S&P Global Ratings expects the COVID-19 pandemic and resulting state government-imposed lockdowns to result in material near-term reductions in rent collections for U.S single-tenant triple-net (NNN) securitizations. As of this publication date, more than 90% of the U.S. population has been placed under stay-at-home orders with restrictions on non-essential activities. Though some states are beginning to ease certain restrictions, remaining widespread restrictions combined with continued nationwide social distancing recommendations and reductions in permitted occupancies will substantially depress NNN securitizations' cash collections for at least the near term.

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak around midyear, and we are using this assumption in assessing the economic and credit implications. In our view, the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates at www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

While we cannot yet fully quantify the effects of the pandemic and accompanying restrictions on non-essential activity, we are assessing how well NNN transactions rated by S&P Global Ratings can withstand reductions in near-term rent collection while still meeting their scheduled obligations.

Our sensitivity runs show that NNN transactions rated by S&P Global Ratings can withstand sustained declines in scheduled rent collection for the next 12 months of approximately 43%-76% across the rating levels of the bonds without suffering interest shortfalls. Pools with higher exposure to more severely disrupted industries, such as casual dining, fitness clubs, and early childhood education, are more vulnerable to near-term liquidity and longer-term credit risk, in our view. Our initial sensitivity analysis did not consider potential government support, servicer/manager advances, or waivers of management and special servicing fees.

Transaction Landscape

Single-tenant NNN lease securitizations are secured by properties that are considered essential to their respective tenants' operations and ability to generate revenues. NNN leases require tenants to pay all maintenance, taxes, and insurance on their properties. S&P Global Ratings currently maintains ratings for six master trusts (across 15 series) managed by five property managers (see charts 1 and 2 below).

Chart 1

Chart 2

COVID-19-caused interruptions have severely impacted many NNN tenants' ability to generate revenue, and thus their ability to pay rent, leading to widespread rent modification requests and some delinquencies. Most property managers for securitizations rated by S&P Global Ratings have reported that the majority of their tenants have requested some form of relief, ranging from partial deferral to full abatement. The managers have generally offered various forms of partial deferral to tenants they've deemed to be most in need and have denied nearly all abatement requests.

Servicer reports reflecting April 2020 rent collections, the first month reflecting the impact of COVID-19, demonstrate varying levels of performance. For the various collection periods, all ending by April 20, we've observed collections as a percentage of schedule rent ranging from 52% to 100%. As we discuss in more detail below, we believe this variance to be driven largely by each issuer's unique mix of industries and locations.

We believe industry mix to be one of the more important performance drivers in the current environment. There are approximately 70 different industries represented by tenants within the collateral pools of NNN transactions rated by S&P Global Ratings, with over 75% of properties, by count, concentrated in eight industries (see table 1). Some operators have high industry concentrations in their collateral pools, while a majority have wide diversity. Pools with higher exposure to businesses unable to operate, or operate at full capacity, in the current environment, such as full service restaurants and fitness clubs, are more likely to experience reduced collections over the near term.

Table 1

The rated transactions have a fair amount of geographic diversity with properties spread over 30-48 states and distributed between primary, secondary, and tertiary markets (see chart 3 below). However, with most states under various forms of lockdown, the impacts from COVID-19 are being felt across the regions. Though it is unclear whether regional mix has contributed significantly to variations in collection performance between early March and now, we are watching closely to understand whether it may play more of a role going forward. In particular, we believe it is possible that portfolios with greater secondary and tertiary market concentrations may exhibit strengthened performance sooner if the restrictions on non-essential businesses and stay-at-home guidance are lifted more quickly outside of primary markets.

Chart 3

Structural Mechanisms Of NNN Transactions

Integrated waterfalls  All the transactions have integrated waterfalls: i.e., all collections received including rent, property liquidation proceeds, and short-term interest from temporary investments are held in one collection account. All collections received can be used to pay senior fees and interest on the bonds. Because our rating analysis looks for timely interest and ultimate principal paid to noteholders, the availability of all cash collections to cover timely interest payments could be a mitigating factor to liquidity stress in the near term. The transactions typically pay senior fees, note interest in sequential order, scheduled principal in sequential order, subordinate fees, and then the equity. Non-payment of scheduled principal does not constitute an event of default.

