NEW YORK--(BUSINESS WIRE)--Fitch Ratings has assigned a 'BBB+' rating to the expected senior unsecured notes due 2027 issued by Realty Income Corporation (NYSE:O). Net proceeds are expected to be used to repay borrowings outstanding under the $2 billion revolving credit facility and, to the extent not used for that purpose, to fund potential investment opportunities and/or for other general corporate purposes. A full list of Fitch's current ratings on O follows at the end of this release.
KEY RATING DRIVERS
The ratings reflect the granularity of O's predominantly retail net lease portfolio, its disciplined acquisition strategy, and management track record. Credit strengths include strong fixed-charge coverage (FCC), ample liquidity, and access to multiple sources of capital.
Leverage has increased over the past several years (5.1x for the trailing 12 months [TTM] ended June 30, 2016 compared to 4.4x at year-end 2009), but is still within O's financial policy and within Fitch's rating sensitivities. The higher leverage has been consistent with O's growth strategy and has been tempered in part by improved granularity and tenant credit quality. Fitch expects that leverage will rise slightly over the next 12 to 24 months to the mid-5x range but remain appropriate for the 'BBB+' rating.
GRANULAR PORTFOLIO WITH IMPROVING TENANT CREDIT
Fitch expects Realty Income's portfolio will exhibit durable and stable operating cash flows through the cycle as a result of the granularity (4,646 stores), lease structure and generally higher-quality tenant credit profile of its portfolio. In addition, Fitch views the portfolio's tenant industry diversification and focus on properties primarily leased to discretionary and non-discretionary retailers favorably. O's underwriting focuses on non-discretionary retail segments that are both resilient through economic cycles and insulated from e-commerce pressures. The portfolio's top segments for second quarter 2016 (2Q16) were drug stores (11% of rental revenues), casual dining and quick service restaurants (8.9%), convenience stores (8.8%), dollar stores (8.7%) and health and fitness (8.2%).
Partially offsetting these factors is some tenant concentration, albeit with highly rated tenants. At June 30, 2016, the top tenants were Walgreens at 6.6% of rental revenue (Fitch IDR: 'BBB'), FedEx at 5.7%, and Dollar General at 4.5%.
CONSISTENT TRACK RECORD
Realty Income's consistent and generally conservative track record in underwriting investments and managing the balance sheet is a credit positive. Realty Income's strategy centers on owning retail and non-retail real estate net leased to stronger credit tenants. However, its experience owning non-retail assets such as industrial and distribution (12.8% of 2Q16 revenue), office (5.8%) and agriculture (2.1%) is somewhat limited. Moreover, some of these asset classes have higher lease renewal risk (i.e. office) and may be less financeable than investment-grade retail, in Fitch's view.
HEADLINE METRICS REMAIN APPROPRIATE
O's net debt-to-recurring operating EBITDA was appropriate for the 'BBB+' rating at 5.0x and 5.1x for the quarter and TTM ended June 30, 2016, respectively. This compares to 5.2x and 5.9x for the years ended 2015 and 2014. When including 50% of preferred stock in total debt, O's leverage was 5.2x for the quarter and 5.3x for the TTM ended June 30, 2016, still appropriate for the 'BBB+' rating.
Free cash flow (FCC) is appropriate for the rating at 3.6x for the TTM ended June 30, 2016, compared with the 3.5x in 2015 and 3.2x in 2014. The improvement has been driven by EBITDA growth from acquisitions as well as contractual rent increases and occupancy gains in the same-store portfolio, partially offset by increased fixed charges associated with debt incurred to fund a portion of those acquisitions. Fitch defines leverage as debt less readily available cash to recurring operating EBITDA. Fitch defines FCC as recurring operating EBITDA less straight-line rent adjustments and recurring capital expenditures divided by total interest incurred and preferred dividends.
