NEW YORK--(BUSINESS WIRE)--Fitch Ratings has assigned a rating of 'BBB' to the senior unsecured issuance by Digital Euro Finco, LLC, a wholly-owned subsidiary of Digital Realty Trust, Inc. (NYSE: DLR). The notes will be fully and unconditionally guaranteed by Digital Realty Trust, Inc. and Digital Realty Trust, L.P. The company expects to use to the net proceeds to repay borrowings under its global revolving credit facility. A full list of Fitch's current ratings for DLR follows at the end of this release.
KEY RATING DRIVERS
The rating reflects that while the acquisition of Telx moderately increases leverage in the near term, Fitch expects the company's metrics to improve in-line with longer-term historical trends, and consistent with a 'BBB' Issuer Default Rating (IDR) for a diversified data center real estate investment trust (REIT). While the Telx transaction adds more operational intensity and decreases margins, the transaction has several benefits, including increased tenant and revenue diversity and complementary business lines.
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 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 and also low unencumbered asset coverage for the rating.
Key Metrics Remain Appropriate For Rating
Fitch estimates run-rate leverage at 5.2x for the year ended Dec. 31, 2015. Fitch recently revised the treatment of REIT cumulative perpetual preferred stock to 50% equity credit from 100%. DLR's run rate leverage based on net debt including 50% of preferred stock was 5.8x for the year ended Dec. 31, 2015, compared with 5.5x and 6.0x in 2014 and 2013, still appropriate for the 'BBB' rating. Fitch forecasts that leverage will remain between 5.5x and 6.0x over the next 12 - 24 months.
Fixed-charge coverage is good for the rating at 3.0x for the year ended Dec. 31, 2015 versus 2.9x for both full year 2014 and 2013. Fitch expects DLR's fixed-charge coverage will be between 2.7x and 3.0x over the next 12 - 24 months, driven by same-store net operating income (NOI) growth offset by higher fixed charges. Fitch defines fixed charge coverage as recurring operating EBITDA less straight-line rents divided by total interest incurred and preferred stock dividends.
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 decreased 180 basis points (bps) year over year to 91.4% at Dec. 31, 2015 as a result of consolidating newly acquired Telx properties operating at occupancy levels well below the rest of DLR's portfolio. Quarterly stabilized same store year-over-year cash NOI growth averaged 2.3% in 2015 due primarily to a renewal leasing spread of 11.5% for the year ended Dec. 31, 2015. During 2015, renewal activity represented 64.6% of lease signings based on square footage.
Comparisons for renewals were challenging for a time due to the rolldown of peak rental rates signed prior to the financial crisis; however, the company has recently been effective in leasing up its existing properties and maintaining its tenant base. Over the next several years, Fitch projects 2.5% to 4.7% same-store NOI growth, driven primarily by developments coming on line and efficient management of the aggregate portfolio inclusive of Telx.
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 in the high 2.0x range over the next two years, appropriate for a 'BBB' rating given Digital Realty's niche property focus.
Digital Realty offers Turn-Key Flex, Powered Base Building, colocation and interconnection space via its 139 operating properties, including 110 throughout North America, 23 in Europe, three in Australia and three in Asia. Top markets as of Dec. 31, 2015 were New York (13.2% of consolidated annualized base rent), London (10.8%), Northern Virginia (10.4%), Dallas (10.4%), and Silicon Valley (8.8%).
The company also benefits from a granular tenant roster, which includes IBM (Rated 'A+'/Stable Outlook) at 7.5% of rent, CenturyLink, Inc. ('BB+' IDR/Stable Outlook) at 6.1%, Equinix, Inc. ('BB' IDR/Stable Outlook) at 4.0%, Facebook, Inc. at 2.3% and AT&T ('A-' IDR/Stable Outlook) at 2.1%.
Good Access to Capital but Limited Secured Debt Market for Data Centers
Since 2006, the company has issued $3.4 billion of common equity, $1.9 billion of preferred equity including most recent issuance, $3.5 billion of dollar-denominated unsecured bonds, and GBP700 million of sterling-denominated unsecured bonds not including the April 2016 issuance. The company's sterling-denominated bonds function as a natural hedge given the company's exposure to the United Kingdom.
Additionally, the company holds a $2 billion global revolving credit facility, refinanced in January 2016, which provides for borrowings in Australian dollars, British pounds sterling, Canadian dollars, Euros, Hong Kong dollars, Japanese yen, Singapore dollars, and U.S. dollars with the ability to add additional currencies in the future subject to certain conditions.
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.
Deep Management Bench
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 VMware 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). Fitch expects that most of Telx's employees will join DLR to manage the colocation and interconnection business.
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 2.1x as of Dec. 31, 2015, which is low for a 'BBB' rating.
Higher Operational Intensity from Telx Transaction
Fitch estimates that EBITDA margins will decline to 54% from approximately 57% due to lower Telx margins, and that Telx's colocation and interconnection business will represent approximately 11% of DLR's total EBITDA. Telx owns only two assets, with the remaining seven locations leased from third-party property owners. As a result, DLR has become a tenant at these locations, which increases lease renewal risk and adds a degree of operating risk into the company's business. Fitch's negative rating sensitivities for leverage may decline if the company further increases its exposure to business segments with higher operating risk.
Adequate Liquidity Coverage Ratio
Liquidity coverage (defined as liquidity sources divided by uses) is adequate at 1.5x for the period from Jan. 1, 2016 to Dec. 31, 2017. Sources of liquidity include unrestricted cash less working capital requirements, availability under the company's global unsecured revolving credit facility, 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) pay-out ratio was 81.4% in 2015 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 pay-out ratio, the company retains approximately $110 million annually.
The Stable Outlook reflects Fitch's expectation that metrics will remain appropriate for the rating over the next one to two years.
Fitch's key assumptions within the rating case for DLR include:
--$850 million of annual development starts;
--$750 million of annual development deliveries.
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 (year end 2015 fixed charge coverage was 3.0x and 4Q15 run rate coverage is 2.8x);
--Fitch's expectation of leverage (including 50% equity credit-to-preferred stock) sustaining below 4.5x (4Q15 run rate leverage is 5.8x and year end 2015 leverage is 6.4x).
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.
FULL LIST OF RATING ACTIONS
Fitch currently rates Digital as follows:
Digital Realty Trust, Inc.
--Preferred stock 'BB+'.
Digital Realty Trust, L.P.
--Unsecured revolving credit facility 'BBB';
--Senior unsecured term loan facility 'BBB';
--Senior unsecured notes 'BBB'.
Digital Stout Holding, LLC
--Unsecured guaranteed notes 'BBB'.
Digital Euro Finco, LLC
--Unsecured guaranteed notes 'BBB'.
The Rating Outlook is Stable.
Date of Relevant Rating Committee: July 10, 2015
Additional information is available on www.fitchratings.com.
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)
Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis (pub. 29 Feb 2016)
Dodd-Frank Rating Information Disclosure Form