PrefBlog

S&P Global Ratings has announced:

• Brookfield Property Partners L.P.’s (BPY) credit quality has been impaired by persistent secular headwinds within its office segment and deteriorating metrics related to higher financing costs.
  Therefore, we lowered the issuer credit ratings on both BPY and Brookfield Properties Retail (BPR; a core subsidiary within BPY’s group structure) to ‘BB’ from ‘BBB-‘.
• We also lowered the issue-level rating on BPY’s unsecured notes to ‘BB-‘ from ‘BB+’ and assigned a ‘5’ recovery rating (rounded estimate: 10%) to the notes.
• In addition, we lowered the issue-level rating on BPR’s senior secured notes to ‘B+’ from ‘BB+’ and assigned a ‘6’ recovery rating (rounded estimate: 5%) to the notes.
• Lastly, we lowered our rating on the company’s preferred shares to ‘B’ from ‘BB’ to reflect increased subordination risk for speculative-grade issuers.
• The negative outlook reflects our view that BPY’s liquidity could be pressured by upcoming recourse maturities over the next two years, while secular headwinds within the office segment could further deteriorate its operating performance.

PRINCETON (S&P Global Ratings) Dec. 21, 2023– S&P Global Ratings today took the rating actions listed above.

Secular headwinds in the office sector have weakened our assessment of BPY’s business risk. BPY owns one of the largest real estate portfolios of any rated real estate company, with approximately $130 billion in total assets. Moreover, we view the company’s high-quality properties and its diversification across product type and geography favorably.

However, while BPY’s retail assets have recovered to pre- pandemic levels (occupancy was 95.1% as of Sept. 30, 2023), occupancy in the office portfolio has continued to erode. As of Sept. 30, 2023, occupancy in the office portfolio slipped to 85.4%, a year-over-year decrease of 140 basis points and well below pre-pandemic levels of 93%. We acknowledge that within the office segment, BPY’s core properties–64 out of its 131 assets, representing a majority of office segment net operating income (NOI)–continue to perform well (95.2% occupancy as of Sept. 30, 2023). The remaining assets (which BPY believes have significant value-add opportunities through development and leasing activities) have languished, with occupancy below 80%. Weighted by asset values, occupancy was 91.1% for BPY’s office assets, demonstrating resilience for premier class ‘A’ workplaces.

We expect sector headwinds facing commercial office real estate will generally remain in place over the next several years, with weaker tenant retention, lower occupancy, and heightened incentives (through tenant inducements) to attract new tenants. We expect occupancy at class ‘A’ properties to be more resilient as the bifurcation of performance between class ‘A’ and class ‘B’ widens. However, we believe capital expenditures (capex) to attract new tenants will reduce BPY’s future cash flows and operating metrics will also be slow to recover. As a result, we revised our business risk assessment on BPY to strong from excellent.

Refinancing risks are rising given BPY’s elevated near-term debt maturities.Excluding extension options, BPY’s weighted-average debt maturity shrunk below three years in recent quarters (to 2.6 years as of Sept. 30, 2023), which we believe poses elevated risks.

We acknowledge that the vast amount of upcoming debt is nonrecourse secured debt and most of the maturing debt contains extension options that BPY can exercise. We believe the company maintains a solid position with its lenders due to parent Brookfield Corp.’s (BN; A-/Stable/A-1) scale and platform (BN is a large owner of real assets with over $140 billion of its own invested capital, including a 75% ownership in Brookfield Asset Management [BAM], a global asset manager with $865 billion of assets under management). Moreover, we think banks are reluctant to take back any commercial real estate assets secured by loans in the current market.

While we believe banks are heavily scrutinizing new commercial real estate loans, particularly those secured by office properties, they are generally willing to refinance existing loans. For example, BPY successfully refinanced over $30 billion in loans across more than 120 individual transactions in 2023, and we expect the company to successfully refinance upcoming secured debt. In many cases, we expect banks to provide extensions on maturing debt.

