Fitch Ratings has affirmed the credit ratings of Duke Realty Corp. (NYSE: DRE) and its operating partnership, Duke Realty Limited Partnership (collectively Duke, or the company) as follows:
Duke Realty Corp.
--Long-term Issuer Default Rating (IDR) at 'BBB-';
--$448 million preferred stock at 'BB'.
Duke Realty Limited Partnership
--Long-term IDR at 'BBB-';
--$850 million unsecured revolving credit facility at 'BBB-';
--$3 billion senior unsecured notes at 'BBB-'.
Fitch has also withdrawn the rating on the company's senior unsecured exchangeable notes, as these securities are no longer outstanding.
The Rating Outlook is Stable.
Key Rating Drivers
The ratings affirmation takes into account Duke's appropriate leverage for the 'BBB-' rating, large pool of diversified industrial, office, and medical office properties, strong access to various forms of capital, and adequate unencumbered asset coverage of unsecured debt. These credit strengths are tempered by challenging suburban office fundamentals - mitigated by the company's portfolio realignment - as well as low fixed-charge coverage for the rating, increased development activity that weighs on liquidity, and execution risk tied to projected asset sales over the near-term.
Strong Portfolio Characteristics - Suburban Office Remains Weak
The company's geographically diversified portfolio of 774 bulk distribution, suburban office, medical office, and retail properties is located across 18 core markets. Duke's portfolio also benefits from a highly diversified tenant base and well-staggered lease expiration schedule, limiting tenant credit risk and lease rollover risk. DRE's 20 largest tenants represented just 17.6% of annual base rents at Dec. 31, 2012. Additionally, lease expirations average 10% of annual base rent over the next five years, and no more than 11% expire in any given year, indicating long-term recurring cash flow stability across the portfolio.
Duke has made substantial progress repositioning its portfolio to focus on industrial and medical office assets while reducing exposure to Midwestern suburban office and retail properties. Fitch has a negative outlook on suburban office fundamentals, and a stable outlook for industrial and healthcare fundamentals, and continues to view DRE's repositioning strategy positively.
Suburban office assets have continued to see tepid demand, elevated leasing costs and stagnant rental rate growth, which Fitch expects to continue over the near term. Occupancy in the same-store suburban office portfolio was just 84.7% at Dec. 31, 2012. In addition, growth in net effective rent remains stagnant and Duke continues to face elevated leasing capital expenditures. Fitch anticipates that DRE's suburban office portfolio will continue to see weak fundamentals in the near term, including weak rental rate growth and elevated leasing costs.
The company's leverage, pro forma for recent transactions, was 7.2x for the trailing 12 months (TTM) ended Dec. 31, 2012, compared with 5.9x at Dec. 31, 2011 and 7.2x at Dec. 31, 2010. Pro forma leverage accounts for the January 2013 equity offering, subsequent line of credit repayment and preferred redemption. Leverage was artificially low at Dec. 31, 2011, given timing of the Blackstone sale. Over the medium term, Fitch expects leverage to trend toward the mid-6.0x range, which is appropriate for the 'BBB?' rating.
In a stress case not anticipated by Fitch in which net operating income (NOI) declines 4.7% in 2013 and 4.3% in 2014 (based on the worst two-year decline in NOI for a balanced portfolio of office/industrial assets as reported by the Portfolio and Property Research 54-market index), leverage would be 9.1x, which would be more consistent with a lower rating.
Low Fixed-Charge Expected to Improve
DRE's fixed-charge coverage ratio was 1.5x for TTM Dec. 31, 2012, flat from 1.5x in 2011. Fitch defines fixed-charge coverage as recurring operating EBITDA, less recurring capital expenditures and straight-line rent adjustments, divided by total interest incurred and preferred dividends. Coverage has remained in the 1.4x?1.6x range since 2007, and Fitch anticipates that the metric will grow toward 2.0x over the next 12-to-24 months, driven by reduced preferred dividends due to recent redemptions, moderate NOI growth, reduced recurring capex and lower-cost debt financing.
In a stress case not anticipated by Fitch, in which same store NOI declines 4.7% in 2013 and 4.3% in 2014, coverage would be 1.3x, which would be more consistent with a 'BB+' rating.
Increasing Development Pipeline
The company continues to increase its development pipeline - the cost to complete represented 3.1% of undepreciated book assets as of Dec. 31, 2012, compared with 2.1%, 1.8% and 0.7% during the prior three years, respectively. That said, the current level represents a stark decline from the market peak. Fitch does not foresee material funding risk over the near term given Duke's strong access to capital and projected asset sales during 2013.
New development starts have also been focused on build-to-suit projects, thus minimizing lease-up risk. Fitch would view negatively a material increase in speculative development.
Adequate Financial Flexibility
Duke has strong contingent liquidity from a pool of 461 unencumbered properties as of Dec. 31, 2012. Unencumbered asset coverage of unsecured debt based on applying an 8.5% cap rate to unencumbered NOI was adequate for the 'BBB-' rating at 2.0x, pro forma for the January 2013 repayment of outstanding borrowings on the line of credit. The average cap rate for asset sales over the past two years has been approximately 8.2%.
DRE's liquidity coverage was only 0.9x for the period Jan. 1, 2013 through Dec. 31, 2014, or 1.1x assuming DRE is able to refinance 80% of maturing mortgages. This risk is offset by Duke's demonstrated access to various forms of capital and aforementioned unencumbered asset profile. Fitch defines liquidity coverage as sources of liquidity divided by uses of liquidity. Sources of liquidity include unrestricted cash, availability under the unsecured revolving credit facility, and projected retained cash flow from operating activities after dividends. Uses of liquidity include pro rata debt maturities, expected recurring capital expenditures, and remaining development costs.
The Stable Rating Outlook is based on Fitch's expectation that leverage will trend lower to the mid-6.0x range, that coverage will grow toward 2.0x, and that the company will maintain adequate financial flexibility over the near-to-medium term.
Preferred Stock Notching
The two-notch differential between DRE's IDR and preferred stock rating is consistent with Fitch's criteria for corporate entities with a 'BBB-' IDR. 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 following factors may have a positive impact on the ratings and/or Rating Outlook:
--Fitch's expectation of leverage sustaining below 6.5x (as of Dec. 31, 2012, leverage was approximately 7.2x pro forma for the January 2013 equity issuance);
--Fitch's expectation of fixed-charge coverage sustaining above 2.0x (LTM coverage was 1.5x).
The following factors may have a negative impact on the ratings and/or Rating Outlook:
--Fitch's expectation of leverage sustaining above 8.0x;
--Fitch's expectation of fixed-charge coverage sustaining below 1.3x;
--Liquidity coverage including development sustaining below 1.0x
(liquidity coverage is 0.9x through Dec. 31, 2014).
Additional information is available at 'www.fitchratings.com'. The ratings above were unsolicited and have been provided by Fitch as a service to investors.
Applicable Criteria and Related Research:
--'Criteria for Rating U.S. Equity REITs and REOCs' (Feb. 26, 2013);
--'Treatment and Notching of Hybrids in Nonfinancial Corporates and REIT Credit Analysis' (Dec. 13, 2012);
--'Recovery Ratings and Notching Criteria for Equity REITs' (Nov. 12, 2012);
--'Corporate Rating Methodology' (Aug. 12, 2012);
--'Parent and Subsidiary Rating Linkage' (Aug 8, 2012).
Applicable Criteria and Related Research
Parent and Subsidiary Rating Linkage
Corporate Rating Methodology
Recovery Ratings and Notching Criteria for Equity REITs
Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis