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Rating action

Scope Ratings GmbH (Scope) has today affirmed the BB+/Stable issuer rating of Deutsche Konsum REIT-AG (DKR). Scope has also affirmed the BBB rating of its EUR 40m bond (ISIN: DE000A2G8WQ9) and the BBB- rating of its senior unsecured debt.

Rating rationale

The rating affirmation reflects the company’s continued growth while it keeps credit metrics stable. Cash flow is resilient and therefore valuation risk arising from peaking inflation is limited, given a large share of CPI-linked lease contracts and the defensive property types the company is invested in.

DKR’s asset base grew further in the 12 months to end-December 2021, with Scope-adjusted total assets of EUR 1,040m at end-December 2021 (up 20% YoY) and Scope-adjusted funds from operations of EUR 37m (up 15% YoY). Growth in the asset base mainly stems from the acquisition of nine properties (EUR 103m) and EUR 58m in fair value appreciation, reflecting an unchanged portfolio yield of 7.7%. DKR is expected to allow for a higher share of capital recycling going forward, enabled by a more mature portfolio. The pace of expansion should therefore slow going forward, with an estimated EUR 250m-350m in net expansion capex until FY 2023/24. Size achieved positioned DKR as one of the largest landlords in Germany investing in food-anchored retail, with high visibility on and access to investment and letting markets.

DKR’s portfolio remained moderately well spread across Germany, with its main markets being Saxony (23% of annualised net rental income or NRI as at end-December 2021), Brandenburg (20%) and Saxony-Anhalt (10%). However, tenant diversification improved, with the top three tenants accounting for 33.5% (down 1.3pp YoY) and the top 10 tenants accounting for 47.8% (down 8.8pp) of pro forma NRI as at February 2022. This is on the back of a higher share invested in retail parks (32% of annualised NRI; up 7 pp YoY), which typically benefit from a more diverse tenant base. Although DKR still shows a highly concentrated tenant portfolio, associated risk is largely mitigated by the investment-grade character of larger tenants and the food-anchored nature of DKR’s portfolio.

The company’s food retail locations remain viable, expressed in a stable financial occupancy of 95%¹ as at end-September 2021 (down 1pp YoY) and a stable weighted average unexpired lease term of 5.4 years as at end-December 2021 (down 0.1year YoY). Both point to DKR’s ability to extend lease contracts or re-let vacant space, consequently limiting downside volatility of cash generation. Stable asset quality is further supported by positive like-for-like growth in rents (1.7% for FY 2020/21). Scope believes cost increases associated with spiking inflation could be partially passed on to tenants as 76% of NRI is linked to the CPI and large food retailers and DIY stores can pass on cost pressure to customers.

The Scope-adjusted EBITDA margin was stable at 65% in FY 2020/21 because pandemic-related measures had a limited adverse impact on DKR’s cash flow (rent collection at 98%). However, an improvement in profitability was held back by a strong increase in non-recoverable service charges (up EUR 4.8m YoY) due to adjustments for expenses from prior periods and revised estimates regarding rechargeable costs. These one-off effects are expected to fade in FY 2021/22 according to the company. However, Scope does not expect a significant improvement in profitability going forward, with profitability staying between 65% and 70% in FY 2021/22 (last 12 months to end-December 2021: 66%). This follows Scope’s understanding of a growing cost base meeting more sluggish portfolio growth. Nevertheless, Scope expects margins to remain stable, reflecting DKR’s overall cash flow resilience despite the accelerated transformation of European retail due to the pandemic.

DKR benefits from high Scope-adjusted EBITDA interest cover (4.4x for the 12 months ending December 2021) that is unlikely to weaken below 3x thanks to: i) resilient cash generation; ii) relatively low funding costs (1.9% as at end-December 2021); and iii) balanced financing of future growth.

Leverage, as measured by the Scope-adjusted loan/value (LTV) ratio, remained stable at 54% as at end-December 2021 (up 1pp YoY), in line with Scope’s expectations. Thanks to the company’s high exposure to tenants selling essential goods, it will remain relatively resilient in terms of cash flow, rental growth expectations and, thus, property values. Scope anticipates no immediate drop in DKR’s property values. Potential increases in the Scope-adjusted LTV ratio due to the company’s expansion strategy are expected to be addressed by an increase in either equity, asset disposals or fair value uplifts from improved rental growth prospects. Scope expects no deleveraging either as G-REIT regulations allow a maximum LTV ratio of 55%, and the company intends to keep leverage at around 50% (reported 53% as at end-December 2021).

Liquidity will continue to be burdened by a high share of short-term debt. Sources of liquidity (unrestricted cash of EUR 1m as at 30 September 2021 and Scope-adjusted free operating cash flow forecasted at EUR 69m) fully cover short-term debt of EUR 54m as at end-September 2021, but liquidity is forecasted to fall below par in 2022/23. However, liquidity risk is manageable in the short-to-medium term due to headroom provided by fully unencumbered investment properties (EUR 55m as at end-December 2021) and around EUR 75m in investments that can be dissolved at short notice, including a EUR 67m short-term loan (at end-December 2021) to its main shareholder under a credit line with a maximum amount of EUR 95m. Scope sees limited risk related to the current use of lending lines. This follows the agency’s understanding that DKR will acquire properties using funds lent to Obotritia as they can be withdrawn at any time. However, Scope would see increased risk if a significant amount of cash continues to be extracted from this intercompany loan to shore up the credit position of Obotritia or other group companies. The EUR 40m of promissory notes issued in March 2022 are dedicated to executing the call option on the EUR 40m step-up bond that matures in March 2025.

Outlook and rating-change drivers

The Outlook is Stable and incorporates Scope’s expectation that DKR’s asset base will grow due to around EUR 100m in net expansion capex for FY 2021/22, leading to annualised rental income of EUR 82m-86m by end-September 2022. Scope anticipates further expansion to be financed with equal amounts of debt and equity. This will keep the Scope-adjusted LTV ratio below 55% in the medium term, while debt protection, as measured by Scope-adjusted EBITDA interest cover, is expected to remain above 4x.

A negative rating action is possible if the Scope-adjusted LTV ratio rose above 55% on a sustained basis, leading to DKR losing its tax-exempt G-REIT status. This could happen if property prices dropped and DKR could not address the increased LTV ratio via asset disposals or equity issuances (due to the main shareholder being less willing and able to support capital increases either actively or passively).

A positive action would require further growth in total assets and gross leasable area, leading to greater diversification by geographies and tenants while keeping credit metrics at current levels.

Long-term debt ratings

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 15 properties valued at EUR 95.6m as at June 2021. The structure’s over-collateralisation is adequate, with an issue-specific LTV ratio of 42%. This positively influences recovery rates in a default scenario. According to Scope’s methodology and based on discounts on assets (as described below), the agency expects a ‘superior’ recovery in a default scenario, thus allowing for a two-notch uplift on the issuer rating of BB+.

Scope’s recovery analysis for senior unsecured debt signals an ‘above-average’ recovery. This is based on a hypothetical default scenario in FY 2023/24 with a company liquidation value of EUR 728m, including a haircut applied to assets, reflecting a BBB category stress according to Scope’s methodology, and liquidation costs of 10% for insolvency proceedings. This compares to EUR 580m of secured financing (forecasted), a fully drawn unsecured credit line of EUR 25m, and EUR 37m in unsecured convertible bonds, EUR 140m in senior unsecured bonds and EUR 30m in Schuldschein loans. DKR’s Scope-adjusted unencumbered asset ratio amounts to 1.5x at end-December 2021 but is anticipated to improve back to above 167% following the execution of the already-signed disposals, allowing for an uplift of the debt class rating to the ‘BBB category’ according to Scope’s methodology.

1. Around 90% based on GLA.

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

Methodology
The methodologies used for these Credit Ratings and/or Outlook, (Corporate Rating Methodology, 6 July 2021; Rating Methodology: European Real Estate Corporates, 25 January 2022), are available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Scope Ratings GmbH and Scope Ratings UK Limited apply the same methodologies/models and key rating assumptions for their credit rating services, while Scope Hamburg GmbH’s methodologies/models and key rating assumptions are different from those of Scope Ratings GmbH and Scope Ratings UK Limited.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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 Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Rated Entity and/or its Related Third Parties participated in the Credit Rating process.
The following substantially material sources of information were used to prepare the Credit Ratings: public domain, the Rated Entity and Scope Ratings' internal sources.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting the Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlook and the principal grounds on which the Credit Ratings and/or Outlook are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlook are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlook are UK-endorsed.
Lead analyst: Philipp Wass, Executive Director
Person responsible for approval of the Credit Ratings: Olaf Tölke, Managing Director
The Credit Ratings/Outlook were first released by Scope Ratings on 31 May 2018. The Credit Ratings/Outlook were last updated on 30 April 2021.

Potential conflicts
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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