m
Free operating cash flow (t+1): EUR 12.6m I EUR 10.0m
Short-term debt (t+1): EUR 8.6m I EUR 8.7m
Coverage: 1.4x I 1.2x

In the past, liquidity was burdened by an ongoing high share of short-term debt. However, DKR has managed to restructure its liabilities by extending its convertibles by five years and introducing long-term financing to replace some short-term debt and flatten the maturity schedule. In addition, DKR managed to improve its free operating cash flow beyond our previous expectations to EUR 12.5m for 2018/19 (excluding non-mandatory, non-executed expansion capex of EUR 92.5m and a net rental contribution of EUR 5.3m), thanks to massive portfolio investments lifting net rental income to EUR 35.5m (annualised). As a result, we judge liquidity to be adequate, relieving the company of a two-notch stress on its financial risk profile, that reflected its former heavy and ongoing dependence on external financing.

In general, Scope believes liquidity to be a manageable risk for DKR in the short to medium term with sufficient headroom provided by a reasonably high share of unencumbered assets (EUR 60m / 12% of total assets as at end-December 2018). This liquidity assessment is also supported by Scope’s view that the company has good, well-established relationships with banks as demonstrated by a financing pipeline of over EUR 40m at the end of December 2018. DKR is anticipated to make use of its unencumbered asset position if it draws upon this pipeline. In addition, the company’s G-REIT status requires adherence to financial covenants with regard to total leverage, thus limiting additional indebtedness to a maximum loan/value ratio of 55%.

Senior secured debt

DKR issued a EUR 40.0m bond in May 2018 with a six-year term (2018/24) and a coupon of 1.80% (ISIN: DE000A2G8WQ9). This bond benefits from a first ranking mortgage on fifteen properties valued at EUR 67.2m as at May 2018. Scope believes that the structure benefits from adequate overcollateralisation, with an issue-specific loan/value ratio of 60%. This positively influences recovery rates in a default scenario. According to Scope’s methodology and reasonable discounts on the company’s asset base (as described below), the rating agency expects a ‘superior’ recovery in a default scenario, thus allowing for a two-notch uplift on the company’s issuer rating of BB+.

Senior unsecured debt

Scope’s recovery analysis signals an ‘above-average recovery’ which translates into instrument ratings of BBB-. Recovery is based on a hypothetical default scenario in FY 2019/20 with the company’s liquidation value amounting to EUR 363m. This value is based on a 36% haircut applied to DKR’s assets, reflecting a market value decline of one standard deviation of the German property price index as well as liquidation costs of approx. 26% for assets and 10% for insolvency proceedings. This compares to secured financing of a forecasted EUR 286m, a fully drawn, unsecured credit line of EUR 25m as well as the unsecured EUR 37m in convertible bonds. Recovery is sensitive to the advance rate used and DKR’s portfolio is judged to be rather illiquid. Scope therefore limits its up-notching on the issuer rating.

Outlook

The Outlook for DKR is Stable and incorporates Scope’s expectation that DKR’s asset base will grow as a consequence of EUR 100m in annual capex leading to recurring funds from operations of around EUR 25m by FY 2018/19. Scope anticipates that further expansion will be equally financed with debt and equity to keep DKR’s loan/value ratio at around 50% while debt protection, as measured by EBITDA interest cover, is expected to remain above 5x.

Rating-change drivers

A negative rating action is possible if the company leverages up to a loan/value ratio of above 55% on a continuing basis, leading to a loss of its tax-exempt G-REIT status.

A positive action would require the company to grow significantly in size, as measured by its total assets, leading to greater diversification with regard to geographies and tenants. This possibility is judged to be remote at present.

The latest information on the rating, including rating reports and related methodologies are available on this LINK.

Stress testing & cash flow analysis
No stress testing was performed. Scope performed its standard cash flow forecasting 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 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/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 31.05.2018.

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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