In some cases, particularly when weaker operating fundamentals (low occupancy or high lease rollover risk) reduce asset values, we would expect BPY to hand back the asset. As of Sept. 30, 2023, BPY has suspended approximately 3% of its contractual payments on nonrecourse mortgage debt. We view this as a portfolio management exercise by BPY, not a default, but could view it more negatively if loan defaults became frequent because it would erode our view of the company’s asset quality. We revised our capital structure modifier score to negative from neutral given BPY’s elevated debt maturities over the next few years.

While BPY’s recourse corporate notes and bank loan maturities (revolving credit facilities and term loans) look manageable in 2024 (approximately $442 million of unsecured notes due in March), its maturities will increase in 2025 with approximately $2.3 billion of total debt coming due. Lack of progress in addressing these maturities well ahead of maturity could hinder our view of the company’s liquidity.

BPY’s relationship with BN enhances its credit. Following the privatization of BPY by BN in July 2021, we continue to view BPY’s group status to BN as moderately strategic. We believe BN would provide financial support to BPY under some circumstances and could help facilitate future refinancing efforts including repayment of its March 2024 bond maturity. BPY is BN’s main vehicle for real estate investments and its largest investment vehicle. This group support provides a one-notch uplift to BPY’s stand-alone credit profile.

The negative outlook indicates a one in three chance of a downgrade over the next 12 months. This reflects our view that upcoming recourse maturities over the next two years could pressure BPY’s liquidity, while secular headwinds within the office segment could further deteriorate operating performance. We project S&P Global Ratings-adjusted debt to EBITDA will be maintained in the 15x area in both 2023 and 2024, with fixed-charge coverage (FCC) sustained at about 1x.

We could lower our ratings on BPY by one notch if:

BPY fails to refinance its upcoming recourse maturities well in advance, pressuring our view of the company’s liquidity;
Its operating performance deteriorates, with occupancy in the company’s core office segment weakening to the low-80% area; or
Its key credit metrics weaken further, with FCC declining below 1x or S&P Global Ratings-adjusted debt to EBITDA rising back above 16x.
We could revise the outlook back to stable if:

BPY bolsters its liquidity, potentially through asset sales, such that upcoming recourse maturities don’t threaten our liquidity assessment;
Its operating performance improves modestly, with a recovery to office occupancy; and
Key credit metrics stabilize or strengthen, with FCC maintained comfortably above 1.0x.

This follows an earlier CreditWatch-Negative placed on the parent company on 2023-10-5.

• Brookfield Property Partners L.P.’s (BPY) fixed-charge coverage deteriorated to below 1.0x in the second quarter of 2023, and we don’t forecast material near-term improvement given our economists’ view that interest rates will remain higher for longer.
• The company also faces heightened refinancing risk, with a capital structure that has significant maturities over the next two years and outsized exposure to floating-rate debt.
• S&P Global Ratings placed all its ratings on the company, including the ‘BBB-‘ issuer credit rating, on CreditWatch with negative implications.
• The CreditWatch negative placement reflects our expectation that we could lower the ratings on BPY, possibly by more than one notch, if we don’t envision the company implementing a near-term plan to reduce refinancing risk and boost coverage levels.

BPY’s deteriorating credit protection measures are unlikely to recover materially over the next two years.As of June 30, 2023, BPY’s adjusted debt to EBITDA increased to 17.3x from 15.2x at year-end 2022 while fixed-charge coverage (FCC) fell to 0.9x from 1.4x. A notable portion of the deterioration was caused by the consolidation of one of its funds’ (BSREP IV) U.S. investments in December 2022 and foreign investments in January 2023, which added a material amount of new debt to BPY while EBITDA has not fully cycled through on our trailing-12 month adjusted metrics. BPY owns a 23% financial stake in the fund but fully consolidates it within its financial statements.

That said, interest rates have risen materially over the past year, and BPY’s substantial exposure to floating-rate debt (45% net of interest rate hedges as of June 30, 2023) has rapidly deteriorated coverage metrics. S&P Global Ratings economists expect interest rates to remain higher for longer, with one additional rate hike expected in 2023. While we acknowledge that BPY’s sizable liquidity position and consistent execution of asset sales mitigate the risk of the company not being able to pay its fixed charges over the near term, BPY has one of the weakest financial risk profiles within our North America real estate coverage given elevated leverage and thin interest coverage. We project adjusted debt to EBITDA to improve slightly to the low-16x area over the next two years but expect FCC to be sustained at about 1x. While we expect BPY to execute meaningful asset sales over the coming years, we anticipate that the majority of proceeds will continue to be distributed up to its parent Brookfield Corp. (BN; A-/Stable/A-1) rather than allocated for debt repayment.