Servicer/manager advances  In all NNN lease transactions rated by S&P Global Ratings, the property manager or the servicer will be obligated to make advances to cover any shortfall in the scheduled payment of timely interest and scheduled principal on the notes. However, we do not give credit to this in our rating analysis because the notes are typically rated higher than the rating on the manager/servicer.

Reserve accounts  Some NNN structures have small liquidity reserves to cover interest shortfalls and senior fees. However, these are designed to primarily cover 'AAA' interest shortfalls and will not be available if there are no 'AAA' rated notes outstanding. As such, most notes in our rated book of NNN lease-backed transactions may not benefit from the reserve accounts to alleviate short-term liquidity shortfalls. Given the liquidity stress that transactions are currently experiencing, we consider the lack of meaningful, permanent liquidity reserves to be a significant structural weakness that could be a driver of negative ratings actions if debt service coverage declines sharply.

Cash trap triggers  All transactions have trigger mechanisms designed to trap excess cash into a debt service account if the monthly debt service coverage ratio (DSCR) drops below a given threshold (typically 1.30x or 1.25x). The transactions shift to early amortization if the three-month average DSCR subsequently breaches a given lower threshold (typically 1.20x or 1.15x). These triggers are typically curable if the DSCR exceeds the given threshold for three consecutive periods. These mechanisms protect the noteholders by ensuring no cash is leaked out to equityholders at times when rent collections are diminished. We have observed that some managers are taking actions, such as temporarily waiving their right to management and special servicing fees, in order to bolster transaction liquidity and keep DSCRs above trigger levels.

Other Potential COVID-19-Related Credit Factors To Watch

We are paying close attention to the following parameters that could lead to rating actions in this sector.

Near-term liquidity concerns from rent deferrals

Disruptions in NNN debt service may be due to delinquencies in tenant payments, rent deferrals granted to the tenants by the NNN property manager, modifications made to the terms of rental agreements, rent abatements, or outright store closings and bankruptcies. So far, we are aware of no NNN tenant bankruptcies or permanent closures due to the COVID-19 outbreak. As of April 15, 2020, issuers have allowed rent deferrals for between 18%-43% of their portfolios (by annualized rent), including partial deferrals, and virtually no abatements. Deferrals, which generally pertain only to a portion of scheduled monthly rent, can range from one to six months, with typical repayment terms of six to 12 months following the end of the deferral period. Some managers are charging interest on these deferrals, while others are requesting lease term extensions in exchange.

S&P Global Ratings' methodology for rating this sector assumes substantial cash flow stresses as part of our analysis, according to our criteria "Methodology And Assumptions For Rating North American Single-Tenant Real Estate Triple-Net Lease-Backed Securitizations" published March 31, 2016. We consider waves of defaults commensurate with applicable rating categories, stressed renewal terms reflecting the macroeconomic strain associated with different rating scenarios, and potential recoveries based on property liquidations (see "CMBS Global Property Evaluation Methodology" published Sept. 5, 2012). The S&P Global ratings-derived liquidation values incorporate our commercial-backed mortgage securities' operating and capital expense assumptions through multiple business cycles in addition to our industry- and market type-specific capitalization rates.

Because S&P Global Ratings believes the U.S. economic recovery will begin to take shape in the third quarter of this year, we are considering supplemental liquidity stresses to address the continued near-term impact of the pandemic, as well as the longer-term possibility that some sectors will face weak consumer traffic recoveries even after stay-at-home guidance and operating restrictions are lifted. This is especially important given that the NNN transactions generally have no substantial dedicated reserve accounts to cover temporary debt service coverage shortfalls.

Additionally, we have performed analyses to determine the breakeven sustained cash collection reductions the deals can withstand without suffering interest shortfalls over the next 12 months. Our initial results show that the transactions can withstand collection reductions of approximately 43%-76%, depending on the transaction and bond seniority. Overall, we observed higher cushions at the higher rating levels and more modest cushions at subordinated rating levels. Should industries among the portfolios' top concentrations experience high levels of delinquencies, bankruptcies, or permanent store closures, the transactions could see payment shortfalls starting with the most subordinate rating levels going up the capital structure.

