NEW YORK--(BUSINESS WIRE)--Fitch Ratings has upgraded the ratings of Duke Realty Corp. (NYSE:DRE) and its operating partnership Duke Realty Limited Partnership (collectively Duke), including the Issuer Default Rating (IDR), to 'BBB+' from 'BBB'. The Rating Outlook is Stable. A full list of rating actions follows at the end of this release.
KEY RATING DRIVERS
The upgraded ratings take into account Duke's achievement and commitment to sustaining more conservative credit metrics, its large, high quality and diversified portfolio of predominantly industrial and medical office properties, as well as its strong access to various forms of capital, including a healthy level of internally generated retained cash flow after dividends.
Moderate development risk and only adequate unencumbered asset coverage of unsecured debt (partly due to non-income producing development assets) balance these credit strengths.
Asset Sales Improve Credit Profile
Fitch expects the percentage of Duke's NOI derived from suburban office properties to decrease to below 2% by year-end 2016 through a combination of asset sales, industrial and medical office same-store NOI (SSNOI) growth and development stabilizations. DRE disposed of $263 million of properties during 1H'16.
Appropriate Leverage for Ratings
Fitch expects DRE's leverage to sustain in the mid-to-high 5.0x range through 2018. The company's leverage was 5.6x for quarter ended June 30, 2016, This compares to 5.8x and 7.2x during 2015 and 2014, respectively.
Fitch's mid-to-high 5.0x range leverage expectation for Duke is appropriate for a 'BBB+' rated REIT focused primarily on high-quality bulk industrial properties. There is some tolerance for DRE's leverage to moderately exceed 6.0x, for example due to a strategic acquisition, provided Fitch's outlook for industrial fundamentals is stable or positive and the agency expects the company to return to the 5.0x to 6.0x range within the one- to two-year Rating Outlook horizon.
Adequate Fixed Charge Coverage
Fitch expects that FCC will improve to the mid-to-high 3.0x range in 2018, driven by low single digit GAAP same-store net operating income (SSNOI) growth, incremental NOI from development deliveries and lower recurring capex given a reduced suburban office footprint. Fixed charge coverage (FCC) improved to 3.2x for the quarter ending June 30, 2016 from 2.6x and 2.0x during 2015 and 2014, respectively, due primarily to reduced leverage and preferred stock redemptions.
Pre-Leasing Balances Development Risk
Fitch expects DRE to start between $400 million to $500 million of new industrial and medical office developments per year through 2018. The company's ability to win new build-to-suit (BTS) developments could push starts closer to the high end of the range.
Fitch's ratings for Duke anticipate a more conservative development posture for the company during this cycle that includes limiting the pipeline size to within a range of 5% to 7.5% of undepreciated assets (currently implies $500 million to $700 million), with the speculative component generally limited to less than half.
Duke's development pipeline totaled $503.5 million including joint ventures (JVs) at the company's share, representing 6.2% of undepreciated gross assets at June 30, 2016. The company's unfunded committed development expenditures (at DRE's share) represented 3.2% of gross assets, which is a manageable figure. The pipeline's leased percentage was solid at 72%.
Fitch expects DRE's GAAP SSNOI growth to sustain in the low single digits through 2018, driven by positive low teens GAAP leasing spreads and modest portfolio occupancy gains. Duke's cash SSNOI increased by 4.5% for the TTM ending June 30, 2016 based on 4.4% growth in its bulk distribution portfolio and 4.9% gains for its medical office assets (20% of SSNOI pool).
Duke's in-service portfolio occupancy was 96.7% at the end of the second quarter, up from 96.4% at Dec. 31, 2015 and 96.3% at Dec. 31, 2014. Spreads on renewal leases were positive 16.9% during the first half of 2016 compared with 12.7% and 9.9% during 2015 and 2014, respectively.
Adequate Financial Flexibility
The company's liquidity profile is also adequate with total sources of liquidity covering total uses by 1.9x for the July 1, 2016 - Dec. 31, 2018 period. Including the cost to complete its development pipeline reduces Duke's coverage to an adequate 1.5x. 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 2.3x unencumbered asset coverage of unsecured debt assuming a stressed 8.25% cap rate, which is adequate for the 'BBB+' rating. Duke's UA/UD is hurt in the near term by the capital allocated to non-income producing development assets.
Duke has a well-balanced debt maturity schedule. The company's prepaid its $275 million 5.95% notes due 2017 this year (including $203 million during 3Q'16) and will retire $130 million of 8.25% 2019 notes on Oct. 20, 2016. The company's $285 million 6.5% unsecured notes due Jan. 15, 2018 will comprise its only remaining unsecured maturity through 2020. The company has full availability under its committed $1.2 billion unsecured line of credit that matures in January 2019 and can be extended by one year.
Conservative Dividend Payout
Fitch expects DRE's dividend payout ratio to improve modestly over the next 12-24 months through SSNOI growth and incremental NOI from development completions and a smaller portfolio contribution from more capital intensive suburban office properties. Duke's AFFO payout ratio was 65.5% during 2Q'16 and 67.1% and 69.2% in 2015 and 2014, respectively, slightly lower than the 75-80% equity REIT sector median. The company retains roughly $80 million of internally generated cash flow annually that can be used to service financial obligations and fund external growth.
The Stable Rating Outlook is based on Fitch's expectation that leverage will stabilize in the mid-to-high 5.0x range and coverage will improve to the mid-to-high 3.0x range. The outlook also assumes that the company maintains adequate financial flexibility over the near to medium term, including managing development risk within its more conservative policy targets relative to the last cycle.
Fitch's key assumptions within our rating case for the issuer include:
--Low single-digit SSNOI growth through the 2018 projection period based on flat to slightly positive occupancy and low double digit positive leasing spreads;
--Acquisitions of $150 million during 2016 and $75 million in 2017 and 2018;
--Dispositions of $800 million during 2016 and none thereafter;
--Development spending of $450 million, $500 million and $400 million during 2016, 2017 and 2018, respectively;
--Unsecured bond issuance of $375 million during 2016, $300 million during 2017 and $500 million during 2018;
--Equity issuance of $200 million during 2016 and none thereafter;
--Dividend growth of 3% per annum.
Positive momentum in DRE's ratings and/or Outlook is unlikely absent the company demonstrating superior capital markets access across the broader REIT universe, consistent with other 'A'-category rated REITs. In addition, the following factors may collectively or individually result in upward rating momentum:
--Fitch's expectation of leverage sustaining below 5.0x (leverage was 5.6x for the annualized quarter ended June 30, 2016);
--Fitch's expectation of FCC above 4.0x (2Q'16 coverage was 3.2x).
The following factors may have a negative impact on the ratings:
--Fitch's expectation of leverage sustaining above 6.0x;
--A change in Duke's development risk profile to more risk;
--Fitch's expectation of FCC sustaining below 3.0x.
FULL LIST OF RATING ACTIONS
Fitch has upgraded the ratings for Duke Realty Corp. and Duke Realty Limited Partnership as follows:
Duke Realty Corporation
--IDR to 'BBB+' from 'BBB'.
Duke Realty Limited Partnership
--IDR to 'BBB+' from 'BBB';
--Senior 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.
Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially 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 and include operating income from discontinued operations and distributions from joint venture operations;
--Fitch has 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.
Additional information is available on www.fitchratings.com
Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)
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