Rating action

The transaction comprises the following rated instruments:

A1 Loan debenture, GBP 1,385.8m outstanding amount: affirmed at AAA_SF

A2 Loan debenture, GBP 364.7m outstanding amount: affirmed at AA+_SF

A3 Loan debenture, EUR 57.6m outstanding amount: upgraded to A+_SF from A_SF

Scope’s review was based on available transaction reporting up to May 2020.

Transaction overview

Griffon Funding Ltd. is a securitisation of a static commercial real estate loan portfolio, comprising 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 75 loans granted by Barclays to finance more than 2,300 properties in the United Kingdom. More than 10,600 leases and rent contracts support the loan service of the portfolio loans. The portfolio shows a high interest coverage ratio of 3.5x and a loan-to-value ratio (LTV) of 52.7%, which incorporates all undrawn amounts up to the respective loans covenanted maximum LTV and indexation to May 2020. Scope assumes that the LTV will 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.

The portfolio is diversified across property sectors, with a focus on office and retail properties. Properties are predominantly office buildings, retail spaces or residential properties (37.3%, 30.7% and 14.9% of total market value respectively), while the remainder qualifies as industrial or mixed use. Regarding regional diversification based on market value, 55.9% of the properties are located in London.

Scope believes that 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 15 years. The tenant credit quality is average, which Scope considers non-investment grade. Only one loan accounts for more than 5% of the portfolio.

Rating rationale

The ratings reflect the legal and financial structure of the transaction as defined in the 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 loans¹.

The ratings reflect the available credit enhancement of the tranches of 33.1%, 15.4%, 12.6% for A1, A2 and A3, respectively; and its expected evolution under the sequential amortisation mechanism which has been triggered. 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 and Covid-19. 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 / P-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 Barclays and 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: 33.1%, A2: 15.4%, A3: 12.6%).

Sequential amortisation mechanism (positive). The senior notes benefit from increasing subordination protection, as amortisation of the notes switched to sequential from pro rata. The senior amortisation trigger has been hit, when the outstanding portfolio balance reduced to less than 75% of the original portfolio balance.

Low loan-to-value mortgages (positive). The commercial real estate loans have a low average loan-to-value ratio (LTV) of 52.7%, based on third-party valuations with an average of 19 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 2,300 properties with more than 10,600 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 78.3m liquidity facility, which would cover 1.9 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 expected recovery upon default.

Macroeconomic uncertainties in the UK (negative)². The still ongoing Brexit-negotiations and the outbreak of Covid-19 may lead to lower viability of UK commercial real estate in general, especially if 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.

Key rating-change drivers

Positive. Deleveraging of the structure accompanied by solid asset performance may result in upgrades.

Negative. Worse-than-expected default and recovery performance of the assets may 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 15.2% 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 8.0% to 82.3% with a weighted average of 52.9%. Scope has assumed that the market values of these properties will decline by 18.2% 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 15.1%; ii) average liquidation costs of 11.5%; 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%, respectively:

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

Rating driver references
1. Confidential documents of the issuer, arranger and originators
2. Scope’s economic research on the UK

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 1.0.
Scope performed a cash flow analysis of the transaction with the use of Scope Cash Flow SF EL Model Version 1.1, 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 (18 December 2019) and the Methodology for Counterparty Risk in Structured Finance (8 July 2020) are available on https://www.scoperatings.com/#!methodology/list.
The models used for this ratings, Scope Portfolio Model (Model) Version 1.0 and Scope Cash Flow SF EL Model Version 1.1, are available in Scope’s list of models, published under: https://www.scoperatings.com/#!methodology/list.
Information on the meaning of each rating category, including definitions of default and recoveries can be viewed in the “Rating Definitions - Credit Ratings and Ancillary Services” published on https://www.scoperatings.com/#!governance-and-policies/rating-scale.
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. Guidance and information on how Environmental, Social or Governance factors (ESG factor) are incorporated into the rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.

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 rating 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 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 had no impact on the credit rating.
Prior to the issuance of the rating action, the rated entity was 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.

Regulatory disclosures
This credit rating is issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0.
Lead analyst: Sebastian Dietzsch, Director
Person responsible for approval of the rating: David Bergman, Managing Director
The rating was first released by Scope on 27 September 2016. The ratings were last updated on 7 August 2019.

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
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