Macroeconomic environment

The novel COVID-19 outbreak has brought on a recession that looks to be just as sharp as what we saw in the Great Recession, only over a shorter time span (see "An Already Historic U.S. Downturn Now Looks Even Worse" published April 16, 2020). Skyrocketing unemployment claims combined with dried-up consumer spending will cause at least a portion of the storefronts in NNN portfolios to see much weaker customer traffic once they are able to resume normal operations.

Long-term credit impact from a rise in defaults and bankruptcies

As businesses remain closed on account of the containment measures, payment deferrals may continue to rise. As of April, issuers have approved approximately 18%-43% of deferral requests. The longer business restrictions remain in force, the more likely delinquencies will rise and could eventually become defaults.

Given the potential for rising defaults, we are reexamining our long-term cashflow projections for the transactions. Among other things, we may perform supplementary sensitivity tests to assess the impact of broad and industry-specific declines in the credit quality of unrated tenants. Though some transactions have substantial concentrations of rated obligors, the majority of tenants in the NNN transactions we rate are unrated.

For the purpose of estimating scenario default rates (SDRs) using CDO Evaluator (CDOE), we generally assume a rating in the 'b' category for such unrated tenants. Given the widespread negative rating actions currently taking place across corporate credits, and particularly among retail and restaurant operators, we may perform sensitivity runs where we test SDRs estimated assuming weaker credit profiles for unrated tenants. To provide a sense of the potential impact of such changes on our SDR assumptions, we estimate that a one-notch downward rating adjustment for all unrated tenants, across all industries, would cause, on average, a 4%-6% increase in SDRs for each of the 'AAA' through 'BBB' categories.

Manager/servicer support to the transactions

As a part of our regular due diligence, S&P Global Ratings spoke with all the property managers for NNN securitizations rated by S&P Global Ratings to gather more data on the portfolios, including the managers' performance outlooks. The managers reported virtually no bankruptcy activity or permanent store closures as a result of the COVID-19 pandemic so far. There was consensus that the tenant industries facing the most significant near-term headwinds include full service restaurants, discretionary retail, early childhood education, fitness clubs and entertainment centers. All managers reported that they had been in direct dialogue with most of their tenants since the start of the pandemic and that a majority had requested some form of rent relief.

The transaction documents mandate that servicers advance payments, to the extent there are shortfalls in noteholder payments due on each payment date. Our rating analysis does not give any credit to these advances; however, transactions where operators advance payments may see less impact from rising delinquencies. As of April, no issuers in the NNN space had made advances to the securitizations.

Government aid to small business

Helping to alleviate the brunt of the recession are government lending programs to small businesses to maintain workers' wages, in addition to expanded unemployment insurance and direct checks provided to American families in the recently passed COVID-19 Aid, Relief, and Economic Security Act. The issuers' portfolios have anywhere between 17%-90% of tenants who could be eligible for the government relief programs. From our conversations with the issuers, we understand that most if not all eligible tenants have applied for the relief. It is unclear at this time what percentage of those applicants have been approved for the loans and have received the funds. Although the relief may be coming for some of these portfolios, it will likely not be enough to fully offset the incoming decline of economic activity in the second quarter. In addition, the operational difficulties surrounding this program, as well as the timeliness of the receipt of relief payments, may be critical to potential shortfalls in the transactions.

At this point, there's a high degree of uncertainty surrounding the depth and length of disruption. We will continue to review our assumptions on the NNN space as the COVID-19 outbreak matures, state government regulations indicate more tangible timelines, and the impact of government aid programs becomes clearer.

Related Criteria

• Methodology And Assumptions For Rating North American Single-Tenant Real Estate Triple-Net Lease-Backed Securitizations, March 31, 2016
• CMBS Global Property Evaluation Methodology, Sept. 5, 2012

Related Research

• An Already Historic U.S. Downturn Now Looks Even Worse, April 16, 2020
• It's Game Over For The Record U.S. Run; The Timing Of A Restart Remains Uncertain, March 27, 2020
• REITrends: COVID-19 Could Threaten Rating Stability For North American REITs, March 17, 2020