SCF RC Master Funding I-II LLC (Series )

Transcription

1 Presale: SCF RC Master Funding I-II LLC (Series ) This presale report is based on information as of Nov. 29, The ratings shown are preliminary. This report does not constitute a recommendation to buy, hold, or sell securities. Subsequent information may result in the assignment of final ratings that differ from the preliminary ratings. Preliminary Ratings Class Preliminary rating(i) Preliminary amount (mil. $) LTV (%) A A (sf) B BBB (sf) (i)the rating on each class of securities is preliminary and subject to change at any time. LTV--Loan-to-value ratio. Profile Expected closing date December Collateral Issuers Property manager and special servicer Backup manager Indenture trustee Sole bookrunner and structuring agent 256 commercial real estate properties across various industry sectors under triple-net leases with the properties' tenants. SCF RC Master Funding I LLC and SCF RC Master Funding II LLC, which are all indirectly owned by SCF Realty Capital LLC. SCF Realty Capital LLC. Midland Loan Services. Citibank N.A. Credit Suisse Securities (USA) LLC. Primary Credit Analyst: Alexander Dennis, CFA, Chicago (1) ; alexander.dennis@spglobal.com Secondary Contact: Anna Qi, New York (1) ; chang.anna.qi@spglobal.com See complete contact list on last page(s) NOVEMBER 29,

2 Rationale The preliminary ratings assigned to SCF RC Master Funding I-II LLC's $ million triple-net lease mortgage notes series reflect our opinion of the credit enhancement available in the form of subordination (for the class A notes), overcollateralization (the aggregate collateral value minus the aggregate allocated loan amount), and the available cushion as measured by the issuers' 1.57x debt service coverage ratio (DSCR). Our preliminary ratings also reflect our view of SCF Realty Capital's (the servicer's) property management and special servicing abilities, the projected cash flows supporting the notes, and the transaction's legal and payment structures. Transaction Strengths The transaction's strengths, in our opinion, include: The properties are typically essential to their respective tenants' operations and ability to generate revenues. The triple-net nature of the leases requires the tenants to pay all maintenance, taxes, and insurance on the properties. The properties are geographically diversified across 35 states. The majority of the properties are subject to master leases, which may reduce any individual property's potential weakness to generate income to support the notes. The property manager and the backup manager must make interest and property protection advances to the extent deemed recoverable. The level of principal amortization before the anticipated repayment (ARD) is moderate. The transaction includes certain performance tests, such as early amortization and a DSCR sweep. Transaction Weaknesses The transaction's weaknesses, in our opinion, include: The tenants' ability to relocate may decrease the occupancy rate and lease income. Some of the properties are not located in densely populated areas. The time needed to find replacement tenants when leases expire or terminate may reduce cash flows. The largest industry group (restaurants and other eating places) represents 74.71% of the properties. The properties may be subject to laws and regulations relating to human health and the environment. Several of the properties do not report unit level fixed-charge coverage ratios (FCCRs). For these situations, typically there is either only sales-level reporting or an FCCR at the corporate level. Several of the leases have optional termination provisions for the tenants, which could reduce cash flow available to repay noteholders if exercised. Several of the properties may be exposed to additional environmental liabilities in the future. For example, properties that were previously gas stations still have underground storage tanks. NOVEMBER 29,

3 Mitigating Factors The following factors, in our opinion, partly mitigate the transaction's weaknesses: SCF RC Master Funding I-II LLC's strategy mainly focuses on operationally essential real estate, which may help reduce tenant relocation upon lease expiration. The properties generally possess good unit-level profitability and have a weighted average unit FCCR of approximately 2.82x. The portfolio benefits from a diverse geographic footprint and tenant base. The properties' general design may accommodate various business types and allows for greater flexibility to replace outgoing tenants. Under our stress scenarios, timely interest and ultimate principal payments are paid on the notes by their legal final maturity. An environmental site assessment was completed for each property, revealing no material adverse environmental conditions. Furthermore, the typical lease includes indemnifications by the tenant relating to various liabilities at the properties, including potential environmental conditions. For leases with early termination provisions, we assumed the early termination options were exercised, which stresses cash flow by triggering re-leasing at lower lease rates earlier in our simulation. We treated properties that only reported sales data instead of unit FCCRs similar to defaulted leases such that they were released at stressed lease rates at the beginning of our cash flow simulation (see the Stress Scenario Assumptions section below for a full description of our treatment of defaulted leases). For properties that were previously gas stations, we assumed a 0% liquidation value. Business Description: SCF Realty Capital LLC The parent company of the issuers and co-issuers is SCF Realty Capital Trust LLC, a Delaware limited liability company, which is a wholly owned subsidiary of SCF Realty Capital LLC (SCF RC), a Delaware limited liability company. SCF RC, established in 2016, provides long-term financing to single-tenant real estate properties operating across a wide variety of industries within the service, retail, and industrial sectors. As of Aug. 31, 2016, SCF RC had an estimated enterprise value of $420 million comprising a portfolio of 327 properties across 35 states. SCF RC directly or indirectly owns substantially all of its assets, including its real estate assets, through various subsidiaries. SCF RC seeks to invest in properties that are leased to small- and middle-market companies that it determines to have attractive credit characteristics and stable operating histories. Many of the companies operate numerous facilities. In addition to small- and middle-market companies, SCF RC may selectively acquire properties leased to large companies that it believes can achieve superior risk-adjusted returns. Underwriting Guidelines SCF RC invests in properties that are leased to small- (less than 50 locations and between $3 million and $100 million in annual sales) and middle-market (between 50 and 500 locations and $100 million to $2 billion in annual sales) companies. SCF RC believes properties leased to small- and middle-market companies offer superior risk-adjusted NOVEMBER 29,

