NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed the ratings of Essex Property Trust (NYSE: ESS) and its operating partnership, Essex Portfolio, L.P. at 'BBB+'. The Rating Outlook is Stable. A full list of rating actions follows at the end of the release.
KEY RATING DRIVERS
Fitch's ratings for Essex consider the company's strong multifamily portfolio position within key densely populated and supply constrained markets in Northern and Southern California and Seattle. These markets have favorable demographics (i.e. above-average job growth and household income levels) and high home-ownership costs that drive demand for apartments. Fitch views the company's management team as amongst the strongest in the multifamily REIT sector based on its track record of superior asset management and capital allocation.
Geographic portfolio concentration and development are factors that balance these credit strengths. The Stable Outlook is driven by Fitch's expectation that the material improvement in credit metrics is largely complete. Moreover, as the issuer is operating at the low end of its financial policies, it has a cushion to buffer against deteriorating operating fundamentals should the cycle turn.
ACHIEVED LOWER LEVERAGE TARGETS
Fitch projects ESS' leverage will sustain around 6x assuming a decelerating but still accommodative operating environment and consistent development expenditures. This compares to leverage of 5.9x and 7.2x for 2015 and 2014, respectively and the issuer's stated 6x - 7x target. Leverage could trend lower depending upon how the issuer sizes development and redevelopment expenditures relative to equity issuances and asset sales. Fitch defines leverage as debt less readily available cash plus 50% preferred stock to recurring operating EBITDA, including recurring distributions from joint venture (JV) operations. Excluding joint venture distributions, leverage would increase by 0.2x - 0.4x depending upon the period.
Fitch expects ESS's fixed-charge coverage (FCC) will improve to the mid-to-high 3x range through 2018. The company's FCC was 3.6x during 2015, higher than 2014 and 2013's 3.2x and in line with 2012's FCC. Fitch defines FCC as recurring operating EBITDA including recurring JV distributions from operations less recurring capital improvements divided by cash interest incurred and preferred distributions.
VIA STRENGTH IN OPERATING FUNDAMENTALS
Fitch expects multifamily REITs will report another year of mid-single digit growth in same store net operating income (SSNOI) and ESS is likely to outperform its peers given the strength in Northern California. Fitch's Base Case for ESS assumes SSNOI growth decelerates but remains above average at 8% in 2016, 6% in 2017 and 4% in 2018 as compared to 10.7% in 2015. Last year marked the fifth straight year of growth above 5.5% and was higher than 2014's 9.2% growth. Essex has maintained same-store occupancy within a range of 96% - 97% during the past five years.
GEOGRAPHIC CONCENTRATION & UNCERTAINTY SURROUNDING TECH
The company is geographically concentrated in three primary markets: Southern California (45% of NOI), San Francisco Bay Area (37%), and the Seattle metropolitan area (18%). These markets generally and ESS specifically have benefited from strong demand driven by tech and related employers in recent years and supply increasing at a slower relative pace. However, there is increasing uncertainty as to where we are in the tech cycle, venture capital fund flows and the potential for tech valuations to decline and weigh on the market's psyche and capacity to absorb new supply.
Strong market wage growth and zoning related barriers to supply have been credit positives for ESS and should support growth over the long term. However, the long-term sustainability is unclear given the high employment and living costs fostered by supply constraints.
At some point these elements could also lead to structural changes in the market. The compounding effects of above-average wage growth could pressure the marginal value of employees and incentivize employers to relocate to lower cost markets. Alternatively, high costs of living could provide the will amongst voters for elected officials to soften zoning barriers to supply. Fitch views these to be long-term risks that are unlikely to occur during the one-to-two year rating outlook horizon.
DEVELOPMENT EXPOSURE IS NOTABLE
The company maintains an active development pipeline with remaining costs to complete the pipeline of $624 million pro rata for ESS's ownership percentage of JVs.
Remaining funding represents 4.5% of gross assets as of Dec. 31, 2015, compared with 3.2% at the end of 2014 and the company's 7.5% cycle peak in 2Q'12. Fitch views unfunded development costs approaching 10% to start becoming a credit concern. Fitch will assess ESS's willingness to dial-back development risk in the face of strong multifamily operating fundamentals as evidence of the company's commitment to maintaining a conservative balance sheet.
ESS has a manageable debt maturity schedule with about 15% of total debt maturing during the next two years pro forma for the recent issuance of $450 million of senior unsecured notes and the repayment of the $150 million of senior unsecured notes that matured in March. Fitch estimates that ESS has a liquidity coverage ratio of 1.1x or ($233 million surplus) through Dec. 31, 2017. Fitch defines REIT liquidity coverage as sources of liquidity (unrestricted cash, availability under ESS's unsecured revolving credit facility, and expected retained cash flows from operating activities after dividends) divided by uses of liquidity (debt maturities, remaining development/redevelopment expenditures and expected recurring capital expenditures).
Fitch estimates that ESS's unencumbered asset coverage of unsecured debt (UA/UD) was 2.5x at Dec. 31, 2015, providing sufficient contingent liquidity to unsecured bondholders. Fitch calculates UA using a direct capitalization approach of annualized fourth quarter 2015 (4Q'15) unencumbered NOI using a stressed 7.5% capitalization rate. ESS's UA/UD is adequate for the rating.
PREFERRED STOCK WITHDRAWAL
On April 15, 2016, ESS repaid the Series H preferred stock. As a result, Fitch has withdrawn the preferred stock rating as the instrument(s) have been taken private.
Fitch's key assumptions within the rating case for ESS include:
--A deceleration in operating fundamentals with SSNOI growth of 8% in 2016 declining to 4% in 2018;
--Operating margins and capital intensity remain flat;
--ESS maintains its current pace of development expenditures and is a modest net acquirer;
--ESS does not issue equity and refinances its secured and unsecured debt maturities with like amounts in both markets.
The following factors may result in a positive revision of ESS's ratings and/or Outlook:
--Fitch's expectation of leverage sustaining below 6.0x and a public commitment by ESS to do so (leverage was 5.9x for the trailing 12 months (TTM) ended Dec. 31, 2015);
--Fitch's expectation of fixed-charge coverage sustaining above 3.5x (coverage was 3.6x for the TTM ended Dec. 31, 2015);
--Should ESS' portfolio exhibit similar durability in operating cash flows relative to peers;
--Should Fitch determine ESS has above-average access to capital consistent with 'A' category peers.
The following factors may result in a negative revision of ESS's ratings and/or Outlook:
--Fitch's expectation of leverage sustaining above 7x;
--Fitch's expectation of FCC sustaining below 2.5x;
--Fitch's expectation of UA/UD sustaining below 2x (UA/UD was 2.5x at Dec. 31, 2015).
FULL LIST OF RATING ACTIONS
Fitch has the following:
Essex Property Trust, Inc.
--Issuer Default Rating (IDR) at 'BBB+'.
Essex Portfolio L.P.
--IDR at 'BBB+';
--Unsecured line of credit at 'BBB+';
--Senior unsecured term loan at 'BBB+';
--Senior unsecured notes at 'BBB+'.
Fitch has withdrawn the preferred stock rating at Essex Property Trust, Inc.
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.
--Fitch has included an estimate of recurring cash distributions from joint venture operations in recurring operating EBITDA. Fitch estimated the amount to be $53 million in 2015.
--Fitch has adjusted the historical and projected net debt by assuming the issuer requires $5 million of cash for working capital purposes which is otherwise unavailable to repay debt.
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