NEW YORK--(BUSINESS WIRE)--Fitch Ratings has upgraded the ratings of Healthcare Realty Trust (NYSE: HR) as follows:
--Issuer Default Rating (IDR) to 'BBB' from 'BBB-';
--Unsecured line of credit to 'BBB' from 'BBB-';
--Senior unsecured term loan to 'BBB' from 'BBB-';
--Senior unsecured notes to 'BBB' from 'BBB-'.
The Rating Outlook is Stable.
KEY RATING DRIVERS
The upgrade of HR's IDR to 'BBB' from 'BBB-' reflects the material improvement in leverage and fixed-charge coverage and Fitch's view of the durability of the operating cash flows for medical office buildings and by extension, HR, on an absolute and relative basis. HR's ratings are tempered by weak contingent liquidity and a persistently high dividend payout ratio which impedes cash retention. The combined effect of these factors on HR's financial flexibility is material and otherwise restricts positive momentum in the ratings and deterioration of these elements could result in negative momentum in the ratings.
MATERIAL REDUCTION IN LEVERAGE
HR has reduced leverage over the past five years with leverage at 6.5x for full year 2014 and 6.2x for the quarter ended Dec. 31, 2014 as compared to 8.8x at Dec. 31, 2010 and down from 6.9x at Dec. 31, 2013. The reduction has been achieved via equity issuances, the lease-up of developments and the focus on high occupancy acquisitions. Fitch had stated that leverage sustaining below 7x could result in positive momentum. Fitch forecasts that HR's leverage will remain around 6.5x through 2017.
Moreover, the durability of medical office building cash flows, as measured by same-store net operating income (SSNOI) growth, reduces the probability of leverage exceeding 7x through-the-cycle absent a change in the size or funding mix of net investment activity. Fitch defines leverage as total debt less readily available cash to recurring operating EBITDA.
Similarly, fixed-charge coverage has increased to 2.4x and 2.5x for the year and quarter ended Dec. 31, 2014, respectively. Fitch had previously indicated fixed-charge coverage sustaining above 2x could result in positive momentum. Fitch forecasts fixed-charge coverage will remain around 2.5x through 2016. Fitch defines fixed charge coverage as recurring operating EBITDA less straight-line rent and recurring maintenance capital expenditures to total interest incurred.
DURABILITY OF OPERATING CASH FLOWS
HR's operating cash flows are durable on an absolute and relative basis to that of suburban office REITs as measured by SSNOI growth and tenant retention. Since 3Q07, HR's SSNOI has averaged 2.3% growth vs. -0.1% for a select group of suburban office REITs, with a lower standard deviation of 0.9% vs. 2.2%.
Similarly, HR has retained 83% of its expiring tenants on average versus 67% for suburban office REITs and with significantly less variation (77% - 89% vs. 51% - 82%) over this same time period. While the magnitude of HR's outperformance has decreased as suburban office fundamentals improve, the low absolute (and relative) volatility is a key rating driver. Fitch does not view suburban office as competition for medical office buildings. The comparison is due to the similarity in headline metrics.
Weaker metrics in prior years were driven by both the size of then to-be-leased development pipeline and the conversion of master leases with embedded vacancies. Fitch anticipates HR will continue to develop, though the pipeline should not grow to levels that would cause a similar erosion. However, doing so could result in negative momentum on the metrics and/or ratings. Moreover, HR has converted the majority of its master leases thus Fitch expects HR's portfolio will exhibit more durable cashflow growth on a forward looking basis.
STRONG LIQUIDITY DRIVEN BY LONG-DATED BUT CONCENTRATED DEBT MATURITIES
Fitch estimates HR's sources of liquidity (unrestricted cash, 88% availability under the revolving credit facility and retained cash flow from operations) cover uses (total debt maturities, committed development expenditures and maintenance capital expenditures) by 4x for the period Jan. 1, 2015 - Dec. 31, 2016. HR's liquidity is driven by its line of credit capacity and staggered debt maturities. HR's next unsecured debt maturity is $300 million senior unsecured notes due 2017 (assuming the line of credit is extended to 2018 per HR's options). Unsecured debt maturities are long-dated yet somewhat concentrated given their size relative to total asset value with 21% and 29% of total debt maturing in 2017 and 2021, respectively.