4 returns, as a result of SCF RC's credit and real estate analysis, lease structuring, and portfolio construction. These companies are often willing to enter into leases with attractive structures and terms that SCF RC believes increase the likelihood of rental payments. For example, by acquiring multiple properties from a small- or middle-market company and leasing them back to the seller under a master lease, the leased properties may represent a meaningful percentage of the tenant's overall operations and increase the importance of the lease to the tenant's business. Most tenants in the collateral pool are not rated by any nationally recognized statistical rating organization. SCF RC therefore estimates creditworthiness by using financial information provided to it by a tenant or prospective tenant. Industry Characteristics: Sector Outlook S&P Global Ratings maintains a positive outlook on the North American REIT sector, reflecting second-quarter 2016 earnings that were generally in line with our expectations for continued same-store net operating income (NOI) growth. We expect the pace of upgrades to decelerate as the year progresses because we believe NOI growth may decelerate and expect the pace of balance sheet improvement to slow down. Drivers of real estate demand (such as job growth) remain solid as a result of steady (albeit slow) economic growth, with a robust labor market and improving consumer spending. While real estate supply in certain markets is increasing, we believe the majority of REITs we rate remain disciplined in terms of development activity compared with previous cycles, and lending standards remain tight. We expect supply absorption in most markets to remain healthy and the level of new supply to remain manageable. Given positive demand and limited supply, we expect the overall pace of NOI growth to remain steady for the remainder of 2016, at about 4.0%, compared with 4.7% last year, with some subsectors experiencing varying growth levels. The retail REIT subsector continues to report stable growth even though it is underperforming the aggregate REIT universe. As the year progresses, increasing operating risk in retail properties (vacancy and re-leasing risk) in certain markets could result in weaker-than-expected performance. Retail REITs could face an increased number of tenant bankruptcies and could experience occupancy and NOI pressure. A broader and faster pace of store closures could also pressure REITs' performances despite limited new supply in the subsector. However, lack of new supply and relatively stable demand remain key factors driving adequate performance. Most retail REITs are focusing on redevelopment and increasing small-shop occupancy. An uptick in retail bankruptcies resulting in a large number of store closings (particularly anchors) are headwinds (re-leasing) and opportunities (low legacy lease rates). Transaction Comparison We compared this transaction with the STORE Master Funding I LLC/STORE Master Funding II LLC/STORE Master Funding III LLC/STORE Master Funding IV LLC/STORE Master Funding V LLC/STORE Master Funding VI LLC/STORE Master Funding VII LLC, Spirit Master Funding LLC/Spirit Master Funding II LLC/Spirit Master Funding III LLC/Spirit Master Funding VI LLC/Spirit Master Funding VIII LLC, and Spirit Master Funding VII LLC transactions, which we rated in March 2013, November 2014, and December 2013, respectively (see "STORE Master Funding I LLC/STORE Master Funding II LLC Series $270 Million Notes Assigned Ratings," published March NOVEMBER 29,

