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Rating action

Scope Ratings GmbH (Scope) has today assigned an initial issuer rating of B-/Positive to DEMIRE Deutsche Mittelstand Real Estate AG (hereafter ‘DEMIRE’). Concurrently, Scope has assigned an initial rating of B to DEMIRE’s senior secured bond (ISIN DE000A2YPAK1).

The rating is supported by the recent bond restructuring¹, which provides time to continue the divestment plan to reduce leverage and stabilise the capital structure. A further benefit is the moderate profitability of the underlying property portfolio, which is diversified by property type and geography and supports stable cash generation. However, the rating is constrained by future risks related to high tenant concentration, weak asset quality and ongoing refinancing needs with another peak in 2027.

The full list of rating actions and rated entities is at the end of this rating action release.

Key rating drivers

Business risk profile: BB-. DEMIRE's business risk profile benefits from a portfolio that is diversified across Germany and property types, as well as moderate operating profitability. It is constrained by the company’s limited size, tenant and property concentration, which could make cash flow more volatile, and generally weak asset quality due to a more secondary portfolio with underperforming assets in terms of occupancy and rental growth.

DEMIRE is a German commercial real estate company of limited size with a portfolio of 54 properties, diversified across property types and Germany, with a focus on B and C cities in economically strong federal states. The company's asset base has shrunk significantly since the end of 2021 and is expected to decrease further with planned asset disposals to further deleverage. A shrinking asset base will further weaken DEMIRE's market positioning as it affects its access to tenants and investors as well as debt and equity markets.

DEMIRE’s portfolio has cluster risk, with the top 10 properties accounting for almost half of contracted rental income – a share that is expected to increase if targeted asset sales are successfully executed – and high tenant concentration, with the top three tenants accounting for 27% and the top 10 tenants accounting for 46% of rental income at the end of September 2024. This high concentration could lead to significant volatility, not only in the portfolio's key performance indicators, such as rental growth or occupancy, but also in cash generation. The latter is partially mitigated by the relatively high proportion of government or municipal (e.g. Bima, the City of Freiburg) and blue-chip tenants (e.g. Commerzbank, Deutsche Telekom). Nevertheless, DEMIRE has recently had an increasing bad debt ratio. This reflects the moderate to weak quality of its smaller tenants as well as the recent insolvencies of Mein Real (2023) and Galeria Karstadt Kaufhof (2024).

In Scope's view, DEMIRE’s limited size and more secondary, non-certified portfolio (ESG factor: credit negative) means it lacks the visibility and competitive advantage to attract high-profile, blue-chip tenants in an environment where tenants are more focused on strong locations and ESG-compliant properties, and it will be challenging to keep these tenants. As such, Scope believes that the tenant structure will change, leaving DEMIRE with a more granular tenant base, albeit of weaker quality, (SMEs or MicroCaps making up the majority of tenants), which is credit positive.

DEMIRE's asset quality is weak compared to its peers. The occupancy rate has been declining continuously since 2019 and stood at 85% at the end of September 2024. The WAULT has also declined, reaching 4.4 years. Poor asset quality is reflected in recent negative like-for-like rental growth (2023: -3.5%, 2024 YTD: -3.2%), which indicates structural weaknesses in the property and tenant portfolio. However, Scope expects rents to grow slightly, supported by potential rent increases, as 75% of leases are index-linked as well as some reversionary potential, offsetting an expected small but steady rise in vacancy. Stronger rental growth is possible if DEMIRE's increased investment bears fruit and parts of the portfolio are reconfigured to increase its attractiveness to tenants.

The good profitability of DEMIRE's buy-and-hold business is the main support for the company's business risk profile. The Scope-adjusted EBITDA margin* has been somewhat volatile but has stabilised above 60% on average (2023: 62%, last twelve months to end-September 2024: 59%). Going forward, Scope expects the EBITDA margin to stabilise at around 60% as rental growth largely offsets a higher proportion of non-recoverable operating costs from vacancy increases.

