NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed the credit ratings for
Realty Income Corporation (NYSE: O, Realty Income) as follows:
--Issuer Default Rating (IDR) at 'BBB+';
--$1.5 billion unsecured revolving credit facility at 'BBB+';
--$3.8 billion of senior unsecured notes at 'BBB+';
--$395.4 million of preferred stock at 'BBB-'.
The Rating Outlook is Stable.
KEY RATING DRIVERS
The affirmation of Realty Income's IDR at 'BBB+' reflects the granularity of the company's net lease predominantly retail property portfolio, the company's disciplined acquisition strategy in an increasingly competitive industry, and long management track record. Credit strengths include strong expected fixed-charge coverage (FCC), good liquidity position, and strong access to multiple sources of capital.
The rating is balanced by leverage that has increased over the past several years (5.8x for trailing 12 months ended Sept. 30, 2014 compared to 4.4x at year-end 2009). During this same period, the company improved the granularity and tenant credit quality of the portfolio. Fitch expects that leverage will decline slightly over the next 12 to 24 months but remain somewhat elevated for the 'BBB+' rating. Unencumbered assets (unencumbered net operating income [NOI] divided by a stressed 9% capitalization rate) coverage of net unsecured debt is also weak for the 'BBB+' rating.
Granular Net Lease Portfolio
As of Sept. 30, 2014, Realty Income's portfolio consisted of 4,284 properties across 49 U.S. states and Puerto Rico, protecting bondholders from possible regional supply-and-demand retail property imbalances. The most significant portfolio transaction over the past two years to broaden portfolio granularity was the acquisition of ARCT, comprising 501 properties, for $3.2 billion.
Fitch views the portfolio's tenant industry diversification favorably. The company owns properties leased to discretionary and non-discretionary retailers. However, it favors non-discretionary retail segments that are both resilient through economic cycles (e.g. not investing in jewelry stores) and insulated from e-commerce pressures (e.g. not investing in locations such as bookstores that sell commoditized products). The portfolio includes 47 tenant industries, and top segments based on third quarter 2014 (3Q'14) revenues were convenience stores (10%), dollar stores (9.6%), drug stores (9.4%), casual dining and quick service restaurants (7.7%) and health and fitness (7%).
Improving Tenant Credit
The company has 231 tenants; however, the top-10 tenant list is somewhat concentrated, comprising 37.5% of 3Q'14 rent. The concentration risk is mitigated in part by the high tenant credit quality. The top three tenants at Sept. 30, 2014 were Walgreens at 5.4% (Fitch IDR of 'A-' with a Stable Outlook), FedEx at 5.1% of rent (IDR of 'BBB' with a Stable Outlook), and Dollar General at 4.9%.
Realty Income has materially increased the percentage of annualized rental revenue derived from properties leased to investment-grade rated tenants, from 2% in 2007 to 15% in 2011 to 46% as of Sept. 30, 2014. Realty Income's current investment-grade rated tenant levels are similar to American Realty Capital Properties, Inc. (not rated by Fitch) at 46%, and above Lexington Realty Trust (IDR of 'BBB' with a Stable Outlook) at 39% and National Retail Properties, Inc. (IDR of 'BBB+' with a Stable Outlook) at 20%. In addition, Realty Income's weighted average remaining lease term is long at 10.4 years, signaling durability in the cash flow, absent tenant bankruptcies.
Long Management Track Record
Realty Income has a long track record of growth since its formation in 1969, having increased the portfolio to 4,284 properties across 47 tenant industries in 3Q'14 from 630 properties across five industries in 1994. The original initiatives of generating monthly income from retail properties leased on a long-term triple-net basis (1969 to 1994) evolved towards being attuned to portfolio diversity as well as focusing on cash flow coverage and underwriting (1997 to 2007). Since the recession, the company has concentrated on improving tenant credit and pursued new industries while re-underwriting and ranking the portfolio.
Realty Income's current 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 (10.3% of 3Q'14 revenue), office (6.7%), agriculture (2.4%) and manufacturing (2.3%) is somewhat limited. The company continued to deepen its bench as a result of diversification outside of retail and, in 2014, appointed Debra M. Bonebrake as Senior Vice President - Industrial, Distribution and Office Properties.