5 27, 2013, "Spirit Master Funding/II/III/VI/VIII LLC $ Million Series Notes Assigned Ratings," published Nov. 26, 2014, and "Spirit Master Funding VII LLC $330.0 Million Notes Series And Assigned Ratings," published Dec. 23, 2013) All three transactions are collateralized primarily by commercial real estate properties (see table 1). Table 1 Transaction Comparison SCF RC Master Funding I-XI LLC STORE Master Funding I LLC/STORE Master Funding II LLC/STORE Master Funding III LLC/STORE Master Funding IV LLC/STORE Master Funding V LLC/STORE Master Funding VI LLC/ STORE Master Funding VII LLC(i) Spirit Master Funding LLC/Spirit Master Funding II LLC/Spirit Master Funding III LLC/Spirit Master Funding VI LLC/Spirit Master Funding VIII LLC(ii) Spirit Master Funding VII LLC(iii) Lease (%) Mortgage loans (%) Largest industry group concentration (%) Largest state concentration (%) Non-zero weighted average FCCR (i)as of October (ii)as of November (iii)as of December FCCR--Fixed charge coverage ratio as reported in the offering memorandum. Pool And Structural Characteristics For the noteholders' benefit, the issuers will grant the indenture trustee a mortgage and assignment of leases for each property included in the collateral. SCF RC Master Funding I-II LLC, according to a guaranty, will agree to repurchase any property for which an issuer has breached certain representations or warranties. The issuers may also substitute certain properties subject to specific criteria that maintain the pool's characteristics (see table 2 for the pool characteristics as of the Sept. 30, 2016, cut-off date). Table 2 Pool Characteristics Aggregate collateral value (mil. $) Aggregate allocated loan amount (mil. $) No. of owned properties 256 No. of leases 94 No. of hybrid leases 0 Average collateral value (mil. $) 1.37 Range of collateral value ($) 170,000-9,230,000 Weighted average initial lease term (mos.) Weighted average remaining lease term (mos.) Range of initial lease term (mos.) Range of remaining lease term (mos.) NOVEMBER 29,

6 Table 2 Pool Characteristics (cont.) Loan-to-value (%) Class A: 75; class B: 80 Weighted average unit FCCR 2.82 Issuer DSCR(i) 1.57 Largest five tenants/borrowers Captain D'S LLC (22.55%); Perkins & Marie Callender's LLC (11.33%); Mirabito Holdings Inc. (10.13%); Doherty Florida 103rd St. LLC (8.53%); and Neighborhood Restaurant Partners Florida Two LLC (5.75%) Largest three state concentrations Georgia (17.91%), Florida (16.27%), and Texas (11.92%) (i)as of the closing date. FCCR--Fixed charge coverage ratio. DSCR--Debt service coverage ratio. Transaction Structure The issuers are bankruptcy-remote special-purpose entities (SPEs) that may, at a future date, issue additional series of notes secured by the entire collateral pool. Each month, available funds will first be used to pay expenses on the collateral pool in the priority shown in table 3. Table 3 Collateral Pool Expense Waterfall Priority Payment 1 Indenture trustee fee. 2 Property manager fee. 3 Special servicer fee. 4 Backup manager fee. 5 Reimbursement of advances and extraordinary expenses (subject to an annual limit) to the property manager, special servicer, backup manager, or indenture trustee. 6 Issuer expenses (subject to an annual limit). 7 Reimbursement of extraordinary expenses (subject to an annual limit) to any relevant third party not previously paid. Any remaining funds will be distributed to pay the series notes based on the series' available amounts in the priority shown in table 3. If, at a future date, the issuers (or any subsequent co-issuers) issue additional series of notes, the funds remaining after paying the collateral pool expenses will first be distributed pro rata among all of the outstanding series, and then the amount allocated to each series will be distributed in the priority shown in table 4. Table 4 Series Waterfall Priority Payment 1 Class A interest. 2 Class B interest. 3 If not in an early amortization period, pay class A scheduled and unscheduled principal; if in an early amortization period, use all available funds to pay down the class A principal balance until it is reduced to zero. 4 If not in an early amortization period, pay class B scheduled and unscheduled principal; if in an early amortization period, use all available funds to pay down the class B principal balance until it is reduced to zero. 5 If during a DSCR sweep period, pay the DSCR reserve account until the amount on deposit equals the aggregate series principal balance. 6 Class A make-whole amount, if any. NOVEMBER 29,

