NEW YORK--()--Fitch Ratings has assigned a credit rating of 'BBB-' to the $150 million issuance of senior unsecured notes by Associated Estates Realty Corporation (Associated Estates; NYSE/NASDAQ: AEC). The notes were offered in a private placement and consisted of $63 million eight-year notes with a yield of 4.02% and $87 million 10-year notes with a yield of 4.45%. Proceeds from the issuance were used to repay borrowings under the company's unsecured credit facility, including amounts borrowed in December to repay two mortgages totaling approximately $33.6 million.
Fitch currently rates Associated Estates Realty Corporation as follows:
--Issuer Default Rating (IDR) 'BBB-';
--$350 million senior unsecured revolving credit facility 'BBB-';
--$150 million senior unsecured term loan 'BBB-';
--$150 million senior unsecured notes 'BBB-'.
The Rating Outlook is Stable.
The 'BBB-' IDR reflects favorable multifamily fundamentals resulting in sustained fixed-charge coverage appropriate for the 'BBB-' rating, the company's primarily acquisition-driven increase in size which incrementally lessens asset concentration, and accelerated leverage reductions via follow-on common stock offerings. The rating action takes into account credit concerns including an increased development pipeline that hampers liquidity, as well as heavy 2013 debt maturities. However, mitigating this concern are the company's continued improvement in access to capital and good contingent liquidity as measured by solid unencumbered asset coverage of unsecured debt.
FAVORABLE PROPERTY FUNDAMENTALS
Improving occupancy and rent rollover rates are resulting in solid fixed-charge coverage. Strong demand and muted new supply in AEC's submarkets have led to same-community physical occupancy of 97.3% as of Sept. 30, 2012, up from 94.8% as of Sept. 30, 2011. Rental rates on new and renewal leases increased by 4.4% in the third quarter of 2012 (3Q'12). Despite difficult comparisons from 2011, leasing momentum continued after new and renewal spreads of 5% in 2Q'12 and 2.2% in 1Q'12. Fixed-charge coverage was 2.5x in 3Q'12 pro forma for the bond offerings, compared with 2.8x in 3Q'12 and 2.1x in fiscal year (FY) 2011. Fitch defines fixed-charge coverage as recurring operating EBITDA less recurring capital expenditures divided by total interest incurred.
Fitch anticipates that positive leasing spreads will continue in the near term due to favorable supply-demand dynamics in AEC's submarkets. For the next 12-to-24 months, Fitch projects that fixed-charge coverage will remain in the 2.5x to 3.0x range due to organic growth and incremental NOI from acquisitions and development, which is appropriate for a 'BBB-' rating.
In a stress case whereby same-store NOI declines are similar to those experienced by AEC in 2009, fixed-charge coverage would remain in the mid-2.0x range in the near term, which would be weaker for the 'BBB-' rating for a multifamily REIT of AEC's size. In a more adverse case than anticipated by Fitch, fixed-charge coverage could approach 2.0x, which could place pressure on a 'BBB-' rating.
EXPANSION IMPROVES ASSET QUALITY
AEC's roots are in the Midwest, though recent acquisitions in other multifamily markets have broadened the company's geographic footprint. Key purchases over the past year were in greater Dallas, TX and Raleigh, NC, with capitalization rates ranging from the low 5% range to the mid 6% range. Moreover, AEC is selectively targeting submarkets with proximity to transportation and employment hubs while shedding older assets in Western Michigan, Duluth, GA, and Columbus, OH.
SMALL SIZE LIMITS CAPITAL ACCESS
Despite its recent growth, AEC remains substantially smaller than most of its multifamily REIT peers, with gross undepreciated assets of approximately $1.5 billion, a total market capitalization of approximately $1.5 billion, and an equity market capitalization of approximately $750 million as of Sept. 30, 2012. The company's smaller size may limit capital markets access, given that REIT-dedicated investors may not be able to acquire a meaningful investment in the company's securities.
The company's small size also results in certain assets contributing materially toward results. AEC's top-five assets contribute approximately 25% of total NOI and the top 10 assets contribute approximately 40% of total NOI, highlighting asset concentration risk.
LEVERAGE APPROPRIATE FOR RATING
A follow-on common stock offering of $87.2 million in June 2012 and capital raises via ATM programs have funded acquisitions and development. Net debt to recurring operating EBITDA was 7.7x in 3Q'12 compared with 7.1x in 2Q'12 and 8.3x in FY2011.
