Unsecured debt secured by some EMEA real estate companies, attracted by low funding costs and migration from bank funding, could be vulnerable to low recovery rates because of subordination to legacy secured debt, according to Fitch Ratings.
“If we were to rate these transactions, this risk could lead us to notch the rating of unsecured debt down from the issuer’s IDR,” it added.
Unrated or recent debut EMEA real estate issuers have traditionally been dependent on secured funding from either the banking sector or structured products such as CMBS. The move towards unsecured debt is typically a funding cost arbitrage strategy to the benefit of equity investors. But recoveries may be low if there is not a suitable level of unencumbered assets and income cover to support unsecured bondholders. We look for unencumbered assets to be at least double an issuer’s unsecured debt before assigning an investment-grade rating. The possibility that unsecured bondholder proceeds could be used to fund equity injections into poorly funded secured structures is also a risk.
In the recent debut unsecured bond issuance by Atrium (BBB-/Stable), which previously used secured funding; subordination risk was mitigated by the size of the unencumbered asset pool and by low financial gearing (loan-to-value of around 20%). The switch to unsecured funding also increased operational and financial flexibility through a release of encumbered assets, which freely allows for development and asset recycling of the property portfolio.
“We expect the focus on subordination and recovery to increase as new, weaker unrated entities look to switch to unsecured funding. They typically have higher leverage, complex structures and weaker pools of unencumbered assets. In addition, it is difficult for issuers to convince existing secured lenders to unwind their funding structures. There may be prepayment penalties as interest rate derivatives were attached to the bespoke funding and secured lenders will not want to relinquish over collateralisation,” Fitch said.
“Once companies have made the switch to unsecured funding, they may be averse to taking secured funding again, even if it were to become cheaper and more widely available. Companies in Fitch’s UK rated property portfolio, where unsecured funding predominates, did not take the easy option of accessing secured debt when values plummeted in 2009 and they were in danger of breaching valuation covenants. They knew that they had built up trust with unsecured debt holders and 1992’s equivalent textbook response of procuring a lifeboat of secured funding would have been unnecessarily costly and hard to unwind later.”