Near-term maturities pose additional risks.BPY has substantial upcoming debt maturities that will need to be refinanced, likely at significantly higher rates. The company’s weighted average debt maturity was slightly below three years as of June 30, 2023 (not including extension options). We believe that BPY maintains a solid position with its lenders due to its parent’s scale and platform (BN is a global asset manager with over $850 billion of assets under management) and the reluctance of banks to take back any commercial real estate assets secured by loans in the current market. In many cases, we expect the banks to provide extensions on maturing debt, albeit at higher rates. In some cases, particularly when weaker operating fundamentals (low occupancy or high lease rollover risk) are reducing asset values, we would expect BPY to hand back the asset to the servicer. As of June 30, 2023, BPY has suspended approximately 3% of its contractual payments on non-recourse mortgage debt. We view this as a portfolio management exercise by BPY, not a default, but could view it more negatively if loan defaults became frequent because it would erode our view of the company’s asset quality.

That said, as one- to three-year extensions are granted by banks or exercised by BPY on its non-recourse CMBS loans, its weighted average debt maturity could narrow further. We believe BPY maintains access to the capital markets where it could issue unsecured debentures or preferred shares, but that its weakening capital structure adds a modest amount of refinancing risk.

The CreditWatch placement reflects the company’s deteriorating interest coverage metrics, continued secular challenges facing the company’s office properties, and a capital structure with a material amount of near-term, floating-rate debt. We will seek to resolve the CreditWatch placement within the next three months.

BPY is a global, diversified real estate company that was taken private by BN in July 2021. BPY is BN’s primary vehicle to make investments across the real estate sector and is also BN’s largest investment vehicle, with approximately $130 billion in total assets as of June 30, 2023. It is the largest real estate company that we rate by total assets. BPY invests primarily in high-quality office properties located in gateway markets and class-A malls in the U.S., with approximately 198 million square feet of office and retail properties (including active development projects) within its core office and core retail platforms.

It will be remembered that BPO’s preferreds are guaranteed by BPY, its parent. The issues remain at Pfd-3(low) by DBRS.

Affected issues are: BPO.PR.A, BPO.PR.C, BPO.PR.E, BPO.PR.G, BPO.PR.I, BPO.PR.N, BPO.PR.P, BPO.PR.R, BPO.PR.T, BPO.PR.W, BPO.PR.X and BPO.PR.Y.

The market took the news badly, with BPO.PR.R down 9.34% on the day (close/close) and BPO.PR.N down 8.43%.

It will be interesting to see what happens with ZPR – as detailed in the December PrefLetter, ZPR’s weight in BPO was 3.10% in mid-November, while the index had exposure of 5.65%. ZPR’s extreme underweighting has been a huge factor in the index fund’s idiotic (positive) tracking error over the past year – but the regulatory problem remains the situation with reset date bucketting.

Thanks to Assiduous Reader hrseymour for bringing this to my attention.

Brompton Funds Limited has announced:

e that the name of Brompton Oil Split Corp. (the “Fund”) has changed to “Brompton Energy Split Corp.” and, commencing today, the class A shares and preferred shares of the Fund are trading under new Toronto Stock Exchange (“TSX”) ticker symbols: ESP and ESP.PR.A, respectively.

As previously announced, at a special meeting of preferred and class A shareholders (“Shareholders”) of the Fund held on December 5, 2023, Shareholders approved a special resolution to implement amendments to update and modernize the investment objectives and investment restrictions of the Fund, among other things (the “Amendments”), including the Fund’s name change.

Details regarding the Amendments are outlined in the Fund’s management information circular dated October 31, 2023 which is available at www.sedarplus.ca and www.bromptongroup.com.

