Rating action

The transaction comprises the following rated instruments:

A1 Loan debenture, GBP 1,053.1m outstanding amount: confirmed at AAA_SF

A2 Loan debenture, GBP 364.7m outstanding amount: upgraded to AAA_SF from AA+_SF

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

Scope’s review was based on available transaction reporting up to November 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 62 loans granted by Barclays to finance 2,002 properties in the United Kingdom. More than 7,800 leases and rent contracts support the loan service of the portfolio loans. The portfolio shows a high interest coverage ratio of 3.1x and a current weighted average loan-to-value ratio (LTV) of 48.1%.

The portfolio is diversified across property sectors, with a focus on office and retail properties. Properties are predominantly office buildings, retail spaces or multi-family properties (37.9%, 31.9% and 13.5% of total market value respectively), while the remainder qualifies as industrial, other-type or mixed-use properties. Regarding regional diversification based on market value, 61.5% of the properties are located in London.

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 loans.

The ratings reflect the available credit enhancement of the tranches of 39.4%, 18.3%, 15.0% 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 recovery rate expected upon default.

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: 39.4%, A2: 18.3%, A3: 15.0%).

Sequential amortisation mechanism (positive). The senior notes benefit from increasing subordination protection, as amortisation of the notes had already 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 48.1%, based on third-party valuations with an average of 22 months since the last valuation¹. 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 2,002 properties with more than 7,800 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 66.6m liquidity facility, which would cover 2.4 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. Brexit 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 upgrade of the A3 loan debenture.

Negative. Worse-than-expected default and recovery performance of the assets may result in downgrades.

Quantitative analysis and assumptions

Scope analysed the reference portfolio based for the first time on its CRE Security and CMBS Rating Methodology published in August 2020 and this rating action concludes the review which started in August 2020. In our framework the analysis centres on the cash-flow generating capacity of the assets, which is driven by: i) the quality of the sponsor and its business plan; ii) the tenancy profile; and iii) the quality of the properties, which is complemented by the transaction’s liability structure of iv) the CRE security and subsequently v) the CMBS. We use Monte Carlo simulations to derive the rating-conditional cash flow and collateral value. We derive the rated instrument’s expected loss and the expected weighted average life of the cash flows it generates. These are then compared to our idealised expected loss table to establish our quantitative rating outcomes.

The likelihood of a default of CRE securities is two-fold: i) term default risk relates to the borrower’s failure to service its contractual interest and principal obligations during the term of the CRE security and ii) refinancing default risk relates to the borrower’s failure to refinance at the maturity of the CRE security. A CRE security is assumed to be in refinancing default if the portfolio exit debt yield is below the all-in refinancing rate or the stressed CRE security loan-to-value is equal or exceeds 100%.

We calculate recovery proceeds after foreclosure to be equal to the estimated collateral value net of liquidation costs. A maximum recovery applies for CRE securities with high recovery rate which is function of the rating category and the CRE security loan-to-value upon default.

Our cash flow framework is based on a bottom-up process of up to five steps: in the first step we assess the sponsor’s quality and the likelihood that it will support the transaction. Secondly, we determine the expected gross cash flow. It results from the sum of: i) the transaction’s expected contractual gross income, which is a function of the tenants’ creditworthiness and the contractual lease terms for tenants open for business; and ii) the rating-conditional estimated gross income for vacant units following a tenant’s default or the lease expiry. Our stochastic approach determines the tenant’s solvency based on the individual creditworthiness and our tenant default correlation framework. Thirdly, we calculate the net cash flow and we determine the collateral value. The net cash flow equals the gross cashflow net of property and vacancy costs. The collateral value equals the capitalised net cash flow at an appropriate capitalisation rate using an income valuation approach. Fourthly, we model the CRE security’s liability structure and we determine its expected loss rate distribution which ultimately determines the CRE security rating. We derive a CRE security term default and refinancing default probability distribution and a CRE security recovery rate distribution. We finally extend the analysis to CMBS to determine the respective tranche’s probability of default and recovery rate and ultimately the respective tranche’s expected loss rating.

Quantitative assumptions

Scope derived rating-conditional cash flows and the underlying properties’ market values having based most of its assumptions on illustrative values in the methodology and adjusting them to reflect portfolio characteristics and recent CRE sector developments. Illustrative values were based on valuer data over at least one full economic cycle.

Scope assumed that the average tenant credit quality for this portfolio is BB-. This reflects the average credit quality of UK-based corporates adjusted downwards by one notch. Scope has chosen this approach given the granularity of the tenant base. Lower credit quality of tenants was assessed in our sensitivity tests.

We analysed the transaction by differentiating five property segments in the portfolio: office, retail, industrial, residential and others. Estimated gross rental income after an asset’s specific void period were based on estimated rental values adjusted down by rental value haircuts. Rental value haircuts at the AAA level ranged between 25.4%-29.9% across the segments. Assumed maintenance capex accounted for an annual 0.5% of property value, while management fees for 2% of gross rental income. Void periods which reflect temporary vacancies following a lease discontinuation event ranged between 18-36 months for the different property types under the AAA scenario. Structural vacancy in our analysis reflects a vacancy which structurally limits the occupied area for a property in its respective market. It reduces the net cash flows over the full life of the property, while void periods limit rental income only for the first 10 years. Structural vacancy levels were assumed to be 7.5%-13%. To determine collateral values Scope capitalised net cash flows by 8.35%-9.14% capitalisation rates under the AAA scenario.

The above assumptions implied that market value of the properties on a portfolio level will decline by around 52.5%. Market value decline affects the loans’ probability of refinancing default through increase in LTVs as well as the level of recovery upon default. We calculated recovery proceeds after a 3-year foreclosure period to be equal to the estimated collateral value net of liquidation costs. Liquidation costs accounted for 9% of property value plus 1.5% of the related loan amount, the latter being capped at GBP 2m.

Sensitivity analysis

Scope tested the resilience of the ratings against deviations of the main input parameters: the tenant quality (as a driver of portfolio defaults) and the capitalisation rate (as major driver of collateral value). 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 assumed capitalisation rate for each segment increase by 20%, respectively:

• A1 loan debenture: sensitivity to lower tenant quality, zero notches; sensitivity to capitalisation rates, zero notches;
   
• A2 loan debenture: sensitivity to lower tenant quality, zero notches; sensitivity to capitalisation rates, two notches;
   
• A3 loan debenture: sensitivity to lower tenant quality, zero notches; sensitivity to capitalisation 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 adjusted assumptions.

Cash flow analysis
Scope Ratings performed a cash flow analysis of the transaction, incorporating tenancy and CRE collateral related assumptions and 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): General Structured Finance Rating Methodology (14 December 2020), CRE Security and CMBS Rating Methodology (17 August 2020) and Methodology for Counterparty Risk in Structured Finance (8 July 2020) are available on 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 Ratings’ 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 received a third-party asset due diligence assessment/asset audit at closing of the transaction. The external due diligence assessment/asset audit/internal analysis was considered when preparing the credit rating and it has no impact on the credit rating.
Prior to the issuance of the credit rating action, the rated entity was given the opportunity to review the credit rating and/or outlook and the principal grounds on which the credit rating and/or outlook is based. Following that review, the credit 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. The credit rating is UK endorsed.
Lead analyst Sebastian Dietzsch, Director
Person responsible for approval of the credit rating: David Bergman, Managing Director
The final ratings were first released by Scope Ratings on 27 September 2016. The ratings were last updated on 24 August 2020.

Potential conflicts
Please see www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures 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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