AMPLE LIQUIDITY AND STRONG ACCESS TO CAPITAL
Realty Income has ample liquidity due to its retained cash flow, limited recurring capex, limited near-term debt maturities and $2 billion line of credit due 2019. As a result, liquidity coverage is 1.7x for the period July 1, 2016 to Dec. 31, 2018. Liquidity coverage improves to 2.0x under a conservative mortgage refinancing approach whereby the company is only able to refinance 80% of upcoming mortgage maturities with new mortgages. Fitch defines liquidity coverage as sources of liquidity (readily available unrestricted cash, availability under the unsecured revolving credit facility, and projected retained cash flows from operating activities after dividends and distributions) divided by uses of liquidity (debt maturities and projected recurring capital expenditures). Near-term debt maturities are manageable with 5.6% maturing in 2016 and 6.5% in 2017.
Fitch anticipates that Realty Income will be able to generate approximately $100 million - $130 million of annual retained operating cash flow despite the track record of monthly dividend increases. Realty Income's dividends comprised 83.6% of adjusted funds from operations in second quarter 2016 (2Q16) as compared to the 82.4% - 92.5% range from 2006 - 2015.
Realty Income has adequate contingent liquidity in the form of unencumbered assets which covered unsecured debt by 2.2x at June 30, 2016. Fitch calculates unencumbered asset coverage as unencumbered NOI divided by a stressed capitalization rate of 9%.
PREFERRED STOCK NOTCHING
The two-notch differential between O'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', 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 Stable Outlook reflects Fitch's expectation that O will operate within its targeted metrics through the rating horizon and the issuer will have sufficient capacity to address any potential tenant credit issues.
Fitch's key assumptions within the rating case for O include:
--Operating cash flows grow by 1.5% driven principally by contractual base rent increases;
--O will make portfolio acquisitions through the use of proceeds from divestments, equity issuances and unsecured debt issuances;
--Recurring operating EBITDA margins remain around 90%;
--Sufficient equity and debt issuances throughout the rating horizon to repay debt, fund acquisitions and maintain leverage below 6x.
The following factors may result in positive momentum in the ratings and/or Rating Outlook:
--Fitch's expectation of leverage sustaining below 4.5x (leverage for TTM ended as of June 30, 2016 was 5.1x);
--Fitch's expectation of FCC sustaining above 3x (FCC for TTM ended as of June 30, 2016 was 3.6x);
--Fitch's expectation of unencumbered assets-to-unsecured debt sustaining above 3x (this ratio is 2.2x as of June 30, 2016);
--Demonstrated market leading capital markets access across the broader REIT universe.
The following factors may result in negative momentum in the ratings and/or Rating Outlook:
--A more aggressive approach towards funding acquisitions heavily with debt financing, which is not Fitch's expectation;
--Fitch's expectation of leverage sustaining above 6x (Fitch has not changed this sensitivity, as the improvement in tenant credit quality and portfolio granularity has been offset to some extent by the company's shorter track record of owning non-retail assets);
--Fitch's expectation of FCC sustaining below 2.5x;
--Tenant bankruptcies resulting in a weakening of the company's credit metrics.
FULL LIST OF RATING ACTIONS
Fitch currently rates O as follows:
Realty Income Corporation
--Issuer Default Rating (IDR) at 'BBB+';
--Unsecured revolving credit facility at 'BBB+';
--Senior unsecured term loans at 'BBB+';
--Senior unsecured notes at 'BBB+';
--Preferred stock at 'BBB-'.
The Rating Outlook is Stable.
Relevant Committee Date: Sept. 29, 2016.
Additional information is available on www.fitchratings.com
Summary of Financial Statement Adjustments - Financial statement adjustments that depart material from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below:
--Historical and projected recurring operating EBITDA is adjusted to add back non-cash stock-based compensation.
--Fitch had adjusted the historical and projected net debt by assuming the issuer requires $10 million of cash for working capital purposes, which is otherwise unavailable to repay debt.
Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)
Recovery Ratings and Notching Criteria for Equity REITs (pub. 03 Dec 2015)
Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis (pub. 29 Feb 2016)
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