Fitch Assigns Scentre's Hybrid Notes 'BBB+' Rating with 50% Equity Credit

(The following statement was released by the rating agency) Fitch Ratings-Sydney-25 September 2020: Fitch Ratings has assigned a 'BBB+' rating to the USD1.5 billion non-call (NC) 6 4.75% and USD1.5 billion NC10 5.125% subordinated hybrid notes due 2080 issued by RE1 Limited in its capacity as trustee and responsible entity of Scentre Group Trust 2. The notes are guaranteed on a joint and several basis by Scentre Group Limited (A/Negative) and Scentre Management Limited in its capacity as trustee and responsible entity of Scentre Group Trust 1, and RE2 Limited in its capacity as trustee and responsible entity of Scentre Group Trust 3, RE (NZ) Finance Limited and Scentre Finance (Aust) Limited. The notes are rated two notches below Scentre's Issuer Default Rating (IDR), which reflects their subordination within Scentre's capital structure. The securities qualify for 50% equity credit as they meet Fitch's criteria with regard to deep subordination, effective maturity in excess of five years, full discretion to defer interest coupon payments for at least five years and limited events of default. Equity credit is limited to 50% and not higher, as deferral of interest coupon is cumulative. The equity credit will be applied until 2075, five years before the maturity of the hybrids in 2080, despite the offering memorandum containing replacement provisions to 2046 for the NC6s and 2050 for the NC10s. Fitch believes the notes will improve Scentre's financial flexibility - the Australia-based REIT will have liquidity to cover all debt maturities until early 2024 - and minimise the impact of the pandemic-related shutdowns on its balance sheet, providing more headroom for the REIT at its current rating. We expect leverage to peak at 8.5x by end-2020, compared with around 10x before the notes' issuance, although still above the level at which we would consider taking negative rating action. We also expect Scentre's leverage to improve to below 7x from 2021 as conditions normalise. The Negative Outlook on the IDR continues to reflect the uncertainty over the structural changes in the retail industry and the effect on Scentre. Key Rating Drivers Equity Credit Applied to Hybrids: Fitch's 50% equity credit on Scentre's subordinated notes is based on discussions with management that these notes will be maintained as a permanent part of Scentre's capital structure and our assessment that the economic incentives for Scentre to maintain these securities in its capital structure are strong, particularly given the structural challenges in retail, which are reflected in the Negative Outlook on Scentre's IDR. We will continue to assess both management's intention and the economic incentives for the notes to remain a permanent part of its capital structure on an ongoing basis. Retail Landscape Changes: We expect structural change in the retail landscape to lower occupancy and rents across the industry once pandemic-related restrictions are relaxed. This is likely to weaken Scentre's historically strong visibility over rental income and is reflected in the Negative Outlook. We expect occupancy to remain strong for the REIT over the medium-to-long term as retailers seek destination centres for their remaining outlets, but believe that leasing spreads and contracted rent escalations will weaken and remain subdued as retailers seek more favourable terms. Scentre's strong visibility over rental income was driven by occupancy that exceeded 99% for the past 25 years, lease tenure of around 15-20 years for anchor tenants and five-to-seven years for specialty tenants, weighted-average lease expiries of around six years, around 10% of leases expiring annually and over 99% of rental income being derived from minimum base rents. This allowed the REIT to report comparable net operating income growth of 2%-3% since 2014, with around 75% of rental growth driven by contractual annual rent escalation, typically CPI plus 2%. Drop in EBITDA on Pandemic: Fitch expects Scentre's EBITDA to decline in 2020 due to the rental relief provided to tenants under the government's guidelines for commercial tenancies - with up to 2,600 tenants in Scentre's portfolio meeting the guidelines, representing up to 30% of rental income. We expect some rent to be recouped via higher lease payments for the remainder of the tenancies or through extensions to lease contracts, which continue to be based on leases with fixed base rents escalating annually, but it will be unable to recoup all of the rent. This may raise Scentre's leverage temporarily to around 8.5x by end-2020, above the level at which we would consider taking negative rating action, before moderating towards historical levels in 2021 as conditions normalise. Australia's Largest Retail REIT: Scentre's