Rating action

The transaction comprises the following instruments:

A1 Loan debenture GBP 2,273.2m (75,00%): affirmed AAA_SF

A2 Loan debenture GBP 409.2m (13.50%): affirmed AA+_SF

A3 Loan debenture GBP 64.6m (2.13%): affirmed A_SF

Scope Ratings has reviewed the performance of Griffon Funding Ltd. and affirms the ratings on the A loan debentures. The affirmation is based on the transaction reporting from April 2019, incorporating the portfolio evolution until June 2019.

The affirmation incorporates the issuer’s proposal to amend five loans for the next transaction payment date in June 2019. The loan amendments are not covered by the pre-authorised amendments clause and include:

• For one loan, the release of collateral and allocated loan amounts so that the calculated loan-to-value ratio increases to 60%, from 52.25%;
• For one loan, the removal of the amortisation feature;
• For one loan, the release of security, exceeding 5% of the total asset value;
• For one loan, the release of collateral and allocated loan amounts exceeding 30% of the total asset value
• For one loan, the exchange of collateral for more than 5% of the total asset value.

Scope determined that the proposal, will not in and of itself and at this time negatively affect the current Scope ratings of the debt instruments. Scope does not express an opinion as to whether this proposal could have other non-credit-related effects.

Transaction overview

Griffon Funding Ltd. is a securitisation of a static GBP 3,030.9m commercial real estate loan portfolio, comprising 97 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.

The transaction performance since the restructuring in November 2018 has been solid, without any loan default to date.

The remaining portfolio is static comprising 97 loans granted by Barclays to finance more than 4,400 properties in the United Kingdom. More than 13,200 leases and rent contracts support the loan service of the portfolio loans. The portfolio shows a high interest coverage ratio (LTV) of 3.7x and a loan-to-value ratio of 50.5%, which incorporates all undrawn amounts up to the respective loans covenanted maximum LTV and indexation to April 2019. Scope assumes the LTV to rise over the transaction life, reflecting a reduction of the currently high price level for commercial real estate 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. Properties are predominantly retail spaces, office buildings or residential properties (32.3%, 23.8% and 13.8% of total collateral value respectively), while the remainder qualifies as industrial or mixed use. Regarding regional diversification based on market value, 56.7% 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 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 with a long weighted average unexpired lease term of more than 10 years. The tenant credit quality is average, which Scope considers non-investment grade.

Rating 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 Bank plc (Barclays), the originator and servicer of the portfolio loans.

The ratings reflect the available credit enhancement of the tranches of 25.2%, 11.7%, 9.6% for A1, A2 and A3, respectively; and its evolution under the pro-rata amortisation mechanism, incorporating the effective mitigation mechanisms. The ratings also reflect the credit risk of a mainly bullet loan portfolio, characterised by material default risk at the loans’ maturity and substantial recovery rate expected upon default. The average good property quality and the high granularity of the property and tenant base reflect positively on default and recovery rates.

The ratings take into account 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, 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 transaction’s counterparty risk exposure to Barclays as portfolio servicer and Elavon Financial Services DAC (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 have to be transferred in case the respective counterparty’s issuer rating falls below BBB, if available. Scope has assessed the credit quality of Elavon, based on public information and public credit ratings.

Key rating drivers

Available credit enhancement (positive). The A loan debenture benefits from the excess spread and credit enhancement from overcollateralisation (A1 25.2%, A2 11.7%, A3 9.6%).

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 22 months since the last valuation. This LTV level supports the recovery rates expectations and helps the probability of successful refinancing at maturity.

Property and tenant base granularity (positive). The loans finance more than 4,400 properties with more than 13,200 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 loans (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.

Pro-rata amortisation mechanism (negative). The pro-rata amortisation of liabilities will delay the deleveraging of the transaction, which reduces the protection from the currently available absolute credit enhancement. Effective triggers (1 loan default, 25% amortisation) partially protect the senior instruments from the effect.

Macroeconomic uncertainties in the UK (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.

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

Rating-change drivers

Positive. A significant deleveraging of the structure 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 change adversely if Brexit negotiation outcomes lead to lower than expected demand for UK commercial real estate, reflecting negatively on property values.

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 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 transaction’s liability structure.

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 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 undrawn amounts, the amortisation profile, information on each loan and borrower, and available overcollateralization for 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 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 has derived for the outstanding portfolio an average default probability of 9.6% for a weighted average life of 2.4 years. This assumption reflects i) the granularity of both the portfolio and the underlying tenant and property base; ii) tenant credit quality; iii) the 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 loan-to-value are credit-positive; whereas the portfolio’s bullet nature is credit-negative. Scope has applied rating-conditional stresses to the cash available for loan repayments and the underlying properties’ market values. Scope derived those 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 has chosen this approach given the granularity of the tenant base. Scope has determined that the ratings exhibit limited sensitivity to a change in tenant quality assumptions. Scope has also assessed the average property quality of the financed properties to be good (PG1.9), based on valuation reports and information provided by Barclays.

Scope has 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 82.9% with a weighted average of 61.6%. Scope has assumed that the market values of these properties will decline by 22.8% from their current level over a horizon of about 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 incorporated i) an average distressed-sale discount of 14.4%; ii) average liquidation costs of 11.8%; and iii) a rating conditional haircut, ranging from 0% under the base case up to 28.7% for assigning 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%.

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.

Sensitivity analysis

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%, 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, four notches;
• A3 loan debenture: sensitivity to lower tenant quality, one notch; sensitivity to recovery rates, three notches; sensitivity to maturity extensions, four notches.

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

Cash flow analysis
Scope has primarily analysed the distribution of portfolio losses and its impact on the rated instruments, with the use of Scope Portfolio Model (Model) Version 1.
Scope performed a cash flow analysis of the transaction with the use of Scope Cash Flow SF EL Model Version 1, incorporating default and recovery rate assumptions over the portfolio’s amortisation period, taking into account the transaction’s main structural features, such as the notes’ priorities of payment, the notes’ size and coupons. The outcome of the analysis is an expected loss and an expected weighted average life for the notes.

Methodology
The methodologies used for this rating(s) are the General Structured Finance Rating Methodology and the Methodology for Counterparty Risk in Structured Finance 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 definitions of default and rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale.

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 received a third-party asset due diligence assessment/asset audit at closing of the transaction. The external due diligence assessment/asset audit was considered when preparing the rating and it has no impact on the credit rating.
Prior to the issuance of the rating or outlook action, the rated entity was given the opportunity to review the rating 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 Sebastian Dietzsch, Director
Person responsible for approval of the rating: David Bergman, Managing Director
The ratings were first released by Scope on 27.09.2016 The ratings were last updated on 15.11.2018.

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
© 2019 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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