NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed the 'BBB+' Issuer Default Ratings (IDRs) of Essex Property Trust, Inc. (NYSE: ESS) and BRE Properties, Inc. (NYSE: BRE) following the announcement that the companies have entered into a definitive merger agreement. The Rating Outlook for both companies is Stable.
Under the terms of the agreement, each BRE common share will be converted into 0.2971 newly issued shares of Essex common stock plus $12.33 in cash and ESS will assume BRE's debt obligations. A full list of rating actions follows at the end of this press release.
Fitch expects a parent-subsidiary relationship will be established between ESS and BRE at the time of the merger's closing. As such, the IDR and Outlook of each issuer is expected to be the same going forward. The relationship is based on Fitch's assumption that BRE's unsecured debt will rank pari passu to that of ESS and legal and operational ties will be strong. Fitch expects the combined entity will a have similar jurisdictional presence, common management, and a centralized treasury.
Key Rating Drivers
The rating affirmations reflect Fitch's expectation for meaningful operating synergies and improved access to lower cost capital for the combined company. The Stable Outlooks incorporate Fitch's view that the combined company (herein: ESS) will continue to drive leverage lower over the near-to-intermediate term through a combination of internal and external property net operating income (NOI) growth, the formation of a joint venture and opportunistic equity issuances.
Rating concerns include an initial increase in ESS' leverage, as well as a reduction in its unencumbered asset coverage of unsecured debt (UA/UD) as a result of the merger.
Combination Viewed Favorably
Fitch generally has a favorable view toward the merger of ESS and BRE, notwithstanding the near-term deterioration in select credit metrics. Merging with BRE will bolster ESS' existing market presence in attractive, supply-constrained, West Coast markets, in which low single-family housing affordability has historically supported strong multifamily fundamentals.
Moreover, the agency expects the combined company will ultimately benefit from improved access to lower cost capital due to its larger size.
Elevated Leverage to Come Down
Fitch believes that ESS management remains committed to reducing leverage below 7.0x. However, Fitch estimates ESS' leverage will increase towards the mid-7.0x range as a result of the merger, up from 6.8x standalone as of Sept. 30, 2013 and 7.3x as of Dec. 31, 2012.
Fitch expects ESS will reduce its leverage to under 7.0x within approximately one year after closing the merger through a combination of same store net operating income (SSNOI) growth, incremental NOI from development deliveries and opportunistic share issuance under the company's at-the-market (ATM) equity program. Sustaining leverage above 7.0x remains a key rating sensitivity that could warrant a downgrade and/or negative revision to ESS' Outlook.
The source of funds for the approximate $950 million cash component of the transaction is a key sensitivity in Fitch's leverage estimate. ESS is considering several funding options, including debt issuances, asset sales and the formation of a joint venture.
Fitch views the formation of a JV as the company's preferred financing path. The agency is comfortable with the execution risk the strategy entails given ESS' successful track record of accessing private equity capital and the high level of institutional interest in yield oriented investments, including commercial real estate assets in core, supply constrained coastal markets.
Fitch's financial projections assume that ESS successfully places $1 billion of assets into a newly formed JV with an institutional investor(s). Fitch further assumes that ESS will retain a 50% stake in the new JV and that the fund will employ 60% leverage, resulting in an approximate $200 million equity requirement that ESS will need to fund, either through additional borrowings or equity.
Funding its JV equity requirement with debt would result in leverage of 7.5x for the combined company. If ESS issues equity to fund its obligation, leverage would be 7.3x.
Under both scenarios, Fitch has assumed that merger synergies offset increased property taxes stemming from California Proposition 13 when estimating the combined company's recurring operating EBITDA. Fitch defines leverage as net debt to recurring operating EBITDA including recurring operating cash distributions from joint ventures.
Lower Unencumbered Asset Coverage
Fitch estimates that ESS' unencumbered asset coverage of unsecured debt (UA/UD) will decrease slightly below 2.0x as a result of the merger from the low 2.0x range as of Sept. 30, 2013 which is a credit concern.
Higher property taxes and the assumed contribution of $1 billion of unencumbered assets into a newly formed JV are the principal reasons for the decline in UA/UD coverage. Fitch calculates the company's UA value using a direct capitalization approach of unencumbered NOI, assuming a stressed 7.5% capitalization rate.
Similar to leverage, Fitch expects internal growth and incremental NOI from development deliveries to lift the company's UA/UD above 2.0x within a year after closing the merger.
Strong Fixed Charge Coverage
Fitch expects ESS' fixed-charge coverage to be 3.0x on a trailing 12 month (TTM) basis for the combined company. This is consistent with standalone ESS' TTM fixed charge coverage of 3.0x at Sept. 30, 2013 and 3.0x for the year ended Dec. 31, 2012.
Fitch defines fixed-charge coverage as recurring operating EBITDA less recurring capital improvements divided by interest incurred and preferred distributions.
Limited Execution Risk
The overlap in asset profiles and markets suggests only a moderate amount of merger integration risk.
The following factors may result in a negative revision to ESS' ratings and/or its Outlook:
--Fitch's expectation of leverage sustaining above 7.0x (Fitch estimates TTM leverage would be 7.3x for the combined company on a pro forma basis assuming $200 million of new equity);
--Fitch's expectation of fixed-charge coverage sustaining below 2.5x (TTM coverage was 3.0x on a pro forma basis);
--Fitch's expectation of UA/UD sustaining below 2.0x (UA/UD was 1.9x on a pro forma basis as of Sept. 30, 2013).
Although Fitch does not anticipate any upwards rating momentum, the following factors could result in a positive revision to ESS' ratings and/or its Outlook:
--Fitch's expectation of leverage sustaining below 6.0x;
--Fitch's expectation of fixed-charge coverage sustaining above 3.5x;
--UA/UD sustaining above 3.0x.
Fitch has affirmed the following ratings:
Essex Property Trust, Inc.
--Issuer Default Rating at 'BBB+';
--Preferred Stock at 'BBB-'.
Essex Portfolio L.P.
--Issuer Default Rating at 'BBB+';
--Unsecured Line of Credit at 'BBB+';
--Senior Unsecured Notes at 'BBB+'.
BRE Properties, Inc.
--Unsecured revolving credit facility 'BBB+';
--Senior unsecured notes 'BBB+';
--Preferred stock at 'BBB-'.
In accordance with Fitch's policies Essex appealed and provided additional information to Fitch that resulted in a rating action that is different than the original rating committee outcome.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Recovery Rating and Notching Criteria for Equity REITs,' Nov. 19, 2013;
--'Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage,' Aug. 5, 2013;
--'Criteria for Rating U.S. Equity REITs and REOCs,' Feb. 26, 2013;
--'Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis,' Dec. 13, 2013.
Applicable Criteria and Related Research:
Recovery Rating and Notching Criteria for Equity REITs - Effective May 12, 2011 to May 3, 2012
Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage
Criteria for Rating U.S. Equity REITs and REOCs
Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis