Swedish Property Company Hemso Fastighets AB #A-/A-2# And #K-1# Ratings Outlook Stable

Stocks and Financial Services Press Releases Thursday June 7, 2018 16:18
STOCKHOLM--7 Jun--S&P Global Ratings

STOCKHOLM (S&P Global Ratings) June 7, 2018--S&P Global Ratings today affirmed its 'A-/A-2' long- and short-term issuer credit ratings on Swedish housing provider Hemsoe Fastighets AB. The outlook is stable.

We also affirmed our 'K-1' short-term Nordic regional scale rating on the company.
At the same time, we affirmed our 'A-' long-term issue rating on Hemsoe's senior unsecured debt.

The affirmation reflects our view that Hemsoe will continue to display robust financial performance on the back of strong profitability from projects coming on stream in the next few years. This will support the balance sheet's resilience through 2020 and offset risks from the company's expansion agenda, which entails notable increases in debt. As such, we expect Hemsoe's debt sustainability metrics (debt to EBITDA and EBITDA interest coverage) to remain stable through 2020. We also project that the company's business strategy will not change materially, so the majority of rental revenues will continue to stem from public-sector tenants.

We determine the ratings on Hemsoe by benchmarking against factors in our criteria for rating public housing providers: industry risk, economic fundamentals, market position, financial performance, debt, liquidity, and financial policies. Hemsoe differs from its rated peers in the public housing and real estate sectors because it has higher exposure to private-sector corporate tenants (41% of revenues) and is actively expanding internationally. Hemsoe's exposure to higher risk leads us to apply a negative adjustment to the long-term rating.

We consider that Hemsoe has a strong enterprise risk profile, based on our view of its low industry risk, solid economic fundamentals, and strong market position. Due to the company's established relationship with the public sector and its efficient project-management processes, Hemsoe enjoys robust demand for its services. As a result, the majority (59%) of its rental income stems from public-service-related properties with long leases. Hemsoe's revenues therefore display modest cyclicality, and the high credit quality of its public-sector tenants supports its overall business profile.

However, we note that large private public services providers, especially in elderly care and education, are among Hemsoe's tenants, adding an element of risk. Furthermore, we observe that there is a material undersupply of elderly care facilities and school buildings in the municipalities where Hemsoe is active. Because Swedish municipalities are legally obliged to supply these services, there is a high probability that the public sector would assume those operations in the event of a fall-off of private operators, in our view. While default risk of individual private operators exists, we consider re-letting risk low, since the municipality would likely step in to ensure provision of legally mandated public services.

Hemsoe is one of the largest providers of public service properties in Sweden, whose economic fundamentals also support a high demand for public services. Moreover, over the past two to three years, Hemsoe has actively divested properties not considered attractive long-term holdings. We view as positive the company's refinement of its property portfolio into key growth areas where there is a strong demand for public services, and undersupply of public services facilities. In our view, these market characteristics mitigate some of the risks from having a high share of private public-services operators as tenants. Together, with a healthy rate of new construction, its portfolio of properties show further improving asset characteristics; its economic vacancy rate is a very low 1.9% as of March 31, 2018. Moreover, Hemsoe worked actively to increase the average lease duration to 9.1 years as of that date, from 8.1 years at end-2016, which supports the predictability of its cash flows and further strengthens its business fundamentals.

Nevertheless, Hemsoe's appetite for international expansion continues. Its non-domestic exposures (Germany and Finland) accounted for 25% of property value as of first-quarter 2018, up from 18% one year earlier. In this regard, we note that parts of the increase in external value is related to currency effects. Still, Hemsoe's international presence, originally due to a legacy portfolio in elderly care in Germany, has increased lately due to the company's search for higher-yielding properties and desire to diversify across several property markets. Hemsoe's international agenda contributes an element of risk that negatively differentiates it from its peers; however, a rising proportion of its international rental income comes directly from public entities. We also note that management is continuously gaining experience in the education and research segments in Germany and Finland, relatively new markets for Hemsoe. Overall, we still regard Hemsoe's strategy as well aligned with its organizational capabilities and market conditions, even though its nontraditional activities weigh on our assessment of its economic fundamentals.

We believe that Hemsoe's ownership structure strengthens its ties with the public sector. The Swedish sovereign wealth fund Tredje AP-fonden owns Hemsoe and is actively involved in defining the company's strategy. We understand that Tredje AP-fonden considers Hemsoe to be a long-term core investment. The owner holds vast liquid assets and provides ongoing support through an agreement to subscribe to commercial paper of up to Swedish krona (SEK) 4 billion (about EUR400 million) if Hemsoe has difficulties issuing in the market. In addition, based on publicly stated capitalization targets for Hemsoe, Tredje AP-fonden appears committed to injecting capital if Hemsoe's capitalization falls below the minimum target, and financial covenants in loans agreements indicate that Tredje AP-fonden will remain Hemsoe's majority shareholder.

Hemsoe is following an ambitious expansion plan. In our base case for 2018-2020, we assume that Hemsoe's investments in new construction will average SEK2.3 billion per year, thereby contributing to its rapidly expanding balance sheet. In addition, because acquisitions are set to remain a key component of Hemsoe's expansion strategy, we expect the company will finance this part of the growth through divestments, in addition to a further enhancement of its existing property portfolio.

We consider Hemsoe's financial performance to be strong, as demonstrated by a five-year average EBITDA-to-revenue ratio of 69%. We foresee that higher-yielding German and Finnish properties coming on stream, in combination with gradual modernization of the Swedish property portfolio, will help strengthen profit margins. We expect EBITDA to revenues will slightly exceed 70% this year. Although we see potential risks from the company's expansion and associated debt buildup, we anticipate that continued strong performance will keep its financial position resilient.

Hemsoe conducts mark-to-market valuations of its properties under International Financial Reporting Standards. As such, its balance sheet is exposed to market volatility. However, we observe that Hemsoe's niche segment of public-policy-related properties has remained attractive, with no negative spill-over effects on yields or values from the subdued sentiment in the Swedish residential real estate market since August 2017. Therefore, we anticipate that fairly stable values of Hemsoe's social infrastructure properties will underpin the balance sheet's resilience throughout our base case. Since we project strong profitability, we foresee Hemsoe's debt to debt plus equity reducing to 68% in 2020 from 70% in 2017, despite a notable nominal increase in debt of SEK6.4 billion.

Hemsoe holds a competent financial management with prudent risk tolerance levels and active treasury management. The maturity profile of its loans have increased notably in recent years standing at 5.7 years at the end of first-quarter 2018 compared with 3.9 years in 2017. We view Hemsoe's financial prudence as positive in light of its expanding nominal loan portfolio. About 30% of interest exposures are repriced within 12 months and with the total interest duration at 5.4 years at end-March 2018, lengthened from 4.3 years one year earlier. Currency exposures are fully hedged, primarily through matching euro funding with currency requirements in its German and Finnish business segments.

Despite rising investments, we expect Hemsoe's debt will stay relatively stable as a proportion of EBITDA, at around 15x, in 2018-2020 as a result of strengthening EBITDA margins. Moreover, EBITDA to interest coverage is currently very strong at around 4.5x due to very low interest rates. Stronger EBITDA, once new properties start operations, will secure the sustainability of Hemsoe's increasing debt stock. But with interest rates likely to rise gradually, we expect Hemsoe's EBITDA interest coverage will dip to 4.2x in 2020.

The stable outlook reflects our view that Hemsoe will continue to report strong and predictable operating cash flows, benefitting from its share of strong public-sector tenants, and stable debt servicing metrics over the next 24 months. Although we see potential risks from the company's expansion and the associated debt buildup, we anticipate that continued strong performance will protect its financial position and that proactive treasury management will contain refinancing risk. In our base-case scenario through 2020, we expect Hemsoe's management will remain conservative, keeping its strategic target of generating more than 50% of rental income directly from public-sector tenants while controlling international expansion.

We could raise the rating if we observe that management's strategy of re-structuring debt portfolio toward longer-term redemption profile notably strengthened its debt service coverage levels, resulting in structurally improved liquidity coverage. Alternatively, ratings upside would emerge if we observed a strengthening of Hemsoe's enterprise risk profile, for example from further improved asset quality and significant structural increase in direct rents from public-sector tenants in combination with maintained financial risk positions and contained international expansion.

We could lower the ratings if we observed that Hemsoe was becoming more exposed to cyclicality and stiffer market competition, which could occur if the proportion of private-sector tenants approached 50% of rental revenues. In addition, rating pressure would accumulate if the company's financial performance deteriorated significantly, leading to higher debt totaling 20x EBITDA and a potentially weaker liquidity position.


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