IMPROVED YET WEAK CONTINGENT LIQUIDITY RESTRAINS RATINGS
HR's unencumbered asset coverage of unsecured debt has improved to 1.8x - 1.9x at Dec. 31, 2014 from 1.4x at Dec. 31, 2013. However, it remains below the 2.0x typically carried by investment grade REITs. Unencumbered assets are REITs' primary source of contingent liquidity to raise proceeds via a sale or pledge against during a time of stress. HR's sub 2x unencumbered asset coverage is a key limiting factor for the ratings. Positive improvement in the ratings is unlikely absent a material improvement. Moreover, a deterioration in contingent liquidity could result in negative momentum on the ratings and/or Outlook.
Fitch calculates unencumbered asset coverage assuming a stressed 8.5% - 9% cap rate on annualized 4Q'14 unencumbered NOI divided by unsecured debt less readily available cash.
DIVIDEND POLICIES IMPEDE CASH RETENTION
HR determines its dividend rate based off of operating cash flow measures before recurring maintenance capital expenditures. HR considers second generation tenant improvements and leasing expenditures to have a direct impact on renewal / new lease terms and thus the company considers these costs as part of the capitalized asset investment. Based on Fitch's methodology, HR paid out 108% of adjusted funds from operations (AFFO) in 2014, as compared to 113% and 114% in 2012 and 2013, respectively. In turn, HR needs to draw on its credit facility or source other forms of liquidity to fund a portion of the common dividend.
GRANULAR TENANT BASE & ASSOCIATION W/ HIGHLY RATED HOSPITALS
HR does not have any material tenant concentration after Baylor Scott & White Health (10% of revenues at Dec. 31, 2014) as the multi-tenant medical office buildings are leased to the individual physicians' group and are typically small in size. While HR does not typically enter into master lease obligations with the hospital that the building and / or tenant is affiliated with, Fitch nonetheless views the portfolio's proximity to the hospital and the credit quality of the hospital system as an indication of the attractiveness of the real estate. HR does not provide tenant EBITDA or EBITDAR coverage.
The Stable Outlook is driven by Fitch's expectations that operating fundamentals will continue to support consistent credit metrics.
Fitch's key assumptions within its rating case for the issuer include:
--SSNOI growth of 2.5% - 3.5% through 2017;
--Net acquisitions of $50 million at a -100bps spread to dispositions, annually;
--Development starts of $15 - $25 million per year;
--Equity issuances via the at-the-market program to fund net investment activity with 60% equity;
--The issuance of $250 million of senior unsecured notes in 2016 and 2017.
Fitch does not envision positive momentum on the ratings and/or Outlook absent addressing the negative sensitivities surrounding contingent liquidity and the dividend payout ratio. However, the following factors may result in positive momentum on the rating and/or Outlook:
--Fitch's expectation of leverage sustaining below 6.0x (leverage was 6.4x for the TTM ended Dec. 31, 2014);
--Fitch's expectation of fixed-charge coverage sustaining above 3.0x (coverage was 2.4x for the TTM ended Dec. 31, 2014).
The following factors may have a negative impact on the ratings or Outlook:
--Unencumbered asset coverage of unsecured debt sustaining below 2.0x (coverage was 1.9x at Dec. 31, 2014);
--An AFFO payout ratio sustaining above 100%;
--Fitch's expectation of leverage sustaining above 7.0x;
--Fitch's expectation of fixed-charge coverage sustaining below 2.0x;
--A material and sustained increase in speculative development.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage' May 28, 2014;
--'Rating U.S. Equity REITs and REOCs: Sector Credit Factors' Feb. 26, 2014.
Applicable Criteria and Related Research:
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage
Rating U.S. Equity REITs and REOCs (Sector Credit Factors)