Annington Limited -- Moody's assigns (P)Caa1 rating to Annington Finance No. 5 plc's proposed GBP500 million PIK toggle notes

London, 19 November 2012 -- Moody's Investors Service has today assigned a first-time corporate family rating (CFR) of B1 and probability of default rating (PDR) of B3 to Annington Limited ("Annington Ltd"). In addition, the agency has assigned a provisional (P)Caa1 rating to the proposed GBP500 million PIK toggle notes maturing in 2022, to be issued by Annington Finance No. 5 plc ("the Issuer").

The PIK notes will be (1) guaranteed by the Issuer's immediate parent company, Annington Homes Limited (AHL), and AHL's parent company, Annington Ltd; (2) secured via share pledges of the Issuer and AHL and sister companies Annington Rentals (Holdings) Ltd (ARHL), Annington Developments (Holdings) Ltd (ADHL) and Annington Subsidiary Holdings Ltd (ASHL); and (3) secured by a first-ranking security interest in the proceeds loan from the Issuer to AHL. The outlook on the ratings is stable.

Moody's issues provisional ratings in advance of the final sale of securities and these ratings reflect Moody's preliminary credit opinion regarding the transaction. Upon the issuance of the notes and a conclusive review of the final documentation, Moody's will endeavour to assign a definitive rating to the notes. A definitive rating may differ from the provisional rating.

RATINGS RATIONALE

Annington Ltd is a newly formed intermediate holding company within the Annington corporate group ("Annington"). Consolidated accounts, historically reported by Annington Holdings plc, will in future be reported by Annington Ltd. with what Moody's understands to be non-material differences. Annington Ltd's CFR is underpinned by the core business of the corporate group -- a large, granular portfolio of residential properties located largely in southern England where occupier demand and house prices are the highest in the country. Consolidated total assets were reported at GBP4.84 billion at financial year-end 31 March 2012. Rental income from the core business is secure and stable; it is derived from the long lease (999 years) and leaseback (200 years) transaction completed between the UK Ministry of Defence (MoD) and Annington in 1996. The lease agreement allows for rents to grow in line with estimated market rents but are then subject to a contractual discount. Leases on any of the properties can be terminated ("released") by the MoD with six months notice at which time the freehold interest to these properties is handed back to Annington. However, due to rent being payable at a discount, the housing stock has greater value with the benefit of vacant possession. Annington has a track record of consistently refurbishing and selling "released" homes at a profit, achieving sales prices close to market value. In addition, asset values over the long term have benefited from the favourable supply and demand imbalance in the UK housing market, particularly within its market niche which is for affordable homes and first time buyers.

Annington Ltd's activities are not widely diversified but include two other smaller related businesses: ARHL, which owns and manages a smaller portfolio of residential investment properties that are leased to private individuals and Housing Associations at market rent; and ADHL, which redevelops some of the larger sites released from the MoD, largely in joint venture with external business partners.

Annington Ltd's CFR is constrained by an aggressive financial policy, illustrated by the quantum and purpose of the PIK notes, which is to part-finance the buy-back of Nomura's shareholding in Annington. The group's financial policy has already led to very weak overall fixed charge coverage, as measured by adjusted EBITDA/gross interest expense (including amortisation of the discount from the zero-coupon bonds) plus ground rents estimated at 0.6x for the first half-year to 30 September 2012 and 0.5x for the financial year 2011/12. Another contributing factor to the weak coverage is the fine yield produced by its low-risk residential investments.

ARHL has c. GBP124 million outstanding debt at 30 September 2012, secured by its property assets with interest payable in cash. However, the group's core business (held in ASHL) raised finance through a whole business securitisation (WBS), with WBS debt reported in the accounts at GBP2.1 billion at 30 September 2012. The WBS cannot cash pay all its interest expense due to the high level of indebtedness relative to income and cash flow generation. This has been accommodated with the issuance of zero-coupon bonds for a portion of the WBS debt. The proposed PIK toggle notes to be issued by Annington Finance No. 5, a company external to the WBS, are forecast to accrue rather than pay interest for at least the next five years.

