Fitch Rates Digital Realty Trust's $500MM 3.950% Notes Due 2022 'BBB'; Outlook Stable

NEW YORK--()--Fitch Ratings has assigned a credit rating of 'BBB' to the $500 million unsecured notes issued by Digital Realty Trust L.P., a subsidiary of Digital Realty Trust, Inc. (NYSE: DLR). The 2022 notes were priced at 99.236% of par, or at 4.076%, a 200 basis point (bps) spread to the benchmark treasury.

DLR intends to use the proceeds to fund eligible green projects and, pending such uses, to repay the company's revolving credit facility. Eligible green projects means new or ongoing projects (including new development, expansions and/or property renovations) and/or existing assets under management by Digital Realty or any of its subsidiaries, which have received, or are expected to receive, any LEED certification rating level (Certified, Silver, Gold or Platinum) or LEED equivalent certification.

The Rating Outlook is Stable.

KEY RATING DRIVERS

Fitch's 'BBB' Issuer Default Rating for Digital Realty reflects the expected implementation of the company's strategy to improve return on invested capital (ROIC) through leasing existing data center space, developing new assets, and selling non-core assets. This strategy should result in strong fixed-charge coverage for the 'BBB' rating. As the largest data center REIT, Digital Realty exhibits credit strengths including a global platform, granular tenant base, strong access to multiple sources of capital, adequate liquidity, and a deep management bench.

The rating also takes into account the niche asset class in which the company operates, resulting in a less liquid investment market than other commercial property asset classes. Credit concerns center on Fitch's expectation that the company will increase leverage over the next several years and the company maintains low unencumbered asset coverage for the rating.

Strategy Focused on Improving Unlevered Cash Flow

The lease-up of existing inventory is one of the company's top priorities. Tenants across the social media, mobility, analytics, and cloud segments are driving the majority of new demand for Digital Realty's properties. Portfolio occupancy was flat year-over-year at 92.1% as of March 31, 2015, but quarterly stabilized same store year-over-year cash net operating income (NOI) growth averaged 3.9% for the trailing 12 months (TTM) due primarily to strong tenant retention. Renewal leasing activity represented 54.4% of leased square footage for the TTM ended March 31, 2015 with a tenant retention rate of 80%. Comparisons for renewals remain challenging due to the rolldown of peak rental rates signed prior to the financial crisis. Over the next several years, Fitch projects 2% to 3% same-store NOI growth, driven primarily by occupancy gains and contractual rental rate increases, offset by some rental rate rolldowns on renewals.

Same-store NOI growth, cash flow from the lease-up of developments, and increased cash flow from joint ventures, offset by a reduction of EBITDA from the sale of non-core assets, should drive fixed-charge coverage of 2.8x over the next two years, appropriate for a 'BBB' rating given Digital Realty's niche property focus. Fixed-charge coverage was 2.9x for the TTM ended March 31, 2015 compared to 2.9x in both 2014 and 2013, and 3.1x in both 2012 and 2011. Fitch defines fixed-charge coverage as recurring operating EBITDA including recurring cash distributions from unconsolidated entities less recurring capital expenditures less straight-line rent adjustments divided by total cash interest incurred and preferred stock dividends.

Global Platform

Digital Realty offers Turn-Key Flex, Powered Base Building, and colocation space, and its 130 properties span 33 markets across 10 countries and four continents. This significant market presence gives the company strong tenant relationships. Top markets as of March 31, 2015 were London (11.7% of annualized rent), Dallas (10.4%), Northern Virginia (10.1%), New York (9.2%), and Silicon Valley (8.8%). The company's significant market presence has built strong tenant relationships and allows it to benefit from a granular tenant roster, which includes CenturyLink, Inc. (Fitch IDR of 'BB+' with a Stable Outlook) at 7.3% of rent, IBM (IDR of 'A+' with a Stable Outlook) at 7%, TelX Group, Inc. at 4.1%, Equinix Operating Company, Inc. at 4% and Facebook, Inc. at 2.4%.

