OREANDA-NEWS. November 17, 2015. Fitch Ratings has affirmed the UK's largest residential landlord Grainger Plc's (Grainger) Long-term Issuer Default Rating (IDR) at 'BB' and its senior secured notes at 'BB+'. The Outlook on the Long-term IDR is Stable.

KEY RATING DRIVERS
German Portfolio Recycling
The planned disposal of the German portfolio is in line with Grainger's renewed focus on the UK. We expect the proceeds to be recycled into UK market-rented assets along with proceeds from its revisionary portfolio in both acquisitions and developments, and as wholly owned and real estate partnerships. In addition to the roughly 1,000 units acquired in the financial year ending 30 September 2015, Grainger has a secured pipeline of a further 600 built-to-rent units together with a significant number of additional properties where it is the preferred bidder or at an advance stage of appraisal.

Increasing Market Rent Assets
Grainger plans to recycle a greater proportion of its regulated property assets back into market- rented properties to increase its recurring income streams. This is likely to be achieved through the development of market-rented properties such as build-to-let schemes. The expected change in business profile is unlikely to affect the rating as we believe the shift will be gradual and we do not forecast a material change in the financial profile. Fitch expects Grainger to adopt a cautious approach, with a commitment to limit development assets to no more than 10% of the group's total assets and the use of third party capital, aided by its proven track record in establishing real estate partnerships.

Stable Forecasts
After years of deleveraging through net divestments, Grainger has reached its management target for LTV, ending its delivering programme and we expect the majority of future proceeds to be reinvested into market rented assets. We expect the Fitch-adjusted LTV to remain below the current 55% level and Fitch-adjusted EBITDA net interest coverage (NIC) to decline to 1.7x in FY15 from 1.9x in FY14 and then improve in the coming years as more market-rented assets come into the portfolio, increasing rental cash flows. Our rating case expects Grainger to generate on average GBP110m EBITDA, converting into cash flow expected to be redeployed into property development and acquisition.

Fitch includes net rental income, fee income and trading profits into its EBITDA estimates in line with management's calculation of operating profit less non-recurring and fair value items. Fitch's LTV is roughly 8% higher than management's consolidated reported LTV as we exclude net asset value from associated and JV interests and development assets.

Stable Operating Risk Profile
The ratings reflects Grainger's bias towards the London market, a defensive GBP1.9bn property portfolio focused on regulated tenancies and recent deleveraging driven by divestments. Grainger's business model is more focused on proceeds from portfolio sales than wholly on recurring rental income as with investment-grade REIT peers. Furthermore, its financial metrics and debt structure - although robust for the ratings - are likely to limit Grainger from reaching investment grade. Our investment-grade REITs typically exhibit LTVs comfortably below 50%.

London-focused Residential Portfolio
Grainger's portfolio of around 8,600 wholly owned units is spread across the UK with London and the South East accounting for 42% by value at end-1H FY15. The portfolio is defensive and largely affordable housing units linked to regulated tenancies, where tenants are often on state benefits with an average age of 71 years. The average value of a UK unit is around GBP230,000 based on vacant possession value. For the time being, a further 2,800 units in Germany add modest geographical diversification and these are all market-rented properties.

Syndicated Loan Refinanced
Grainger refinanced its core syndicated loan facilities in August 2015. The amount committed is GBP580m, of which a term loan is around GBP250m and a revolving credit facility is GBP330m. Both mature in August 2020, extending average maturities post-refinancing to 5.8 years from 4.4 years at end-1H15 with lower interest rates (interest margin at 170 basis points). The average cost of debt was reduced to 4.6% following the refinancing from 5.4% in FY14 and 6.1% in FY13.

Solid Asset Cover
The GBP275m secured notes are rated a notch higher than Grainger's IDR to reflect above-average recovery expectations. The secured notes benefit from a guarantor group providing a floating charge over a large majority of Grainger's UK residential portfolio, in turn providing an asset cover of around 1.4x as of end-March 2015 (asset cover is defined as the market value of properties held by the secured notes core guarantors over core gross debt facilities). The secured notes rank pari passu with other secured lenders. Secured noteholders further benefit from a parent guarantee and a sizeable net asset value from non-guarantor wholly owned subsidiaries and JV investments leading to an asset cover above 1.5x.

KEY ASSUMPTIONS
- Low single digit house price inflation driving trading profits and gross rental income over the next three years.
- Increased recurring rental income from its growing market-rented portfolio.
- Trading profits in line with historical average as revisionary assets are vacated and sold leading to free cash flow.
- Development capex spending of GBP200m-GBP250m during the next three years and a rising proportion of built-to-rent assets for its own balance sheet.
- Lower interest costs as interest rates trend towards 4.6% average cost achieved in rent refinancing and swap expiry.
- Disposal of the German portfolio and gradual reinvestment into UK assets in the coming three years.

RATING SENSITIVITIES
Negative: Future developments that could lead to negative rating action include:
- A material reduction in trading, rental and fee income resulting in EBITDA NIC below 1.25x on a consistent basis and LTV above 65%.
- Declining asset cover to below 1.2x and shrinkage of the core guarantors' property portfolio to below GBP500m for the secured group.
- Liquidity score on an 18-month cycle below 1.25x (above 2.0x at end-March 2014) and a decline in average debt maturities to below three years (around five years at end-March 2014).

Positive: Future developments that could lead to positive rating action include:
- The likelihood of an upgrade is limited at this time considering the reliance on asset sales and the future capex requirement embedded in the change in business profile.
- Sustainable recurring trading, rental and fee income resulting in EBITDA NIC above 1.75x on a consistent basis and LTV below 50%.
- Increase asset cover to above 1.5x for the main secured group.
- Improved diversification of funding sources with longer debt maturities.

LIQUIDITY
Solid Liquidity
Available liquidity remains good with GBP242m available at end-1H FY15 and its syndicated facilities renewed in 3Q. Refinancing risk is low as Grainger has refinanced its main facilities extending maturities to 2020, it maintains diversified sources of capital and has demonstrated a strong track record in deleveraging and obtaining support from relationship banks. The group also has a solid track record of accessing equity markets and establishing real estate partnerships that allow for third party capital to grow the business.