In addition, leverage as measured by adjusted net debt/recurring EBITDA was extremely high at c. 30.7x for the 2011/12 financial year ending 31 March 2012 compared to 16.5x for 2010/11 - the difference being largely due to a GBP79 million fair value write down of interest rate swaps in 2011/12. At 30 September 2012, Annington Ltd's effective leverage, as measured by adjusted consolidated debt/ total assets, was moderate at c. 48%; but following the issuance of the PIK, pro forma effective leverage is estimated to rise immediately to a much higher level of c. 59% (all data and ratios as adjusted by Moody's).

Annington Ltd's B3 PDR is two notches lower than the B1 CFR, given the rating agency's view of a higher than average recovery rate in the event of default. In Moody's opinion, there is a high degree of refinancing risk at maturity. The amount of PIK notes outstanding at maturity will depend on the level of interest accrued. This in turn will be a function of the volume of property releases from the MoD and management's ability to continue realising close to the portfolio's fair value with the benefit of vacant possession (reported as 98% on an historic average basis since 2000 by Annington) , thus raising additional cashflow to service debt. However, should an event of default result in the disposal of group's assets, by virtue of their valuation and the quality of the MoD as tenant of the core business, this would be likely to support higher than average recovery levels on the PIK toggle notes than would usually be experienced by creditors under such circumstances.

The PIK notes (P) Caa1 instrument rating has been notched down from the CFR to reflect its subordinated status. A contractual restricted group for the PIK issuance will be created that includes its immediate parent AHL and sister companies ARHL, ADHL and ASHL. (ASHL is the holding company of the WBS). The PIK notes will be secured only by the proceeds loan from the Issuer to AHL and a charge on the shares of the above-mentioned members of the restricted group. The PIK notes will not be collateralised by a charge on any of the restricted group's assets. In the event of default, any recovery made by the PIK note holders will be effectively and structurally subordinated to the claims of investors in the WBS notes and lenders of ARHL and its subsidiaries' secured banking facilities.

The group's liquidity is supported by the strong cash flow generated from the rental income of its core business and management's reported track record in selling released assets at an average of 98% of value with the benefit of vacant possession. Liquidity is adequate for the next 12 to 18 months insofar as the WBS has been enhanced by liquidity facilities to avoid payment default and the financing structure contains zero-coupon bonds, thereby enabling rental income from the MoD to cover all contractual debt servicing. In addition, the PIK toggle notes can accrue interest if cashflow from future MoD releases is insufficient to cash pay. Furthermore, ARHL's secured cash pay bank loans are set at levels that can be serviced by ARHL income. Headroom under ARHL's bank loans leverage and interest cover covenants is adequate at present, with the minimum headroom for any one covenant at 30 September 2012 at around 17%.

The stable rating outlook assumes that over time Annington Ltd's fixed charge coverage will trend towards 1.0x, liquidity will remain adequate on a forward-looking basis of 12 to 18 months, including but not limited to adequate headroom under the group's various financial covenants.

WHAT COULD CHANGE THE RATING UP/DOWN

Although unlikely in the near term, upward pressure on the rating could arise when Annington Ltd's leverage materially declines enabling it to cash pay the interest expense on the PIK notes on a sustainable basis.

Negative pressure on the rating could arise if any of the companies outside or within the restricted group of the WBS issue debt or their assets suffer from a decline in fair market value such that Annington Ltd's adjusted debt/total assets trends towards 70%, which in turn decreases the notes' estimated recovery given default as well as increasing refinancing risk beyond current expectations. A deterioration in credit quality of the WBS could also result in negative pressure on the rating. Negative pressure could also arise if (1) interest cover does not gradually improve towards 1.0x; or (2) any liquidity challenges develop that are not adequately addressed.

PRINCIPAL METHODOLOGY

The principal methodology used in rating Annington Ltd was Moody's Approach for REITs and Other Commercial Property Firms Industry Methodology published in July 2010. Please see the Credit Policy page on www.moodys.com for a copy of this methodology.

Established in 1996, Annington is an unlisted property investment group that primarily owns around 40,000 residential units leased to the UK'sMinistry of Defence and reported consolidated total assets of GBP4.84 billion at financial year-end 31 March 2012.

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