RPT-Fitch rates Grainger IDR 'BB'; secured notes 'BB+(EXP)'

Nov 18 (Reuters) - (The following statement was released by the rating agency)

Fitch Ratings has assigned Grainger Plc an Issuer Default Rating (IDR) of 'BB' with Stable Outlook. Fitch has also assigned the company's prospective GBP200m secured notes an expected rating of 'BB+(EXP)'. The final instrument rating is contingent upon the receipt of final documentation conforming to information already received by the agency.

Grainger is the UK's largest residential landlord with resilient through-the-cycle cash flow across its diversified income streams of rental income, trading profits from portfolio sales and fee income from managing third-party residential portfolios. The rating reflects its bias towards the London market, a defensive GBP1.8bn property portfolio focused on regulated tenancies and recent de-leveraging driven by divestments. Grainger's business model is more focused on proceeds from portfolio sales than on rental income, and its financial metrics and debt structure - although robust for the current rating - are likely to limit Grainger from achieving an investment grade. Fitch forecasts stable financial metrics into 2014 and 2015 with comfortable headroom for the rating.

The notes are rated a notch higher than Grainger's IDR to reflect above-average recovery expectations. The secured notes will be issued from Grainger Plc with a guarantor group providing a floating charge over a large majority of Grainger's UK residential portfolio providing an asset cover of 1.4x. The prospective notes will rank pari passu with other secured lenders. Recovery expectations are further enhanced by a sizeable net asset value from non-guarantor wholly owned subsidiaries and JV investments.

KEY RATING DRIVERS

UK-Focused Residential Portfolio

Grainger's portfolio of around 10,000 units is spread across the UK with London and South East accounting for 60% as of the financial year to September 2013. The portfolio is defensive and includes a large proportion of regulated tenancies. The average value of a UK unit is GBP213,000 based on vacant possession value. A further 3,000 market- rented units in Germany add modest geographical diversification. In terms of portfolio value Germany represents less than 10% of the portfolio.

Focus on Reversionary Assets

Around half of EBITDA is typically trading profits generated from the sale of regulated tenanted properties. These tenants are often on state benefits with an average age of 71. These properties are reversionary assets as they are purchased at a discount to market value, and with the tenant on average vacating the property in 10-12 years, typically driven by mortality rates. Current reversionary assets equate to about 70% of the portfolio and would be worth around 30% more (GBP452m at FYE13) in vacant possession. This reversionary surplus is then crystallised into profits over time upon sale of the properties.

Stable Forecasts

Fitch expects stable financial metrics into 2014 and 2015 with EBITDA net interest cover (NIC) above 1.5x and loan to value (LTV) around 55%. This follows recent years of de-leveraging primarily driven by disposals and slower re-investment in the group's reversionary assets. Fitch's rating case expects Grainger to generate around GBP100m EBITDA yearly. Fitch includes net rental income, fee income and trading profits into its EBITDA estimates in line with management's operating profit less non-recurring and fair value items. Fitch LTV is roughly 6%-7% higher than management's consolidated reported LTV as we exclude net asset value from JV interests and development assets.

Stable Trading Profits

Grainger's large portfolio ensures that a constant number of reversionary properties become vacant on a yearly basis, having averaged around 7% per year. Profit margins are partly a function of house price inflation. However, volumes of sales are constant through the cycle, underlining the liquidity of residential assets. The number of reversionary asset disposals, and profit margins have been in line with historical trends, except in 2009 when the latter was slightly below trend.

Inflation Positive on Cash-flow

Most aspects of the business model benefit from long-term inflation. Inflationary rental income increases are passed on, and over the long term property valuations have outperformed inflation. Grainger's current capital structure is adequate to withstand the cyclical nature of property values. Reversionary assets are long term in nature and over the last 50 years there has not been a decade in the UK without positive house price inflation. Fitch expects this trend will continue given the under-supplied UK housing market.

Adapting to Long-term Trends

Because of the finite number of regulated tenancies in the UK Grainger may encounter fewer opportunities to re-invest sales proceeds into new reversionary assets. This is not currently a risk as the current portfolio is likely to be able to sustain its trading profits at current levels for at least the next ten years. Beyond this timeframe re-investment of sale proceeds are likely to be redeployed into boosting other segments.

Increase in Fee Income

Grainger has de-leveraged through divesting minority stakes and growing revenue streams such as fee income from services provided for assets under management. Grainger generated GBP13m in FY13, up from around GBP6m in FY10. Essentially some of the foregone net rental income from divestments has been replaced with fee income. Strategically fee income allows Grainger to grow its revenue streams with less capital employed. JV interests are funded on a non-recourse basis and in aggregate have similar leverage metrics to Grainger Plc. They are equity-accounted and are treated by Fitch as off balance sheet and not factored into our ratios.

New Bond Issue

The prospective secured notes will pre-pay existing bank debt, in turn extending debt maturities and, importantly, reducing bank debt exposure. Post the transaction around 40% of the company's debt will be financed by non-banking institutions. The average debt maturity will be around four to five years with around 70% of debt funding either hedged or fixed over that similar period. The Germany portfolio is funded in EUR-denominated debt, minimising currency translation risk.

Strong Liquidity

At FYE13 the group had GBP62m of unrestricted cash and GBP213m of undrawn headroom under the core bank facility committed until 2016. This comfortably covers debt maturities over the next 18 months of GBP73m (assuming the notes pre-pay bank facilities) and committed capex of GBP23m. Our rating case expects Grainger to remain free cash flow positive into 2014 and 2015. As a result the Fitch liquidity score on an 18-month basis is 2.9x. Grainger has a solid track record of accessing equity markets with strong institutional investor support, coupled with support from its relationship banks.

RATING SENSITIVITIES

Positive: Future developments that could lead to positive rating actions include:

-Sustainable recurring trading, rental and fee income resulting in EBITDA NIC above 1.75x on a consistent basis and LTV below 50%

-Increase in asset cover to above 1.5x. Asset cover is defined as the market value of properties held by the secured notes core guarantors over net debt at the issuer level.

-Improved diversification of funding sources with longer debt maturities

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 and a decline in average debt maturities to below three years

Grainger plc