NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed the ratings for Equity Residential (NYSE: EQR), including the company's Issuer Default Rating (IDR) at 'A-'. The Rating Outlook is Stable. A full list of ratings follows at the end of the release.
KEY RATING DRIVERS
The affirmation reflects the company's low leverage for the rating and Fitch's expectation that EQR has the willingness and capacity to maintain it through-the-cycle. Fitch views EQR as having sector-leading access to capital, and a portfolio that, while concentrated and prone to more operating volatility than its peers, should demonstrate above-average growth and transactional liquidity and financeability through cycles given its high quality and location in markets with strong long-term demand.
Portfolio Consolidated Within Core Coastal Markets
In early 2016, EQR disposed of non-core, primarily suburban assets, to Starwood Capital Group completing the exit from two markets and consolidating the portfolio within the markets that it wishes to focus on long term. EQR's portfolio is now 98% contained within Boston, Los Angeles (including Orange County), New York, San Diego, San Francisco, Seattle and Washington, D.C. markets, which generally have above-average growth and transactional liquidity and financeability through-the-cycle.
Appropriate Credit Metrics
Fitch expects that EQR continues to maintain a robust development pipeline over time, such that, combined with the company's special dividend paid in October 2016, leverage will sustain in the 6.5x-7x range over the long term. Leverage will likely be below the low end of this range over the next two years as the company slows its development activity relative to previous years. EQR's leverage based on the annualized quarter ended Sept. 30, 2016 was 5.3x (5.4x when including 50% of preferred stock) and fixed charge coverage (FCC) was 3.3x, both of which are good for the rating.
Measured Development Exposure
The company's total development pipeline and unfunded development pipeline as a percentage of gross assets remain smaller than many of its closest peers, with projects focused in its core markets of San Francisco, Washington, D.C., Seattle and Southern California. The size of the pipeline and the unfunded portion increased to pre-recession levels from 2013-2014, but EQR has since reduced development exposure by about 50%. As of Sept. 30, 2016, total development and unfunded development as a percentage of gross assets stood at 4.3% and 1.4%, respectively, down from the recent peak of 8.5% and 4.1% in 2014, respectively.
Weakening New York and San Francisco Fundamentals
New York (19.1%) and San Francisco (17.4%) are the company's first and third largest markets, as measured by third quarter 2016 (3q16) same store net operating income (SSNOI) contribution. New York was the company's weakest market for the first nine months of 2016, generating 0.8% SSNOI growth. Fitch expects EQR's New York assets will have negative rent growth in 2017 and remain the worst performing of EQR's markets.
While San Francisco was the company's best performing market (8.4% SSNOI growth), softer fundamentals due to increased supply and weaker demand in these markets will likely weigh on the portfolio's overall cash flow growth. Fitch expects San Francisco rent growth will slow considerably; trending towards historical averages but remain positive nonetheless. Strength in Seattle and Southern California should keep overall portfolio SSNOI growth positive throughout the projection period.
Washington, D.C. Grinding Along
Washington, D.C. is EQR's second largest market at 18.3% of 3Q16 SSNOI and may also continue to weigh on the overall portfolio performance. SSNOI increased by 1.4% for the first nine months of 2016, the second worst-performing market in EQR's portfolio. Although Washington, D.C. was one of the strongest real estate markets during the global financial crisis, the metro district has been hurt by an abundance of new supply (likely in response to the early cycle growth) coupled with tepid job growth and uncertainty surrounding near-term government job growth. Fitch expects this market to improve modestly throughout the projection period.
Good Liquidity; Strong Capital Access
Fitch calculates that EQR's pro forma liquidity coverage ratio is 1.5x for the period Oct. 1, 2016 to Dec. 31, 2018, which is adequate for the rating. Fitch defines liquidity coverage as sources of liquidity (unrestricted cash, availability under its unsecured revolving credit facility, expected retained cash flows from operating activities after dividends and distributions, net proceeds of the October 2016 $500 million unsecured bond issuance, and a portion of net proceeds from property dispositions) divided by uses of liquidity (debt maturities, unfunded development costs, special dividend and recurring capital expenditures).
The company has demonstrated strong access to nearly all forms of capital to fund its business and address debt maturities, recently demonstrated by its October 2016 $500 million 10-year unsecured bond offering executed at a 125 basis points (bps) spread to the benchmark Treasury, one of the lowest spreads ever within the U.S. REIT sector.
Good Contingent Liquidity
EQR's unencumbered cash NOI stressed at a 7% capitalization rate covered its net unsecured debt by 3.9x as of Sept. 30, 2016. The company has consistently maintained net UA/UD above 2.5x. The quality of the unencumbered portfolio is consistent with the quality of the overall portfolio, based on location and age.
Preferred Unit Notching
The two-notch differential between EQR's IDR and preferred stock rating is consistent with Fitch's criteria for corporate entities with an IDR of 'A-'. Based on Fitch criteria in 'Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis, dated Feb. 29, 2016 and available 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 Fitch's expectation that EQR's leverage should sustain within the expected 6.5x-7x range over the longer term, and that the company has significant cushion relative to its current metrics to absorb operating weakness.
Fitch's key assumptions within our rating case for the issuer include:
--SSNOI growth is in the low single digits for 2016-2019;
--$350 million of acquisitions in 2016 followed by $500 million of annual acquisitions all at a 5% initial yield, and $500 million of annual dispositions at a 5.75% capitalization rate in 2016, with spreads reducing to 50bps in 2017 and 25bps in 2018;
--$170 million and $870 million of development completions in 2016 and 2017, respectively, followed by reduced development spend and deliveries reflecting a more conservative approach to development;
--Special dividends approximating $4 billion in common distributions for 2016;
--Secured debt maturities financed dollar-for-dollar with unsecured bond issuances through the forecast period.
The following factors may have a positive impact on EQR's ratings or Outlook:
--Combined with EQR management's commitment, Fitch's expectation of leverage sustaining below 6.5x throughout cycles (Fitch expects leverage to sustain between 6.5x-7.0x on a longer-term basis; leverage was 5.3x as of Sept. 30, 2016);
--Fitch's expectation of FCC sustaining above 3.5x (coverage was 3.3x for the quarter ended Sept. 30, 2016).
The following factors may have a negative impact on EQR's ratings or Outlook:
--A deviation from EQR's current portfolio, capitalization or financing strategy that could result in a deterioration in the company's market-leading access to capital on an absolute or relative basis;
--Fitch's expectation of leverage sustaining above 7.5x;
--Fitch's expectation of FCC sustaining below 2.5x;
--A liquidity coverage ratio sustaining below 1.0x.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings for Equity Residential and its operating partnership, ERP Operating L.P. (collectively EQR) as follows:
--Long-Term IDR at 'A-';
--Preferred stock at 'BBB'.
ERP Operating Limited Partnership
--Long-Term IDR at 'A-';
--Short-Term IDR at 'F2';
--Unsecured revolving credit facility at 'A-';
--Senior unsecured notes at 'A-';
--Commercial paper notes at 'F2'.
The Rating Outlook is Stable.
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 adjusted the historical and projected net debt by assuming the issuer requires $40 million of cash for working capital purposes, which is otherwise unavailable to repay debt;
--Fitch considers EQR's mortgage principal reserves as readily available cash and a reduction to gross debt in its leverage calculations as it is specifically earmarked for debt repayment.
Additional information is available on www.fitchratings.com.
Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)
Recovery Ratings and Notching Criteria for Equity REITs (pub. 03 Dec 2015)
Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis (pub. 29 Feb 2016)
Dodd-Frank Rating Information Disclosure Form
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