Strong Access to Capital but Limited Secured Debt Market for Data Centers

Since 2006, the company has issued $2.7 billion of common equity, $1.6 billion of preferred equity, $2 billion of dollar-denominated unsecured bonds, and GBP700 million of sterling-denominated unsecured bonds. The company's sterling-denominated bonds function as a natural hedge given the company's exposure to the United Kingdom. In August 2013, the company refinanced its global RCF, increasing its total borrowing capacity to $2 billion from $1.8 billion and also refinanced the senior unsecured multi-currency term loan facility, increasing its total borrowing capacity to $1 billion from $750 million.

In September 2014, the company formed a joint venture with an affiliate of Griffin Capital Essential Asset REIT, Inc. (GCEAR). This is the company's second large institutional joint venture following the venture with an investment fund managed by Prudential Real Estate Investors in September 2013. The GCEAR venture arranged a $102 million five-year secured bank loan at LIBOR plus 225 basis points, representing a loan-to-value ratio of 55%.

Despite the company's strong access to capital, the availability of mortgage capital for data centers is not as deep compared with other commercial real estate property types, limiting the sources of contingent liquidity.

Adequate Liquidity

Liquidity coverage (defined as liquidity sources divided by uses) is adequate at 1.1x for the period from April 1, 2015 to Dec. 31, 2016. Sources of liquidity include unrestricted cash, availability under the company's unsecured RCF, and projected retained cash flows from operating activities after dividends and distributions. Uses of liquidity include debt maturities as well as projected recurring capital expenditures and cost-to-complete future development.

The company's adjusted funds from operations (AFFO) payout ratio was 82.3% in the first quarter of 2015 (1Q'15), compared with 87.6% in 2014 and 83.9% in 2013, all of which are indicative of the company's ability to generate and retain moderate organic liquidity. Based on the current AFFO payout ratio, the company retains approximately $70 million annually.

Deep Management Bench

In November 2014, the company announced that A. William Stein was appointed Chief Executive Officer and to the board of directors. Mr. Stein had been serving as interim CEO since March 2014. He served as the company's Chief Financial Officer from July 2004 until May 2015, as well as Chief Investment Officer from 2004 to April 2014. Mr. Stein joined the company's predecessor private equity fund in April 2004 and, having overseen the company's growth and achievement of investment-grade credit ratings, is well-positioned to serve in this role, in Fitch's view.

In April 2015, the company announced that Andrew Power was appointed Chief Financial Officer. Mr. Power joins Digital Realty following a 13-year career in investment banking that included advising DLR on its 2004 IPO, as well as many of its subsequent follow-on offerings.

The company has a strong management team in areas such as real estate expertise as well as technical acumen, and it continues to work collaboratively with its business partners such as VMare and Compunext to provide accommodative data center solutions (e.g., direct connections to VMware vCloud Air, creation of the Global Cloud Marketplace with various cloud service providers).

Expected Increase in Leverage

Leverage is low for the 'BBB' rating, with debt net of readily available cash as of March 31, 2015 to recurring operating EBITDA for the TTM of 5.0x, compared with 4.9x as of Dec. 31, 2014 and 5.6x as of Dec. 31, 2013. In April 2014, the company's exchangeable debentures were exchanged into common equity, which constituted one element of the leverage reduction.

Fitch's base case anticipates that the company will fund upcoming debt maturities and development with debt, and to a lesser extent, proceeds from asset sales, which should result in leverage rising back towards approximately 5.5x over the next 12-to-24 months, which would remain appropriate for a 'BBB' rating. In a stress case not anticipated by Fitch in which the company experiences low single-digit declines in same-store NOI, leverage reaches 6x, which would be weak, albeit adequate, for a 'BBB' rating.

Separately, in October 2013, the company's board of directors authorized a $500 million share repurchase program, although it has yet to be utilized. Fitch does not expect Digital Realty to use this program actively; should it do so, it would weaken the position of unsecured bondholders and could result in negative rating actions, depending on the magnitude of the buyback.

Less Contingent Liquidity for Data Centers

Data centers are specialized properties and technological obsolescence over the long term is possible. However, there are significant barriers to entry and medium-term IT trends are favorable. Compared with other real estate assets, data centers have a less liquid investment market with fewer potential buyers, making these assets potentially more difficult to divest or borrow against in a depressed market. These market characteristics can reduce the ability of data centers to serve as a source of contingent liquidity. Digital Realty's financial metrics are intrinsically strong for the 'BBB' rating category; however, the ratings are constrained by the data center properties being a less-than-mature asset class and the less liquid market for trading and financing these assets.

Digital Realty is committed to an unsecured funding profile. However, the company's unsecured debt incurrence has outpaced the growth of the unencumbered pool. Unencumbered assets (unencumbered NOI divided by a stressed capitalization rate of 10%) covered net unsecured debt by 2.0x as of March 31, 2015, which is low for a 'BBB' rating.

Exchangeable Senior Debentures Rating Withdrawal

Fitch withdrew the 'BBB' rating for Digital Realty Trust, L.P.'s exchangeable senior debentures in December 2014. In April 2014, these debentures were exchanged into common equity and these ratings were no longer relevant to the agency's coverage.

Preferred Stock Notching

The two-notch differential between Digital Realty Trust, Inc.'s IDR and preferred stock rating is consistent with Fitch's criteria for corporate entities with an IDR of 'BBB'. Based on Fitch research titled 'Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis', available on Fitch's web site at 'www.fitchratings.com', 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.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for DLR include:

--Fitch assumes DLR's same-store NOI will grow by approximately 2% in 2015 and 3% 2016 due to driven primarily by occupancy gains and contractual rental rate increases.

--Fitch assumes $150 million in asset sales, with a 9% capitalization rate, annually in 2015 and 2016. The company has sold three assets in 2015, and in aggregate is targeting $400 million of dispositions, including non-technical assets. DLR is targeting range of 0%-10% capitalization rates on asset sales, with the low end representing vacant assets.

--Fitch assumes that Digital Realty will incur $500 million in development spending in 2015 and $500 million in 2016 at a 10% return.

--Fitch's forecast does not assume any equity offerings or secured debt incurrence during the forecast period.

--Fitch assumes that Digital Realty, L.P. will issue an incremental $250 million of unsecured notes in 2016 at a rate of 4% to fund portion of development and repay upcoming maturities.

RATING SENSITIVITIES

The following factors may result in positive momentum in the rating and/or Outlook:

--Increased mortgage lending activity in the data center sector;

--Fitch's expectation of fixed-charge coverage sustaining above 3x (TTM fixed-charge coverage is 2.9x);

--Fitch's expectation of leverage sustaining below 4.5x (TTM leverage is 5.0x).

The following factors may result in negative momentum in the rating and/or Outlook:

--Sustained declines in rental rates and same-property NOI;

--Fitch's expectation of fixed-charge coverage sustaining below 2.5x;

--Fitch's expectation of leverage sustaining above 6x;

--Base case liquidity coverage sustaining below 1x.

Related Committee Held Date: Dec. 12, 2014.

Additional information is available on www.fitchratings.com.

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 28 May 2014)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393

Recovery Ratings and Notching Criteria for Equity REITs (pub. 18 Nov 2014)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=813628

Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis (pub. 25 Nov 2014)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=821568

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=986722

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=986722

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.

Contacts

Fitch Ratings
Primary Analyst
Steven Marks
Managing Director
+1-212-908-9161
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Stephen Boyd, CFA
Director
+1-212-908-9153
or
Committee Chairperson
Michael Weaver
Managing Director
+1-312-368-3156
or
Media Relations:
Sandro Scenga, +1 212-908-0278
sandro.scenga@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Steven Marks
Managing Director
+1-212-908-9161
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Stephen Boyd, CFA
Director
+1-212-908-9153
or
Committee Chairperson
Michael Weaver
Managing Director
+1-312-368-3156
or
Media Relations:
Sandro Scenga, +1 212-908-0278
sandro.scenga@fitchratings.com