NEW YORK--(BUSINESS WIRE)--Fitch Ratings has upgraded the credit ratings of Duke Realty Corporation (NYSE: DRE) and its operating partnership, Duke Realty Limited Partnership (collectively, Duke, or the company) as follows:
Duke Realty Corporation
-- Issuer Default Rating (IDR) to 'BBB' from 'BBB-';
-- Preferred stock to 'BB+' from 'BB'.
Duke Realty Limited Partnership
-- IDR to 'BBB' from 'BBB-';
-- Senior unsecured line of credit to 'BBB' from 'BBB-';
-- Senior unsecured notes to 'BBB' from 'BBB-'.
Fitch has also assigned a 'BBB' rating to the company's $250 million senior unsecured term loan.
The Rating Outlook is Stable.
Key Rating Drivers
The ratings take into account Duke's large pool of diversified industrial, office, and medical office properties, strong access to various forms of capital, and adequate unencumbered asset coverage of unsecured debt. These credit strengths are tempered by a modest pro forma liquidity surplus over the next several years and execution risk tied to asset sales in the near term.
Asset Sales Improve Credit Profile
Duke sold $877 million of properties during 2013 at a 6.8% in-place cap rate. The transactions furthered previous portfolio repositioning consistent with a 60%, 25%, 15% mix of bulk industrial, suburban office, and medical office building (MOB) assets, respectively. More importantly, the dispositions accelerated de-levering while strengthening the durability of the company's cash flows. Fitch expects that the company will continue to prune the portfolio via suburban office asset sales over the next 12-24 months, further improving financial flexibility while reducing exposure to more capital-intensive properties. However, there is execution risk in this strategy given that occupancy in markets such as St. Louis and Washington D.C. remains weak and may pressure the company's ability to sell assets in Fitch's expected 8%-8.5% cap rate range.
Appropriate Leverage for Ratings
Leverage based on 4Q'13 recurring operating EBITDA was 6.6x at Dec. 31, 2013 compared to 7.2x at Dec. 31, 2012 and 6.5x at Dec. 31, 2011 (leverage for 2012 and 2011 are pro forma for a January 2013 common equity issuance and late-2011 Blackstone suburban office portfolio sale, respectively). Fitch expects that leverage will stabilize around 6.5x, driven by approximately $440 million of pre-leased development completions in the latter half of 2014 and a 60%/40% mix between equity and debt on future growth The 6.5x leverage is appropriate for a 'BBB' rated REIT focused primarily on high-quality bulk industrial properties. Fitch defines leverage as net debt-to-recurring operating EBITDA.
Adequate Fixed Charge Coverage
Fixed charge coverage (FCC) was 1.9x for the year ended 2013, an increase from 1.6x and 1.5x during 2012 and 2011. Fitch expects that FCC will exceed 2.0x over the next 12-24 months and sustain in the low 2.0x range, driven by low single-digit same-store net operating income (SSNOI) growth, accretive development completions, and lower recurring capex given a reduced suburban office footprint. Projected FCC is consistent with the 'BBB' IDR. Fitch defines FCC as recurring operating EBITDA, less recurring capital expenditures and straight-line rent adjustments, divided by total interest incurred and preferred dividends.
Pre-Leasing Mitigates Development Risk
Duke's cost to complete its development pipeline has steadily increased to 3.9% of gross assets at Dec. 31, 2013 from 0.7% in 2009. However, the risk profile of developments has declined significantly, as 89% (compared to 47% in 2008 and 61% in 2009) of the portfolio is pre-leased. Fitch expects the company to emphasize pre-leased projects over the near term - a credit positive - with a measured appetite for speculative development depending on individual submarket fundamentals.
Duke's SSNOI increased 3.7% in 2013, with all three property types growing in excess of 3%. In-service occupancy of 94.2% at Dec. 31, 2013 is the highest achieved in over 10 years and has facilitated the company's ability to push rents. Renewal leasing spreads increased 3.1% during 2013 compared to 1.5% in 2012 and (0.9%) in 2011, indicating improving pricing power across property types, though suburban office rent growth remains muted. Strong operating results have been somewhat mitigated by increased leasing capex in suburban office renewals, where capex per square foot per lease year has increased steadily to $2.26 in 2013 from $1.40 in 2009.