Strong Fixed-Charge Coverage
FCC is strong for the rating at 3.2x for the TTM Sept. 30, 2014 and 3.5x in 3Q'14 pro forma for the redemption of class E preferred stock with the unsecured revolving credit facility in October 2014 (pro forma), respectively, up from 3.1x in 2013 and 2.6x in 2012. 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, drove the increase. Fitch defines FCC as recurring operating EBITDA less straight-line rent adjustments less recurring capital expenditures divided by total interest incurred and preferred dividends.
Fitch's base case projections are predicated on contractual base rent increases (1.5% same-store rent growth) and additional acquisitions (assumed to be $650 million in 2015 and $500 million in 2016), which should result in coverage approaching 3.5x over the next 12 to 24 months, which is strong for the 'BBB+' rating. In a stress case not anticipated by Fitch in which tenant bankruptcies reduce annual rent by approximately 2.5% annually in 2015 and 2016, FCC would fall to 3x, still strong for the 'BBB+' rating.
Good Liquidity and Strong Access to Capital
Liquidity coverage is good for the rating at 1.8x for the period Oct. 1, 2014 to Dec. 31, 2016. Fitch defines liquidity coverage as sources of liquidity (readily available unrestricted cash, availability under the unsecured revolving credit facility pro forma, and projected retained cash flows from operating activities after dividends and distributions) divided by uses of liquidity (debt maturities and projected recurring capital expenditures).
Longer term, debt maturities are manageable as of Sept. 30, 2014 pro forma, with 0.2% maturing during the remainder of 2014 followed by 5.4% in 2015 and 10.5% in 2016.
The company has a long track record of monthly dividend increases. Fitch anticipates that the company's adjusted funds from operations (AFFO) payout ratio will remain at approximately 85% (85.7% in 3Q'14, although this ratio increased to 88.4% in 2013 as a result of the dividend increase associated with the ARCT acquisition). Recent AFFO payout levels indicate the company's ability to generate over $80 million in organic liquidity annually.
Somewhat Elevated Leverage
Net debt-to-recurring operating EBITDA was 5.8x at 3Q'14 pro forma, down from 5.9x in 2013 and 6.4x in 2012. The redemption of class E preferred stock increased leverage from to 5.8x pro forma 5.5x during 3Q'14, as Fitch treats REIT preferred shares as 100% equity for leverage purposes. Under Fitch's base case, leverage is forecasted to remain between 5.5x and 6x in 2015-2016, which would remain appropriate for the rating. In a stress case (principally a material tenant bankruptcy) scenario not anticipated by Fitch, leverage could sustain above 6x, which would place pressure on the 'BBB+' rating and/or Outlook.
Weak Unencumbered Asset Coverage
Unencumbered assets (unencumbered NOI divided by a stressed capitalization rate of 9%) cover net unsecured debt by 2x as of Sept. 30, 2014 pro forma, which is weak for the 'BBB+' rating but reflects adequate contingent liquidity from the company's unencumbered property pool.
Preferred Stock Notching
The two-notch differential between Realty Income'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.
The Stable Outlook reflects strong FCC for the rating, a high degree of portfolio granularity, adequate liquidity and strong access to capital, offset by elevated leverage and weak unencumbered asset coverage for the rating.
The following factors may result in positive momentum in the ratings and/or Rating Outlook:
--Fitch's expectation of leverage sustaining below 4.5x (pro forma leverage is 5.8x);
--Fitch's expectation of FCC sustaining above 3x (pro forma FCC is 3.5x);
--Fitch's expectation of unencumbered assets-to-unsecured debt sustaining above 3x (this ratio is 2x pro forma).
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.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Recovery Ratings and Notching Criteria for Equity REITs' (Nov. 18, 2014);
--'Corporate Rating Methodology' (May 28, 2014);
--'Rating U.S. Equity REITs and REOCs: Sector Credit Factors' (Feb. 26, 2014);
--'Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis' (Dec. 23, 2013).
Applicable Criteria and Related Research:
Rating U.S. Equity REITs and REOCs (Sector Credit Factors)
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage
Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis