NEW YORK--(BUSINESS WIRE)--Fitch Ratings has assigned a 'BBB-' rating to the expected senior unsecured notes due 2026 issued by EPR Properties (NYSE: EPR). Net proceeds are expected to be used for general corporate purposes. A full list of current ratings follows at the end of the release.
KEY RATING DRIVERS
ANNOUNCED CNL TRANSACTION
EPR's planned acquisition of CNL Lifestyle Properties (CNL) is a credit positive for bondholders; however, the company's credit profile will remain appropriate for the 'BBB-' rating. The acquisition diversifies the ski portfolio with a premier asset in Northstar and establishes a relationship with a leading operator in Vail Resorts. The transaction also results in immediately lower leverage and higher fixed-charge coverage, although Fitch expects the company to sustain leverage around 5.0x over the longer term.
The transaction initially improves headline credit metrics, with leverage decreasing approximately 0.5x to the mid 4.0x range, compared to 5.3x and 4.9x at year-end 2015 and 2014, respectively. Fitch expects the company will sustain leverage over the longer term around 5.0x. When including 50% of the company's preferred stock as debt, leverage increases by approximately 0.4x.
Fixed charge coverage, pro forma for the transaction, increases to the mid 3x range for the quarter ended Sept. 30, 2016, up from 2.9x and 2.8x in 2015 and 2014, respectively. Fitch expects the company will sustain coverage around 3.0x over the longer term.
The transaction further improves tenant diversification (top 10 tenant revenue is reduced to 60% from 64% pro forma). These positives are offset by an increase in exposure to the recreation segment to 30% of NOI from 21%, which Fitch views as a slight negative given the lower mortgage financeability, and hence contingent liquidity, of this asset class.
Beyond the CNL transaction, Fitch's ratings reflect EPR's consistent cash flows generated by the company's triple-net leased megaplex movie theatres and other investments across the entertainment, education and recreation segments, resulting in maintenance of strong leverage and fixed-charge coverage metrics for the rating. EPR benefits from generally strong levels of rent coverage across its portfolio and structural protections including cross-collateralization among properties operated by certain tenants.
While cinema attendee demand has remained relatively consistent over a long time period thereby supporting the durability of EPR's operating cash flows, other investment segments lack a similar long-term track record. Credit concerns include significant, though improving tenant concentration and concerns about the company's investment in niche asset classes that are less proven and may be less liquid or financeable during periods of potential financial stress and/or have limited alternative uses.
FAVORABLE DEBT MATURITY PROFILE
Debt maturities are manageable through 2018, with no year representing more than 7.2% of total debt. Beyond 2018, maturities represent solely unsecured debt offerings which are larger in size but still mostly well-spaced. Fitch expects the company will be able to effectively ladder its debt maturity profile, which should reduce refinancing risk in any given year. Fitch expects the company to repay all of its upcoming secured debt maturities with unsecured debt, resulting in a fully unencumbered portfolio. However, in certain instances the company may assume secured debt when acquiring assets.
MINIMAL LEASE EXPIRATION RISK
From 2016 to 2029, no more than 6% of total revenue expires in any single year. EPR's education segment represents 22% of total revenue and all leases expire after 2030, with the exception of two immaterial lease expirations in 2017 and 2018.
Historically, most tenants have chosen to exercise their renewal options, which has mitigated re-leasing risk and provided predictability to portfolio-level cash flows. Over the past several years some tenants have given back space, but more recently this trend has subsided. Rent renewal spreads can vary greatly depending on the operating performance of the asset.
ADEQUATE LIQUIDITY
Fitch calculates that EPR's liquidity coverage ratio pro forma for the note issuance is 1.7x for the period Oct. 1, 2016 to Dec. 31, 2018. Fitch defines liquidity coverage as sources of liquidity (unrestricted cash, availability under the revolving credit facility, expected retained cash flows from operating activities after dividend payments) divided by uses of liquidity (debt maturities, development expenditures and capital expenditures).
EPR paid out 80% of its adjusted funds from operations (AFFO) in dividends in the third quarter of 2016, in-line with the past two previous years. Fitch expects the company's payout ratio to sustain in the mid-80% range on a long-term basis, and internally generated liquidity will be used in part to fund new investments.
APPROPRIATE UNENCUMBERED ASSET COVERAGE OF UNSECURED DEBT
EPR has solid contingent liquidity from its unencumbered asset pool. Unencumbered asset coverage of net unsecured debt (UA/UD) improves to just above 2x from 1.8x, pro forma for the transaction, when applying a stressed 12% capitalization rate to unencumbered net operating income (NOI). This ratio is adequate for a 'BBB-' IDR. The company continues to unencumber megaplex theatre assets, improving the quality of the unencumbered pool as EPR continues to utilize a predominantly unsecured funding model. Nonetheless, EPR's assets generally are less financeable and have fewer potential buyers than more traditional commercial real estate.
HIGH TENANT CONCENTRATION IS RECEDING
EPR's largest tenant, American Multi-Cinema, Inc. (AMC) ('B+' on Rating Watch Negative), accounted for 17% of pro forma total revenues in the third quarter of 2016, down from 20% the year prior. The exposure to AMC has consistently decreased since the company's inception and the company's top 10 tenants accounted for 60% of pro forma total revenue in the most recent quarter, down from 68% a year ago.
EPR's largest charter school tenant, Imagine Schools, Inc. (Imagine) accounted for 5% of total revenues in third quarter of 2016, decreasing as expected after recent sales. These sales not only reduce EPR's exposure to Imagine, but also help demonstrate some degree of liquidity in the public charter school space. The company has been expanding its relationships with new charter school operators. EPR had 48 tenants during the 2015 to 2016 school year, compared with just one tenant during the 2010 to 2011 school year.
While most of EPR's theatre leases and all of its charter school leases for a given operator are cross-defaulted, a tenant bankruptcy could allow for the rejection of certain non-economic leases. Most of EPR's top tenants are either unrated or have below-investment grade ratings; thus the potential for corporate default, bankruptcy and lease rejection could reduce EPR's rental revenues. Mitigating this risk is that on a portfolio and property-level basis, EBITDAR covers rent payments by a healthy margin for nearly all of EPR's properties. Operator concentration risk is partially mitigated by the fact that the primary drivers of theatre box office consumer demand are location and which movies are showing at a particular theatre as opposed to theatre operator.
NICHE SECTORS
The ratings reflect EPR's focus on investing in non-core property types that are likely less liquid or financeable during periods of market stress. While the company's theatre properties are typically well located and have high-quality amenities, alternative uses of space may be limited or may require significant capital expenditures to attract non-theatre tenants. The recreation and education facilities are also high-quality, but the mortgage financeability and depth of the asset transaction market of the assets is uncertain. Going forward, management intends on continuing to focus on its three investment segments, which Fitch views positively. Management has a highly specialized knowledge within EPR's investment segments which helps shape the company's longer-term strategy.
SOFTENING THEATRE DEMAND TRENDS
Given the limited fungibility of the real estate, Fitch considers the operating environment for EPR's key tenants. North American box office revenue has proven resilient growing at a compound annual growth rate of nearly 4% over the past 25 years. In 2015, box office revenue was up 8% from $10.4 billion in 2014, and reached a record high in nominal dollars. However, Fitch expects the exhibitor industry's attendance growth will remain challenging and ticket price growth, which had previously offset attendance declines, has been decelerating.
To counter these factors, exhibitors have been improving the customer experience through a variety of amenities such as luxury seating and new beverage concepts within the theatres has both expanded revenue streams and increased the frequency of customer visits. Moreover, EPR's theatre portfolio is 100% leased and since the company's formation in 1997, no theatre tenant has missed a lease payment. Despite the lack of lease payment defaults, EPR has realized negative leasing spreads upon renewal from time-to-time, which partially reflects the limited alternative tenants and uses for the assets.
EDUCATION SEGMENT EVOLVING
EPR is highly focused on the burgeoning market for education investments. The portfolio is 100% leased. EPR has been able to work through prior issues with Imagine, while reducing exposure to the operator, expanding to 48 operators during the 2015 to 2016 school year. The demand for enhanced education at an early age has begun to outpace the supply within the U.S. as the national waiting list currently holds over 1 million students. The largest investment risk in this segment is the mismatch between the charter renewal cycle (typically every five to 10 years) and the average lease term (15 to 20 years) and the potential for charter renewals to be based on political or budget factors rather than performance factors. Alternative uses for charter school facilities should the school lose its charter and EPR need to seek an alternative tenant is largely unproven.
PREFERRED STOCK NOTCHING
The two-notch differential between EPR'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.
STABLE OUTLOOK
The Stable Outlook reflects Fitch's expectation that EPR will operate within its targeted metrics through the rating horizon and the issuer will have sufficient capacity to address any potential tenant credit issues.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for EPR include:
--Annual same-store NOI growth of 2% in 2016 to 2018. These increases reflect both contractual rent escalations and participation by way of overage rents;
--Annual investments between $700 to 800 million from 2016 to 2018, with a yield of 9%;
--CNL transaction closes in early 2Q 2017;
--Sufficient unsecured bond issuances for 2016, 2017 and 2018, respectively;
--Annual equity issuances between $200 to 300 million from 2016 to 2018, though issuance is at management's discretion;
--Approximately $5 million of capital expenditures each year from 2016 to 2018. Capital expenditures are low due to primarily triple net lease structure and long-term leases;
--Annual divestments between $100 to 200 million from 2016 to 2018.
RATING SENSITIVITIES
The following factors could result in positive momentum in the ratings and/or Outlook:
--Fitch's expectation of leverage sustaining below 4.0x (pro forma leverage was in the mid 4x for the quarter ended Sept. 30, 2016, although Fitch expects the company to sustain leverage around 5.0x);
--Fitch's expectation of fixed-charge coverage sustaining above 3.0x (pro form coverage was in the mid 3x area for the quarter ended Sept. 30, 2016).
The following factors could result in negative momentum on the ratings and/or Outlook:
--Fitch's expectation of Leverage sustaining above 5.5x;
--Fitch's expectation of fixed-charge coverage sustaining below 2.2x;
--A liquidity coverage sustaining below 1.25x, coupled with a strained unsecured debt financing environment;
--Meaningful, operational deterioration in the movie exhibitor and/or charter school segments.
FULL LIST OF RATING ACTIONS
Fitch currently rates EPR as follows:
EPR Properties
--Issuer Default Rating (IDR) 'BBB-';
--Unsecured Revolving Line of Credit 'BBB-';
--Senior Unsecured Term Loan 'BBB-';
--Senior Unsecured Notes 'BBB-';
--Preferred Stock 'BB'.
The Rating Outlook is Stable.
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.
Applicable Criteria
Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)
https://www.fitchratings.com/site/re/885629
Treatment and Notching of Hybrids in Non-Financial Corporate and REIT
Credit Analysis (pub. 29 Feb 2016)
https://www.fitchratings.com/site/re/878264
Additional Disclosures
Solicitation Status
https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1016011
Endorsement Policy
https://www.fitchratings.com/regulatory
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