portfolio of Australian premier shopping centres was valued at around AUD54 billion at end-2019, of which its share was around AUD38 billion. The portfolio contains seven of the country's top-10 retail malls and four of the top five in New Zealand, capturing over 7.5% of total Australian retail sales with over 548 million customer visits a year. Over 80% of capital is located in Sydney, Melbourne and Brisbane, cities that drove economic growth in 2019. Scentre's portfolio mix changed to comprise 43% experiential stores by end-2019 - such as food and beverage, health, beauty and entertainment - to reflect the changing retail landscape and consumer preferences. Prudent Development Exposure: Scentre has limited development exposure, with its five-year plan focusing on optimising its current portfolio to meet changing consumer preferences. It has also deferred some capex in light of the current environment and continues to review its plan. Scentre had active development projects worth AUD0.2 billion (both past and future cash flow) at end-2019, with a share of AUD0.1 billion, or around 0.3% of the value of its investment properties; in the past, the company typically invested around AUD500 million on development each year. Market-Leading Capital Access: Fitch believes Scentre has sector-leading and durable access to diverse capital sources, including debt, demonstrated by its successful pricing of AUD4.1 billion in subordinated notes in September 2020 and securing around AUD1.9 billion in additional bank facilities and issuing AUD2.3 billion in senior notes in May 2020 to shore up its liquidity at the onset of Australia's pandemic-related restrictions. The company also issued debt in multiple currencies, including US dollars, euros, pound sterling and Australian dollars, and across a wide range of tenors. It also benefits from its ability to recycle capital through selling and entering into joint ventures on its properties. ESG - Exposure to Social Impact: Scentre has an ESG Relevance Score of 5 for exposure to social impact. Retailers in many markets - including Australia - were combating challenges from e-commerce and shifts in customer spending, with e-commerce's market share gains accelerating amid the pandemic as consumers were encouraged by government restrictions to avoid brick-and-mortar stores. We do not expect all retailers to recoup lost sales after the pandemic and some may not survive the social distancing period, despite aid from governments and landlords. The market weakness will most acutely affect lower-grade malls, which typically host more vulnerable retailers, but all market participants are likely to be affected. Derivation Summary Scentre's rating is well-positioned compared with US peer Simon Property Group (NYSE:SPG), Inc. (A/Negative). The ratings of both REITs reflect their high-quality retail real-estate portfolios - placing them among the world's largest REITs - cycle-tested management teams, market-leading capital access, conservative financial policies and significant scale, which helps efficiencies. However, both REITs are exposed to the changing retail landscape, particularly following pandemic-related restrictions in Australia and the US, which may lower profitability and ability to manage leverage at levels below their negative rating sensitivities. The Outlook on Simon was revised to Negative from Stable to reflect weaker credit metrics stemming from its debt-funded acquisition of 80% of TRG and the challenges Simon faces to reduce leverage due to moderating operating performance and elevated capital needs as it navigates the changing retail landscape. The quality of Scentre's portfolio is comparable with that of European peer Unibail-Rodamco-Westfield SE (BBB+/Negative). The two-notch difference reflects Unibail's elevated leverage following its acquisition of Westfield's international operations and delays in its ability to deleverage to a level commensurate with its rating. The Negative Outlooks for both entities also reflect their exposure to the changing post-pandemic retail landscape and ability to manage leverage or deleverage to a level commensurate with their ratings. The one-notch difference between Scentre and Australian peer Mirvac Limited (A-/Stable) reflects Scentre's larger scale and limited development exposure as well as Mirvac having a homebuilding business. These factors offset Mirvac's more conservative financial profile as it seeks to manage its development exposure risk. The Stable Outlook on Mirvac reflects the diversification in its REIT portfolio between office, industrial and retail, compared with the Negative Outlook on Scentre, reflecting its exposure solely to the retail industry. Key Assumptions Fitch's Key Assumptions Within Our Rating Case for the Issuer - Re-leasing spreads of around -7.5% in 2020 