7 Table 4 Series Waterfall (cont.) Priority Payment 7 Class B make-whole amount, if any. 8 Class A post-ard additional interest and deferred post-ard additional interest, if any. 9 Class B post-ard additional interest and deferred post-ard additional interest, if any. 10 Issuer and extraordinary expenses to the extent not paid in table All remaining funds to the issuers. DSCR--Debt service coverage ratio. ARD--Anticipated repayment date. If the monthly DSCR level (all collected and available funds divided by the monthly debt service on the notes) is less than or equal to 1.25x and an early amortization period is not in effect, a DSCR sweep period will occur. During this period, the funds remaining after paying item 4 in table 3 will be deposited into the DSCR reserve account. A DSCR sweep period will continue until the monthly DSCR is greater than 1.25x for three consecutive determination dates or an early amortization period begins. The issuers will use all funds in the DSCR reserve account as available funds in an early amortization event. An early amortization period will be in effect if the three-month rolling average DSCR level is less than or equal to 1.15x, any series of notes has not been fully redeemed by its respective ARDs in November 2021, or an event of default has occurred. An early amortization period caused by a low DSCR will cure after the DSCR level is above 1.15x for three consecutive months. As noted in items 3 and 4 in table 3, all available funds (after paying expenses and interest) will be paid sequentially to classes A and B until their principal balances are reduced to zero. The property manager must make interest or principal advances on the notes, to the extent they are deemed recoverable. The advances are meant to cover any shortfalls resulting from missed lease payments or property vacancies, as well as any interest and principal shortfalls, in case the notes may not be paid in full by their final maturity. This requirement excludes principal payments in the post-ard period (other than on the final maturity date), make-whole amounts, post-ard additional interest, and deferred post-ard additional interest. If the property manager fails to make an advance, the backup manager must make the advance in its place. These requirements for advances serve as a form of liquidity for the notes. S&P Global Ratings' Stress Scenario Assumptions In accordance with our criteria for rating single-tenant real estate triple-net lease-backed securitizations, we ran various cash flow scenarios to determine the appropriate preliminary ratings for the series notes, given the transaction's credit enhancement, and we tested the transaction's sensitivity to changes in default timing (see "Methodology And Assumptions For Rating North American Single-Tenant Real Estate Triple-Net Lease-Backed Securitizations," published March 31, 2016). In our opinion, the risk to the cash flow generated from the portfolio of properties and their associated leases stems from four major factors: Defaults of the initial pool of tenants (the lessees); NOVEMBER 29,

8 The property manager's ability to re-lease the properties vacated by defaulted lessees to new tenants, and the renewal rate of tenants who reach the end of their leases; The lease terms for new tenants (rental rate and term of lease); and The liquidation value of those properties that the manager can't re-lease and chooses to liquidate. We used Standard & Poor's CDO Evaluator in conjunction with our ratings on the lessees (or 'B' for unrated lessees), the collateral value of future lease payments, and the current lease terms to determine the initial pool of lessees' initial default rate. Under our 'A ' and 'BBB' stress scenarios, our default assumptions for the portfolio are 77.2% and 66.1%, respectively. If a tenant defaulted, we assumed that 30.0% and 20.0% of the properties for the 'A' and 'BBB' stress scenarios would be liquidated, respectively. We assumed stressed liquidation values of 27.7% and 32.0% of the appraised value for the 'A' and 'BBB' stress scenarios, respectively (subject to a 12-month lag). For properties with potential environmental issues, including properties that were gas stations before their current use, we assumed 0% stressed liquidation values. We assumed the remaining defaulted properties were re-leased for a second lease cycle (subject to a 12-month lag) with lease terms equal to 100.0% of the weighted average original term of the leases in the portfolio and at a rental rate equal to 70.0% and 75.0% of the rental rate under 'A' and 'BBB' stresses, respectively. At the end of this second lease cycle, we assumed the properties would be liquidated at 67.3% of the appraised value. To determine the various liquidation values assumed above, we estimated the properties' values using our commercial real estate methodology under three specific circumstances: The property is occupied by a tenant that is making full payments under the lease (the leased value). In determining each property's leased value, we assumed rental income based on the in-place leases, the appraiser's estimate of market rent, and recent leasing data from the market. We also applied a vacancy deduction to the potential gross income. We estimated expenses and expense reimbursements based on information from the appraisals and comparable properties. These expenses included fixed items, such as real estate tax and insurance, estimated management fees, and variable expenses, which were reimbursed in our income projections. We determined net cash flow after deducting estimated leasing commissions, tenant improvement expenses, and capital reserves and expenditures based on projected lease roll assumptions. We selected direct capitalization rates based on such factors as appraisal and market cap rates, property performance and tenant strength, and property type. The property is unoccupied but is still a viable location that can be used with minor structural improvements (the dark value). In determining a dark value, we assumed each property was unoccupied and unencumbered by any leases. Because we viewed this operating performance decline as temporary, we stabilized the dark properties with income and expense projections based on market data and information from the appraisal. We deducted capital items from S&P Global Ratings' NOI, including tenant improvements and leasing costs required to lease up the entire unoccupied space. We then estimated one year of downtime for the lease-up. We used a stressed capitalization rate for this analysis. The property is no longer a viable location for the existing tenant or another related business and must undergo major construction for alternate use. In these cases, we typically limit the liquidation value to the land value. For each rating stress scenario, we assumed a stressed liquidation value for the properties being liquidated after a default of the lessee, and we assumed a 67.3% expected case value for the properties being liquidated at the end of the second lease cycle. NOVEMBER 29,