The Fund invests in an actively managed portfolio consisting primarily of equity securities of dividend paying (at the time of investment) global energy issuers with a market capitalization of at least $2 billion (at the time of investment) which may include companies operating in energy subsectors and related industries such as oil & gas exploration and production, equipment, services, pipelines, transportation, infrastructure, utilities, among others. The Fund may also invest up to 25% of the value of the portfolio (as measured at the time of investment) in equity securities of other global natural resource issuers which include companies that own, explore, mine, process or develop natural resource commodities or supply goods and services to those companies, including directly or indirectly through exchange-traded funds.

The affected issue is OSP.PR.A, now ESP.PR.A.

DBRS has announced that it:

downgraded its credit ratings on Laurentian Bank of Canada (LBC or the Bank), including the Bank’s Long-Term Issuer Rating to BBB (high) from A (low). Concurrently, DBRS Morningstar confirmed the Bank’s Short-Term Issuer Rating at R-1 (low). The trend for all credit ratings is Negative. The Bank’s Intrinsic Assessment (IA) is BBB (high) while its Support Assessment (SA) remains SA3. The SA3 designation, which reflects no expectation of timely external support, results in the Bank’s Long-Term Issuer Rating being equivalent to the IA. These credit rating actions resolve the Under Review with Negative Implications status under which LBC was placed on November 3, 2023.

KEY CREDIT RATING CONSIDERATIONS
The credit rating downgrades and Negative trends reflect DBRS Morningstar’s view that LBC’s franchise strength and profitability prospects have significantly weakened with a limited visibility on the Bank’s long-term strategic path. The fundamental challenges faced by the Bank’s Personal Banking franchise in recent years has led to a sustained weakness in financial performance. Further, the Bank’s ability to improve earnings and growth prospects in the near to medium term will likely be affected by the adverse series of recent events, including the unexpected and sudden departure of the former President and CEO and the rapid succession of executive leadership departures, while there remains the uncertainty related to the delay in the Bank’s renewed strategic plan. Of note, LBC continues to report the lowest levels of profitability among Canadian medium-size banks rated by the DBRS Morningstar. The Bank is dealing with these fundamental changes and operational issues amid an uncertain economic environment with increasing headwinds. As a result, the challenging operating environment will likely make the timely and successful execution of a new strategic plan more complicated. The credit ratings also consider LBC’s relatively high proportion of brokered deposits and higher cost base.

Supporting its credit ratings, LBC has demonstrated good credit quality with low impairments and loan losses; however, DBRS Morningstar expects that asset quality metrics will deteriorate from current levels in F2024 as a result of the high interest rate environment, which has materially increased debt-servicing costs. Despite recent events, the Bank’s balance sheet fundamentals remain stable with higher levels of liquidity to deal with any potential deposit outflows. LBC’s capital position is adequate with sufficient buffers to absorb stressed levels of loan losses.

CREDIT RATING DRIVERS
Given the Negative trends, credit rating upgrades are unlikely. DBRS Morningstar would change the trends to Stable if LBC’s new leadership demonstrates a sustained improvement in the Bank’s franchise position and financial performance while maintaining a similar risk profile.

Conversely, additional operational missteps and/or a failure to execute on the strategic initiatives leading to further deterioration in franchise strength and earnings generation would result in a credit ratings downgrade. Furthermore, increased pressure on funding and liquidity would also result in a credit ratings downgrade.

CREDIT RATING RATIONALE
Franchise Combined Building Block (BB) Assessment: Good/Moderate
LBC is Canada’s eighth-largest Schedule I bank with assets of $49.9 billion as at October 31, 2023. The Bank offers retail services in Québec through its branch network as well as commercial lending across Canada and in the U.S. LBC also distributes financial products to brokers and financial advisors across Canada through its wholesale arm, B2B Bank. Over the past few years through 2022, LBC’s franchise has been faced with fundamental challenges in its Personal Banking business, which resulted in customer attrition, shrinking loans, and stagnant deposits. Two years into the current strategic plan that was unveiled on December 10, 2021, the Bank has undertaken a digital-first approach and introduced new and enhanced digital capabilities to close gaps in its Personal Banking business, particularly across mortgage, Visa, and deposit products. On October 2, 2023, following the mainframe outage, the Bank announced the sudden and unexpected departure of its president and CEO, Rania Llewellyn, and the resignation of its board chair, Michael Mueller. With Éric Provost only recently being appointed as president and CEO, DBRS Morningstar has limited visibility into LBC’s long-term strategic direction, although the Bank’s current focus is on improving operating efficiency and simplifying the organizational structure.