and -10% in 2021 to 2023, with average contracted annual rent escalations of CPI plus 2% - Rent per square metre to increase by around 1.0% in 2020, excluding pandemic-related rental relief provided, before declining by around 4.0% in 2021 and increasing by 4.0%-5.0% in 2022 and 2023 (2019: -1.6%) - Capex of AUD500 million a year in 2020-2023 - No interim dividend to be paid in 2020; from 2021, dividend payout ratio to revert to 85% of funds from operations RATING SENSITIVITIES Factors that could, individually or collectively, lead to positive rating action/upgrade: Fitch may revise the Outlook to Stable if one or more of the following are achieved: - Net debt/operating EBITDA remaining below 7.5x on a sustained basis (2019: 6.7x). - Operating EBITDA/interest paid remaining above 3.0x on a sustained basis (2019: 4.0x) Factors that could, individually or collectively, lead to negative rating action/downgrade: - Net debt/operating EBITDA deteriorating to above 7.5x for a sustained period. - Operating EBITDA/interest paid deteriorating to below 3.0x for a sustained period. - Sustained weakening of the retail sector or indicators of structural change in the retail landscape, as indicated by occupancy falling below 95%, weaker average rent per square metre or a higher variable rental component. Best/Worst Case Rating Scenario International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579. Liquidity and Debt Structure Strong Liquidity and Asset-Liability Management: Scentre announced that it had available liquidity of AUD4.4 billion at end-1H20, pro-forma for the AUD869 million bond that matured in July 2020. Scentre's liquidity will be enhanced by the issuance of the AUD4.1 billion subordinated notes. These actions have allowed the REIT to cover all debt maturities to early 2024. Scentre's average debt maturity was 4.2 years at end-2019, compared with weighted-average lease expiries of 6.0 years. The company's funding comprises bonds and bank facilities and it has access to global markets with outstanding bonds denominated in US dollars, euros, pound sterling or Australian dollars. Scentre swaps all of its foreign-currency debt into floating Australian dollars to hedge foreign-exchange risk, then manages its interest-rate risk on a portfolio basis, where typically more than 75% of its interest rates are fixed (2019: 85%, 2018: 69%). REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING The principal sources of information used in the analysis are described in the Applicable Criteria. ESG Considerations Scentre has an ESG Relevance Score of 5 for exposure to social impact, reflecting the risk to its business from a move to online shopping, particularly following a change in consumer behaviour during the pandemic-related social distancing measures. This has a negative impact on the company's credit profile and is highly relevant to the rating. Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a score of 3 - ESG issues are credit neutral or have only a minimal credit impact on the entity(ies), either due to their nature or the way in which they are being managed by the entity(ies). For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg. RE1 Limited ----subordinated; Long Term Rating; New Rating; BBB+ Contacts: Primary Rating Analyst Kelly Amato, CFA Director +61 2 8256 0348 Fitch Australia Pty Ltd Suite 15.01, Level 15 135 King Street Sydney 2000 Secondary Rating Analyst Leo Park, Associate Director +61 2 8256 0323 Committee Chairperson Vicky Melbourne, Senior Director +61 2 8256 0325 Media Relations: Peter Hoflich, Singapore, Tel: +65 6796 7229, Email: peter.hoflich@thefitchgroup.com Leslie Tan, Singapore, Tel: +65 6796 7234, Email: leslie.tan@thefitchgroup.com Additional information is available on www.fitchratings.com Applicable Criteria Corporate Hybrids Treatment and Notching Criteria (pub. 11 Nov 2019) (https://www.fitchratings.com/site/re/10100477) Corporate Rating Criteria (pub. 01 May 2020) (including rating assumption sensitivity) (https://www.fitchratings.com/site/re/10120170) Corporates Notching and Recovery Ratings Criteria (pub. 14 Oct 2019) (including rating assumption sensitivity) (https://www.fitchratings.com/site/re/10090792) Sector Navigators - Addendum to the Corporate Rating Criteria (pub. 26 Jun 2020) (https://www.fitchratings.com/site/re/10125796) Additional Disclosures Dodd-Frank Rating Information Disclosure Form (https://www.fitchratings.com/site/dodd-frank-disclosure/10137009) Solicitation Status (https://www.fitchratings.com/site/pr/10137009#solicitation) Endorsement Status (https://www.fitchratings.com/site/pr/10137009#endorsement_status) Endorsement Policy (https://www.fitchratings.com/site/pr/10137009#endorsement-policy) ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. 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