NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed the ratings of Healthcare Realty Trust (NYSE: HR) including the Issuer Default Rating (IDR) at 'BBB'. The Rating Outlook remains Stable. A full list of rating actions follows at the end of this release.
KEY RATING DRIVERS
The affirmation of HR's IDR at 'BBB' reflects the low leverage and high fixed-charge coverage and Fitch's view of the durability of the operating cash flows for medical office buildings and by extension, HR, on an absolute and relative basis. HR's ratings are tempered by weak contingent liquidity and a persistently high dividend payout ratio which impedes cash retention. The combined effect of these factors on HR's financial flexibility is material and otherwise restricts positive momentum in the ratings and deterioration of these elements could result in negative momentum in the ratings.
MATERIAL REDUCTION IN LEVERAGE; EXPECTED TO STABILIZE
Fitch projects HR will maintain leverage between 6x - 6.5x through 2018, comparable to 2015 levels. HR has reduced leverage over the past five years with leverage at 6.3x for both 2015 and 2014 as compared to 8.7x at Dec. 31, 2010 and down from 6.7x at Dec. 31, 2013. The reduction was achieved via equity issuances, the lease-up of developments and the focus on high occupancy acquisitions.
Moreover, the durability of medical office building cash flows, as measured by same-store net operating income (SSNOI) growth, reduces the probability of leverage exceeding 7x through-the- cycle absent a change in the size or funding mix of net investment activity. Fitch defines leverage as total debt less readily available cash to recurring operating EBITDA.
Similarly, fixed-charge coverage increased to 2.9x for 2015 up from the low 2x range. Fitch forecasts fixed-charge coverage will remain around 3x through 2018 with it being a bit higher initially until balances on the revolving credit facility are repaid with the next unsecured bond issuance. Fitch defines fixed charge coverage as recurring operating EBITDA less straight-line rent and recurring maintenance capital expenditures to total interest incurred.
DURABILITY OF OPERATING CASH FLOWS
HR's operating cash flows are durable on an absolute and relative basis to that of suburban office REITs as measured by SSNOI growth and tenant retention. Since 3Q'07, HR's SSNOI has averaged 2.5% growth vs. 0.1% for a select group of suburban office REITs, with a lower standard deviation of 1.2% vs. 2.4%.
Similarly, HR has retained 84% of its expiring tenants on average versus 67% for suburban office REITs and with significantly less variation (77%-91% vs. 50%-82%) over this same time period. While the magnitude of HR's outperformance has decreased as suburban office fundamentals improve, the low absolute (and relative) volatility is a key rating driver. Fitch does not view suburban office as competition for medical office buildings. The comparison is due to the similarity in headline metrics.
Weaker metrics in prior years were driven by both the size of then to-be-leased development pipeline and the conversion of master leases with embedded vacancies. Fitch anticipates HR will continue to develop, though the pipeline should not grow to levels that would cause a similar erosion. However, doing so could result in negative momentum on the metrics and/or ratings. Moreover, HR has converted the majority of its master leases thus Fitch expects HR's portfolio will exhibit more durable cashflow growth on a forward looking basis.
STRONG LIQUIDITY DRIVEN BY LONG-DATED BUT CONCENTRATED DEBT MATURITIES
Fitch estimates HR's sources of liquidity (unrestricted cash, availability under the revolving credit facility and retained cash flow from operations) cover uses (total debt maturities, committed development expenditures and maintenance capital expenditures) by 3.6x for the period Jan. 1, 2016-Dec. 31, 2017. HR's liquidity is driven by the capacity on its $700 million revolving credit facility and longer dated debt maturities. HR's next unsecured maturities are any balance on its revolving credit facility and term loan in 2018 and 2019, respectively assuming extension options are exercised. Debt maturities are long-dated but have a noteworthy concentration in 2021 when 28% matures.
IMPROVED YET WEAK CONTINGENT LIQUIDITY RESTRAINS RATINGS
HR's stressed unencumbered asset coverage of unsecured debt was 1.7x at Dec. 31, 2015 up from 1.4x at Dec. 31, 2013. However, it remains below the 2.0x typically carried by investment grade REITs. Unencumbered assets are REITs' primary source of contingent liquidity to raise proceeds via a sale or pledge against during a time of stress. HR's sub 2x unencumbered asset coverage is a key limiting factor for the ratings. Positive improvement in the ratings is unlikely absent a material improvement. Additionally, a deterioration in contingent liquidity could result in negative momentum on the ratings and/or Outlook.
Fitch calculates unencumbered asset coverage assuming a stressed 8.5%-9% cap rate on annualized 4Q'15 unencumbered NOI divided by unsecured debt less readily available cash.
DIVIDEND POLICIES IMPEDE CASH RETENTION
HR determines its dividend rate based off of operating cash flow measures before recurring maintenance capital expenditures. HR considers second generation tenant improvements and leasing expenditures to have a direct impact on renewal/new lease terms and thus the company considers these costs as part of the capitalized asset investment. Based on Fitch's methodology, HR paid out 93% of adjusted funds from operations (AFFO) in 2015, as compared to 113%, 114% and 108% in 2012, 2013 and 2014, respectively. In turn, HR needs to draw on its credit facility or source other forms of liquidity to fund a portion of the common dividend when the payout ratio is above 100%.
GRANULAR TENANT BASE & ASSOCIATION WITH HIGHLY RATED HOSPITALS
HR does not have any material tenant concentration after Baylor Scott & White Health (10% of revenues at Dec. 31, 2015) as the multi-tenant medical office buildings are leased to the individual physicians' group and are typically small in size. While HR does not typically enter into master lease obligations with the hospital that the building and/or tenant is affiliated with, Fitch nonetheless views the portfolio's proximity to the hospital and the credit quality of the hospital system as an indication of the attractiveness of the real estate. HR does not provide tenant EBITDA or EBITDAR coverage.
Fitch's key assumptions within the rating case for HR include:
--The issuer does not materially change its development or acquisition activity;
--SSNOI growth largely offsets development and redevelopment expenditures;
--HR issues a modest amount of equity ($28m/yr) and a $250 million senior unsecured note issuance at 4.5%.
Fitch does not envision positive momentum on the ratings and/or Outlook absent addressing the negative sensitivities surrounding contingent liquidity and the dividend payout ratio. However, the following factors may result in positive momentum on the rating and/or Outlook:
--Fitch's expectation of leverage sustaining below 6.0x (leverage was 6.3x for the trailing 12 months (TTM) ended Dec. 31, 2015);
--Fitch's expectation of fixed-charge coverage sustaining above 3.0x (coverage was 2.9x for the TTM ended Dec. 31, 2015).
The following factors may have a negative impact on the ratings or Outlook:
--Unencumbered asset coverage of unsecured debt sustaining below 2.0x (coverage was 1.7x at Dec. 31, 2015);
--An AFFO payout ratio sustaining above 100%;
--Fitch's expectation of leverage sustaining above 7.0x;
--Fitch's expectation of fixed-charge coverage sustaining below 2.0x;
--A material and sustained increase in speculative development.
FULL LIST OF RATING ACTIONS
Fitch has affirmed HR's ratings as follows:
--IDR at 'BBB';
--Unsecured line of credit at 'BBB';
--Senior unsecured term loan at 'BBB';
--Senior unsecured notes at 'BBB'.
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 adjusted the historical and projected net debt by assuming the issuer requires $2.5 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)
Dodd-Frank Rating Information Disclosure Form