Financial risk profile: B-. DEMIRE’s financial risk profile is supported by the recent bond restructuring, which provides time to continue with the divestment plan to reduce leverage and stabilise the capital structure. However, it is constrained by the company's continued reliance on external financing or asset sales to meet upcoming debt maturities.

In November 2024, DEMIRE announced the successful completion of the restructuring of its EUR 600m bond (outstanding notional amount: EUR 499m before restructuring), which was originally due in October 2024. Key elements of the restructuring included the extension of the remaining bond nominal to end-December 2027 with a 5% cash coupon and a 3% payment-in-kind (PIK) coupon in 2027. The restructuring reduced the nominal amount of the bonds by EUR 246m through a tender for EUR 50m at par and a tender for EUR 196m mainly at a price of 76.25%. The partial redemption was funded by cash on the balance sheet and a EUR 93m shareholder loan. Scope does not provide an equity credit for the shareholder loan as it does not meet the required criteria, while it is structurally subordinated to senior secured debt.

DEMIRE benefits from limited incremental funding requirements due to good operating cash generation from its buy and hold portfolio and the PIK nature of the shareholder loan provided. As such, Scope expects debt levels to remain stable despite increased capital expenditure, which should help to stabilise or improve cash generation. The successful completion of the issuer’s divestment programme will enable further debt reduction and alleviate ongoing refinancing concerns/stabilise the capital structure.

The loan/value ratio is expected to decline to between 50% and 55% in the future from 61% at end-2023 (end-September 2024: 55%), with only limited fair value adjustments foreseen until 2026. Further improvements depend on the realisation of divestment proceeds, which could significantly improve not only the loan/value, but also debt/EBITDA, which remains between 13x and 15x in Scope's rating scenario (last twelve months to end-September 2024: 13.5x). While Scope expects positive like-for-like rental growth, this will not be sufficient to significantly reduce debt/EBITDA over the next 12-24 months. This is mainly due to the reduced portfolio size following the deconsolidation of the Limes portfolio, which did not contribute to deleveraging due to its non-cash nature.

EBITDA interest coverage is expected to remain above 2.2x (last 12 months to end-September 2024: 4.1x), despite the expected increase in the weighted average cost of debt to over 8% at end-2024 (end-September 2024: 1.9%). This is driven by the coupon increase to 5% from 1.875% on the EUR 600m bond extension in November and the 22% interest burden on the EUR 93m shareholder loan. However, the shareholder loan has a PIK toggle, which is expected to be used on each interest payment date to support the issuer's liquidity profile. In addition, the bond incentivises early redemption of a minimum of EUR 50m in 2025 and 2026 to avoid PIK interest in the form of an extension fee (on top of the cash coupon) of 3% in 2026 and 2% in 2027 (not part of the rating case assumptions).

Liquidity: inadequate. Liquidity is inadequate. Cash sources (pro forma cash of approximately EUR 60m at end-September 2024 following the bond restructuring and expected free operating cash flow of EUR 40m until the end of 2026) are not considered sufficient to cover cash needs (EUR 109m of maturing bank debt between end-September 2024 and the end of 2026). However, Scope believes that most maturing loans will be rolled over, refinanced with other banks or will not necessarily result in cash outflows for DEMIRE. This is because these loans are non-recourse.

This will not be the case for capital market debt. As such, Scope notes that the EUR 252m bond repayment in 2027 is dependent on either the successful execution of asset sales to free up the required capital or the extension and increase of secured financing. Significant progress on the divestment programme over the next 12-18 months could alleviate Scope’s concerns about the issuer's liquidity profile.

Supplementary rating drivers: credit-neutral. Supplementary rating drivers have no impact on the issuer rating.

One or more key drivers of the credit rating action are considered an ESG factor.