Earnings Combined Building Block (BB) Assessment: Moderate
Relative to its peers, LBC has demonstrated lower profitability although it has a higher share of noninterest income at about 27% of total revenue as at October 31, 2023. The Bank’s net income decreased by about 20.1% year over year (YOY) to $181.1 million in F2023 as a result of lower noninterest income and higher provision for credit losses and operating expenses. While a decrease in noninterest income was largely driven by reduced capital markets revenue, noninterest expenses increased on higher salaries, employee benefits, and ongoing investments in technology. Noninterest expenses included restructuring charges of $18.2 million resulting from changes in the Bank’s management structure, as well as strategic review-related charges of $5.9 million. As a result, the operating efficiency ratio deteriorated to 71.1% in F2023 from 67.7% in the prior year. Partly offsetting the downward pressure on net earnings, net interest income grew 1.8% YOY to $746.3 million in F2023; however, the net interest margin as calculated by DBRS Morningstar compressed by 6 basis points (bps) to 1.51% on higher funding costs, which outpaced growth in asset yields.

Risk Combined Building Block (BB) Assessment: Good
Amounting to $37.1 billion as at October 31 2023, gross loans contracted by 1.1% YOY in F2023, compared with 11.4% YOY growth in the prior-year period. A reduction in commercial and nonmortgage personal loans was partly offset by an increase in residential mortgages. The bulk of credit risk lies in the commercial book, which accounted for about 48% of total loans as at October 31, 2023 and has concentrations in commercial real estate and inventory financing. Overall, the Bank’s asset quality is good with low impairments and loan losses. The gross impaired loans ratio increased by 19 bps YOY to 62 bps in F2023, largely because of increased impairments in commercial mortgages. As with the rest of the banking sector, DBRS Morningstar expects asset quality metrics to further deteriorate from current levels amid the challenging macroeconomic environment. Furthermore, if not managed prudently, the Bank’s continued realignment of the loan portfolio and geographic expansion, as well as any additional deficiencies in IT capabilities and uncertainties around its new strategic direction, could expose LBC to heightened levels of operational and credit risk.

Funding and Liquidity Combined Building Block (BB) Assessment: Good/Moderate
LBC’s overall funding and liquidity position remains sound. Accounting for about 65% of the funding base, total deposits, including capital markets deposits, declined by 4.1% YOY to $26.0 billion in F2023. Personal deposits, which represented 86% of total deposits, remained broadly stable at $22.3 billion in F2023 on the back of an uptick in direct retail deposits. Broker-sourced deposits marginally declined to $10.7 billion and accounted for about 41% of total deposits. The Bank expects to attract more direct client deposits on a national level in the coming years, which DBRS Morningstar would view favourably over broker deposits. Liquidity levels are strong, with liquid assets forming 23% of total assets as at Q4 2023.

Capitalisation Combined Building Block (BB) Assessment: Good/Moderate
LBC’s capital ratios under the standardized approach are above regulatory minimums and provide adequate buffers to absorb stressed levels of loan losses. DBRS Morningstar would view favourably a larger capital buffer, sufficient to absorb significant losses, especially as the Bank undertakes an “accelerated evolution of its strategic plan” and continues to grow its commercial loan book, which may be more susceptible to weakness in the event of a sustained economic downturn. The CET1 capital ratio increased to 9.9% as at Q4 2023, compared with 9.1% for the same period of F2022, primarily reflecting lower risk-weighted assets as well as internal capital generation.

Further details on the Scorecard Indicators and Building Block Assessments can be found at https://www.dbrsmorningstar.com/research/425414.

The affected issue is LB.PR.H. It remains rated at P-3(low) by S&P.