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Rating action

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

Rating rationale

The rating affirmation reflects the company’s continued but slowed growth owing to adverse macroeconomic conditions, while credit metrics remain within Scope’s base case and requirements as a tax-exempt real estate investment trust (REIT). Cash flow is resilient given the large share of CPI-linked lease contracts and the defensive property types the company is invested in; these will be needed to balance out the higher interest rates on future debt.

DKR’s asset base grew further in the 12 months ending December 2022, with Scope-adjusted total assets at EUR 1,136m at end-December 2022 (up 9% YoY), while Scope-adjusted funds from operations of EUR 38m remained fairly flat. Growth in the asset base mainly stems from the acquisition of 25 properties (EUR 98m) in FY 2021/22 and EUR 28m in fair value appreciation corresponding to 4.9% of total assets (over the June 2021 valuation), reflecting a slightly lower portfolio yield of 7% (7.7%). The size achieved has positioned DKR as one of the largest landlords in Germany investing in food-anchored retail, allowing high visibility on and access to investment and letting markets.

DKR’s portfolio remained moderately spread across Germany. However, tenant diversification is more concentrated, with the top three accounting for 35.4% (up 1.9pp YoY), though this was somewhat mitigated by the perceived investment grade quality of the top three tenants, which are all active in non-cyclical food retail. However, the share in pro-forma NRI of the top 10 tenants reduced to 51.3% (down 3.3pp) as at December 2022.

The company’s food retail locations remain supportive to the portfolio, with a high financial occupancy of 94% (EPRA measured) as at end-September 2022 (down 1pp YoY) and a stable weighted average unexpired lease term of 5.0 years as at end-December 2022 (down 0.4 years YoY). Both point to DKR’s ability to extend lease contracts and re-let vacant space, which limit the downside volatility of cash generation. The stable asset quality is further supported by positive like-for-like growth in rents (3.5% for FY 2021/22), which will continue to be strong based on the high inflation and lag on the feed-through of CPI increases to revenue (84% of net rental income is linked to the CPI and large food retailers and DIY stores can pass on costs to customers).

The Scope-adjusted EBITDA margin deteriorated to 61.4% in FY 2021/22, partially explained by the two-year timing mismatch between acquisitions and disposals. However, profitability is unlikely to improve substantially because CPI-indexed increases in rents lag those in costs. Scope therefore expects profitability to stay between 60% and 65% for the next two years before returning to historical levels of above 65%. Nevertheless, margins are expected to be stable with limited downside risk, reflecting the cash flow resilience to the transformation of the European retail industry.

The rapidly increasing interest rates are also having an adverse impact on DKR’s financial risk profile. DKR benefits from historically high Scope-adjusted EBITDA interest cover (3.7x for FY 2021/22), with a large share of fixed-rate debt (89% at December 2022) limiting the deterioration of the ratio. Nevertheless, as new debt and refinancing will be done at much higher rates than the current average of 2.3% (up 30 bp within one quarter), DKR’s interest cover will weaken towards 3x at YE 2022/23. Thereafter, Scope expects interest cover to improve based on i) CPI-linked rental increases strengthening EBITDA; ii) a peak to the rise in interest rates; and iii) the lower expected growth rate in assets incurring slower growth in debt than historically observed.

Leverage, as measured by the Scope-adjusted loan/value ratio, improved to 52% as at end-December 2022 (down 2 pp YoY), helped by fair value increases. The company’s high exposure to tenants selling essential goods ensures cash flow, rental growth expectations and, thus, property values remain resilient. Nevertheless, increased yield requirements in a high interest rate environment are putting pressure on asset values, which Scope forecasts to result in a single-digit decrease in fair values. The associated potential increase in the Scope-adjusted loan/value ratio in addition to a potential increase due to the expansion strategy are expected to be covered by increases in equity or asset disposals to comply with the LTV requirement for REITs of below 55%.

Liquidity will continue to be burdened by the high share of short-term debt. Sources of liquidity (unrestricted cash of EUR 1m as at 30 September 2022 and Scope-adjusted free operating cash flow forecasted at EUR 19m) do not cover short-term debt of EUR 91m as at end-September 2022. However, liquidity risk is manageable in the short to medium term due to the headroom provided by the fully unencumbered investment properties (EUR 103m as at end-December 2022) and around EUR 90m in highly liquid investments including a EUR 82m short-term loan (at end-December 2022) under a EUR 95m credit line and another EUR 25m credit line, both provided by its main shareholder, Obotritia Capital KGaA. Scope sees limited risk related to the use of lending lines because DKR acquires properties using the funds lent to Obotritia as these can be withdrawn at any time. However, the risk would increase if Obotritia or other group companies continue to extract a significant amount of cash from this intercompany loan.

DKR does not yet have a dedicated ESG strategy. Most ESG requirements relate to the ESG strategies of tenants.

DKR is in a dispute with Potsdam tax authorities regarding its REIT status and is appealing. Nevertheless, DKR has formed tax provisions of EUR 14m as of the last reporting date, with a balancing receivable from the tax office. No matter the outcome, DKR has indicated that it will continue to adhere to the REIT rules.

Outlook and rating-change drivers

The Outlook for DKR is Stable and incorporates Scope’s expectation that DKR’s asset base will grow, via around EUR 70m in net expansion capex for FY 2022/23, leading to annualised rental income of EUR 80m-84m by end-September 2023. Scope anticipates further expansion to be financed with equal amounts of debt and equity. This will keep the Scope-adjusted loan/value ratio at around 55% into the medium term. Debt protection, as measured by Scope-adjusted EBITDA interest cover, is expected to deteriorate due to increased interest rates payable expected on new and refinanced debt but remain above 3x. 

A negative rating action is possible if the Scope-adjusted loan/value ratio reached above 55% on a continued basis, leading to DKR losing its tax-exempt REIT status. This could happen if property prices drop and DKR cannot address the increased loan/value ratio via asset disposals or equity issuances (due to the main shareholder becoming less willing and able to support capital increases either actively or passively).

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

Long-term and short-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 13 properties valued at EUR 96m as at September 2022. The structure’s over-collateralisation is adequate, with an issue-specific loan/value 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), a ‘superior’ recovery is expected in a default scenario, thus allowing for a two-notch uplift to BBB 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 2024/25 with a company liquidation value of EUR 712m, 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 420m 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 68m in Schuldschein loans. DKR’s Scope-adjusted unencumbered asset ratio amounts to 1.9x at end-December 2022, allowing for an uplift of the debt class rating to the BBB category according to Scope’s methodology.

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, (European Real Estate Rating Methodology, 25 January 2023; General Corporate Rating Methodology, 15 July 2022), are available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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 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 Outlook and the principal grounds on which the Credit Ratings and Outlook are based. Following that review, the Credit Ratings were not amended before being issued.
 
Regulatory disclosures
These Credit Ratings and Outlook are issued by Scope Ratings GmbH, Lennéstraße  5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and Outlook are UK-endorsed.
Lead analyst: Thomas Faeh, 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 29 March 2022.
 
Potential conflicts
See www.scoperatings.com under Governance & Policies/Regulatory for a list of potential conflicts of interest disclosures related to the issuance of Credit Ratings.

Conditions of use/exclusion of liability
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