Under Fitch's base case projections, AEC's leverage will sustain in the 7.0x to 7.5x range over the next 12-to-24 months as the company grows earnings via acquisitions and development while funding such activity with approximately 45% debt and 55% equity. In a stress case whereby same-store NOI declines are similar to those experienced by AEC in the 2009 period, leverage would sustain around 8.0x, which would be more appropriate for a 'BB+' rating. In a more adverse case than anticipated by Fitch, leverage could sustain above 8.5x in the near term, which would be weak for a 'BB+' rating.
DEVELOPMENT CONSTRAINS LIQUIDITY
AEC's development pipeline consists of two active projects in Dallas and Bethesda, MD, as well as two future projects in Dallas and Los Angeles. Draws on the company's $350 million unsecured revolving credit facility to fund these projects weakened liquidity coverage to 1.2x (defined as liquidity sources divided by uses) for the period from Oct. 1, 2012 to Dec. 31, 2014. However, pro forma for the private placement offerings, liquidity coverage improves to 1.7x. Sources of liquidity include unrestricted cash, availability under AEC's unsecured revolving credit facility, and projected retained cash flows from operating activities after dividends and distributions. Uses of liquidity include debt maturities and projected development, and recurring capital expenditures.
Debt maturities are heavy in 2013, however, totaling 21.1% of total debt as of Sept. 30, 2012. Assuming an 80% mortgage refinance rate on upcoming secured debt, liquidity coverage would improve to 4.8x, but Fitch views this scenario as unlikely as the company endeavors to continue unencumbering the portfolio via equity offerings and unsecured debt.
GOOD CONTINGENT LIQUIDITY
Third quarter 2012 annualized unencumbered NOI divided by a stressed capitalization rate of 7.5% covered unsecured debt by 2.9x, which is strong for a 'BBB-' rating. Pro forma for the repayment of mortgage debt on select assets with the private placement unsecured bond offerings, unencumbered asset coverage is 2.1x, which is adequate for a 'BBB-' rating.
Unencumbered NOI represented 58% of 3Q'12 NOI and Fitch anticipates unencumbered NOI increases to 74% on a pro forma basis, compared with 45% in 2011 and 34% in 2010. This positive trend is indicative of the company's commitment toward growing its unencumbered pool, to the benefit of unsecured creditors.
LIMITED UNSECURED-BORROWER TRACK RECORD
The private placement bond offerings improve the company's unsecured-borrower track record, building on recent transactions including the upsizing of the unsecured term loan to $150 million from $125 million. In addition, the covenants in AEC's unsecured debt agreements do not restrict financial flexibility.
The Stable Outlook reflects that the 'BBB-' rating is not likely to change in the near-to-medium term. Fitch anticipates that AEC will continue growing in a measured manner via acquisitions and development while maintaining fixed-charge coverage in the 2.5x-to-3.0x range and leverage in the 7.0x to 7.5x range over the next 12-to-24 months.
WHAT COULD TRIGGER A RATING ACTION
Fitch does not anticipate positive rating momentum in the near term. However, the following factors may result in positive rating and/or Outlook momentum:
--Undepreciated assets sustaining above $2 billion (undepreciated assets were approximately $1.5 billion as of Sept. 30, 2012);
--Fitch's expectation that fixed-charge coverage sustains above 3.0x given the company's size (3Q'12 fixed-charge coverage was 2.5x pro forma);
--Fitch's expectation that leverage sustains below 7.0x given the company's size (as of Sept. 30, 2012 leverage was 7.7x based on 3Q'12 annualized recurring operating EBITDA).
The following factors may result in negative rating and/or Outlook momentum:
--Fitch's expectation that fixed-charge coverage ratio sustains below 2.0x;
--Fitch's expectation that leverage sustains above 8.0x;
--A base case liquidity coverage ratio that excludes the impact of refinancing activities sustaining below 1.0x (pro forma liquidity coverage is 1.7x).
Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.
Applicable Criteria and Related Research:
--'Recovery Rating and Notching Criteria for Equity REITs', Nov. 12, 2012;
--'Corporate Rating Methodology', Aug. 8, 2012;
--'Criteria for Rating U.S. Equity REITs and REOCs', Feb. 27, 2012.