9 Cash Flow Analysis To determine whether the available credit support is sufficient to withstand the assumed losses, we examined various simulated cash flow scenarios. In each, the cumulative effects of the assumptions we detailed above were four default curves in two default cycles (see table 5). In each scenario examined, the class A and class B notes could pay timely interest and full principal by their rated final maturity. Although the transaction documents require the property manager and backup manager to make advances on interest payments (to the extent deemed recoverable), no advances were assumed in the cash flow modeling scenarios. Table 5 Default Curves Year Curve 1 (%) Curve 2 (%) Curve 3 (%) Curve 4 (%) Legal Structure The issuers are bankruptcy-remote, Delaware limited liability companies, which were formed solely to hold the owned properties and the related leases and to issue notes. The issuers' sole member is SCF RC, a Delaware limited liability company and a wholly owned subsidiary of SCF Funding LLC, a Delaware limited liability company. We expect the issuers' SPE provisions to be consistent with S&P Global Ratings' bankruptcy-remoteness criteria. In rating this transaction, S&P Global Ratings will review the legal matters that it believes are relevant to its analysis, as outlined in its criteria. Related Criteria and Research Related Criteria Methodology And Assumptions For Rating North American Single-Tenant Real Estate Triple-Net Lease-Backed Securitizations, March 31, 2016 Principles For Rating Debt Issues Based On Imputed Promises, Dec. 19, 2014 Global Investment Criteria For Temporary Investments In Transaction Accounts, May 31, 2012 Understanding Standard & Poor's Rating Definitions, June 3, 2009 Legal Criteria For U.S. Structured Finance Transactions: Special-Purpose Entities, Oct. 1, NOVEMBER 29,

10 Related Research Research Update: STORE Capital Corp. Assigned 'BBB-' Rating, Positive Outlook, Aug. 31, 2016 Spirit Master Funding/II/III/VI/VIII LLC $ Million Series Notes Assigned Ratings, Nov. 26, 2014 Global Structured Finance Scenario And Sensitivity Analysis: Understanding The Effects Of Macroeconomic Factors On Credit Quality, July 2, 2014 Spirit Master Funding VII LLC $330.0 Million Notes Series And Assigned Ratings, Dec. 23, 2013 STORE Master Funding I LLC/STORE Master Funding II LLC Series $270 Million Notes Assigned Ratings, March 27, 2013 In addition to the criteria specific to this type of security (listed above), the following criteria articles, which are generally applicable to all ratings, may have affected this rating action: "Post-Default Ratings Methodology: When Does Standard & Poor's Raise A Rating From 'D' Or 'SD'?," March 23, 2015; "Global Framework For Assessing Operational Risk In Structured Finance Transactions," Oct. 9, 2014; "Methodology: Timeliness of Payments: Grace Periods, Guarantees, And Use of 'D' And 'SD' Ratings," Oct. 24, 2013; "Counterparty Risk Framework Methodology And Assumptions," June 25, 2013; "Criteria For Assigning 'CCC+', 'CCC', 'CCC-', And 'CC' Ratings," Oct. 1, 2012; "Methodology: Credit Stability Criteria," May 3, 2010; and "Use of CreditWatch And Outlooks," Sept. 14, STORE Master Funding I LLC/STORE Master Funding II LLC Series $270 Million Notes Assigned Ratings," published March 27, 2013, "Spirit Master Funding/II/III/VI/VIII LLC $ Million Series Notes Assigned Ratings," published Nov. 26, 2014, and "Spirit Master Funding VII LLC $330.0 Million Notes Series And Assigned Ratings," published Dec. 23, 2013) All three transactions are collateralized primarily by commercial real estate properties (see table 1). Analytical Team Primary Credit Analyst: Alexander Dennis, CFA, Chicago (1) ; alexander.dennis@spglobal.com Secondary Contact: Anna Qi, New York (1) ; chang.anna.qi@spglobal.com NOVEMBER 29,

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