Adequate Financial Flexibility
Duke has no unsecured maturities until February 2015 and, on average, only 11.3% of pro rata debt matures annually during the next five years, indicating modest refinancing risk. The company's liquidity profile is also adequate with total sources of liquidity covering total uses by 1.0x for 2014-2016. When including Duke's cost to complete the development pipeline, coverage weakens to 0.8x. Fitch expects asset sales and equity issuance under the company's at-the-market (ATM) equity program will offset the liquidity shortfall. Fitch defines liquidity coverage as sources of liquidity divided by uses of liquidity. Sources of liquidity include unrestricted cash, availability under the unsecured revolving credit facility, and projected retained cash flow from operating activities after dividends. Uses of liquidity include pro rata debt maturities, expected recurring capital expenditures, and remaining development costs.
DRE's liquidity profile is also supported by 2.1x pro forma unencumbered asset coverage of unsecured debt assuming a stressed 8.25% cap rate, which is consistent with a 'BBB' rating.
Conservative Dividend Payout
Accretive growth and a flat per share dividend drove the company's AFFO payout ratio lower to 74% in 2013 compared to 80% in 2012 and 84% in 2011. This leads to solid internally generated cash flow of roughly $75 million annually that is available to service fixed charges and fund external growth. Fitch expects the dividend to increase moderately over the next 12-24 months given continued accretive growth from development completions, improved operational stability from the realigned portfolio, and fact that the quarterly dividend has remained at $0.17/share since 2009, which is inconsistent with peers. Nonetheless, Fitch expects the AFFO payout ratio to remain in a prudent range.
Strong Access to Capital
Since 2006, Duke has raised on average $478 million of unsecured bonds per annum at a 5.4% coupon, demonstrating strong access to capital. The company has also raised $2 billion of common equity and $535 million of preferred equity during that span. Duke's established presence in the capital markets and underlying liquidity in its securities is a credit positive that enhances financial flexibility. Fitch notes that 29% of common equity issuance during that span consisted of $575 million raised in 2009 at $7.65/share or 30% discount to consensus net asset value (NAV) at the time. The severe dilution incurred by shareholders may affect the company's willingness to issue well below NAV in the future.
The Stable Rating Outlook is based on Fitch's expectation that leverage will stabilize around 6.5x, that coverage will exceed 2.0x, and that the company will maintain adequate financial flexibility over the near- to medium-term.
Preferred Stock Notching
The two-notch differential between DRE's IDR and preferred stock rating is consistent with Fitch's criteria for corporate entities with a 'BBB' IDR. These preferred securities are deeply subordinated and have loss absorption elements that would likely result in poor recoveries in the event of a corporate default.
The following factors may have a positive impact on the ratings and/or Rating Outlook:
-- Fitch's expectation of leverage sustaining below 6.0x (as of Dec. 31, 2013, leverage was 6.6x;
-- Fitch's expectation of FCC sustaining above 2.5x (LTM coverage was 1.9x).
The following factors may have a negative impact on the ratings and/or Rating Outlook:
-- Fitch's expectation of leverage sustaining above 7.0x;
-- Fitch's expectation of FCC sustaining below 1.5x.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
-- 'Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis' (Dec. 23, 2013);
-- 'Recovery Ratings and Notching Criteria for Equity REITs' (Nov. 19, 2013);
-- 'Corporate Rating Methodology' (Aug. 5, 2013);
-- 'Parent and Subsidiary Rating Linkage' (Aug. 5, 2013);
-- 'Criteria for Rating U.S. Equity REITs and REOCs' (Feb. 26, 2013).
Applicable Criteria and Related Research:
Criteria for Rating U.S. Equity REITs and REOCs
Parent and Subsidiary Rating Linkage
Corporate Rating Methodology: Including Short-Term Ratings and Parent
and Subsidiary Linkage
Recovery Ratings and Notching Criteria for Equity REITs
Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT
Credit Analysis - Effective Dec. 15, 2011 to Dec. 13, 2012