Outlook and rating sensitivities

The Positive Outlook reflects the stabilisation of the issuer's capital structure through the recent bond restructuring, which provides some time to further deleverage without an immediate stress on liquidity, which remains under pressure. Deleveraging the balance sheet is expected through significant, planned asset sales, while the loan/value and debt/EBITDA are expected to remain between 50-55% and 13-15x, respectively, for the time being without additional property sales. In addition, the Outlook takes into account the continued refinancing of secured bank loans, albeit at a higher all-in cost, but still enabling DEMIRE to maintain an EBITDA interest cover above 2.2x going forward.

The upside scenario for the ratings and Outlook is:

• Easing concerns about the company's liquidity profile, supported by a further reduction in senior secured bonds enabled by further asset sales.

The downside scenario for the ratings and Outlook is:

• Growing concerns about liquidity and refinancing, triggered by a delay in asset sales relative to the issuer's plans.

Debt rating

DEMIRE has EUR 252m in capital market debt (senior secured bond) outstanding as at end-November 2024.

Scope’s recovery analysis for the senior secured bond (ISIN DE000A2YPAK1) suggests an excellent recovery, which would theoretically allow for a three-notch uplift on the issuer rating. The recovery is based on a hypothetical default scenario in FY 2026 with a distressed enterprise value of EUR 585m. This value is based on the liquidation value of the company and includes a discount of approximately 26% for DEMIRE's investment properties, consistent with a B category stress and reflecting the secondary nature of the portfolio, as well as 10% for insolvency costs. This compares to forecasted secured bank debt of EUR 137m, a secured bond of EUR 252m and EUR 143m in unsecured subordinated debt at the time of a potential default.

Scope has assigned a B rating to the senior secured bond, one notch above the issuer rating. While Scope acknowledges the collateral provided (share and account pledges) for the senior secured bond, there is a significant amount of secured bank debt that ranks higher than the senior secured bond and benefits from a better collateral package (collateralised by real estate). The rating agency also notes the potential volatility of the capital structure on the path to default, which could involve the introduction of additional secured bank debt. Both of these factors could reduce the recovery expectations of the holders of the senior secured bond, which constrains the up-notching of the debt instrument rating for the senior secured bond to one notch.

Environmental, social and governance (ESG) factors

Scope has made no adjustment for governance under supplementary rating drivers but highlights the rated entity's complex group structure. While the multi-layered structure allows DEMIRE to protect its liquidity in times of disruption within the property/sub-holding SPVs (see Limes default²), it creates some operational risk. However, the double LuxCo structure created because of the bond restructuring gives bondholders direct access to the shares of the companies under the second LuxCo layer (including DEMIRE and Fair Value REIT-AG) in the event of default. Scope sees this as an advantage over the previous structure.

DEMIRE's portfolio of non-certified properties is a competitive disadvantage which, combined with the more secondary locations in which the issuer operates, limits the rent levels achievable and requires relatively high capital expenditure to remain attractive to tenants, thereby avoiding the risk of stranded assets.

All rating actions and rated entities

DEMIRE Deutsche Mittelstand Real Estate AG

Issuer rating: B-/Positive, new

Senior secured debt instrument (ISIN DE000A2YPAK1) rating: B, new

*All credit metrics refer to Scope-adjusted figures.

Rating driver references
1. DEMIRE - Corporate news 11/11/2024
2. DEMIRE - Ad-hoc news 22/07/2024

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, (General Corporate Rating Methodology, 16 October 2023; European Real Estate Rating Methodology, 28 March 2024), 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/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 these 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 and/or Outlook were 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, Managing Director
Person responsible for approval of the Credit Ratings: Sebastian Zank, Managing Director
The Credit Ratings/Outlook were first released by Scope Ratings on 19 December 2024.

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, as well as a list of Ancillary Services and certain non-Credit Rating Agency services provided to Rated Entities and/or Related Third Parties.

Conditions of use/exclusion of liability
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