Fitch Affirms EPR Properties' IDR at 'BBB-'; Outlook Stable
Fitch's ratings reflect EPR's consistent cash flows generated by the company's triple-net leased entertainment, education and recreation segments, resulting in strong leverage and fixed-charge coverage metrics for the rating. EPR benefits from generally strong levels of rent coverage across its portfolio and structural protections including cross-collateralization among properties operated by certain tenants.
Credit concerns include significant, though improving, tenant concentration and the company's investments in asset classes that may be less liquid or financeable during periods of potential financial stress and/or have limited alternative uses.
KEY RATING DRIVERS
Growing Niche Sectors: The ratings reflect EPR's focus on investing in the growing entertainment, recreational and educational sectors. Approximately 76% of EPR's second quarter 2017 (2Q17) revenues are derived from tenants in the entertainment (predominantly theater) or recreation business. Consumer cultural trends toward valuing experiences over ownership and combining retail sales with experiences (i. e. experiential retailing) appear to be validating EPR's portfolio strategy. EPR is also focused on the trend towards public charter school creation and enrollment.
The company's theater properties are typically well located and have high-quality amenities, such as luxury seating and higher-quality food and beverage offerings; however, alternative uses of this space may be limited or may require significant capital expenditures to attract non-theater tenants. The recreation and education facilities are approximately 99% occupied as of June 30, 2017, but the mortgage financeability and depth of the asset transaction market of these asset classes is less robust than that of other real estate sectors. Going forward, management intends to continue to focus on the three investment segments in which it has a competitive/first-mover advantage and developed an investment track-record, which Fitch views positively. Management has highly specialized knowledge within the company's investment segments, which helps shape the company's longer-term strategy.
Minimal Lease Expirations: From 2017 to 2025, no more than 5% of total revenue expires in any single year; except for an immaterial lease expiration in 2018, EPR's education and recreation segments have no leases expiring until 2024.
Historically, most tenants have chosen to exercise their renewal options, which has mitigated re-leasing risk and provided predictability to portfolio-level cash flows, although the dearth of rental expirations and the propensity to invest in property capital improvements upon expiration limits the sample size for evaluating renewal and new lease rental rate changes.
Favorable Debt Maturity Profile: Debt maturities are manageable with $37 million or 1.3% of total debt maturing through 2019. Beyond 2018, with the exception of a $25 million financing, maturities represent solely unsecured debt offerings which are larger in size but mostly well-spaced. Fitch expects the company will continue to effectively ladder its debt maturity profile, which should reduce refinancing risk in any given year.
Tenant/Asset Concentrations: The company's top-10 tenants accounted for 60% of 2Q17 total revenue, which is well above a select-peer average of 24%. EPR's largest tenant, American Multi-Cinema, Inc. (AMC), accounted for 19% of total revenues in the second quarter and three theater tenants accounted for 33% of second quarter revenues. On March 31, 2017, Fitch downgraded AMC's parent company AMC Entertainment's IDR to 'B'/Stable. EPR's largest education tenants, Imagine Schools, Inc. and Basis Independent Schools, each accounted for 3% of total revenues in the second quarter. The company has been expanding its relationships with new charter school operators to minimize tenant concentration in that segment. EPR had 61 operators as of June 30, 2017, compared with just one tenant during the 2010 to 2011 school year.
EPR's largest assets include the $250 million mortgage receivable on a portfolio of 13 ski resorts related to the CNL Lifestyle transaction which represents approximately 4% of EPR's gross assets at cost; No other individual asset represents more than 4% of gross assets. The company holds approximately $940 million in total mortgage receivables.
Theater Demand Trends: North American box office revenue has proven resilient over the past 10 years, growing at a CAGR of approximately 2.5%. However, ticket price growth, which had previously offset attendance declines, has decelerated since 2010. Fitch expects exhibitor industry attendance growth will remain challenging.
Exhibitors have been improving the customer experience through a variety of amenities such as luxury seating and new beverage concepts, which has expanded revenues. Moreover, EPR's theater portfolio is 100% leased and, since the company's formation in 1997, no theater tenant has missed a lease payment. Despite the lack of lease payment defaults, EPR has realized negative leasing spreads upon renewal from time to time, which partially reflects the limited alternative tenants and uses for the assets.
Evolving Education Segment: EPR is focused on the growing market for education investments, in particular public charter schools which represent 12.8% of EPR's annualized NOI as of June 30, 2017; EPR's total educational portfolio, including private schools and early childhood education centers, represents 22.5% of its annualized NOI as of June 30, 2017. The demand for enhanced education at an early age has resulted in public charter school enrollment growth nearly tripling over the past 10 years. EPR has been able to work through charter non-renewals and reduce exposure to public charter-school operator Imagine, a top-10 tenant for the company, while expanding to 61 operators portfolio-wide.
The largest investment risk in this segment is the difference between the charter renewal cycle (typically every five to 10 years) and the average lease term (15-20 years) and the potential for charter renewals to be based on political or budget factors rather than financial or performance factors; academic performance will likely be a primary factor in determining lease renewal, which is out of EPR's control. Alternative uses for charter school facilities, should the operator lose its charter and EPR need to seek an alternative tenant, is largely unproven.
Weaker Unencumbered Asset Coverage: Unencumbered asset coverage of net unsecured debt (UA/UD) is 1.7x when applying a stressed 12% capitalization rate to unencumbered NOI. This ratio is weak compared to EPR's peers with investment-grade IDRs. The company continues to unencumber its megaplex theater assets, improving the quality of the unencumbered pool as EPR transitions to a more unsecured funding model. Nonetheless, EPR's assets generally are less financeable via the mortgage market and have fewer potential buyers than more traditional commercial real estate, reflecting the higher stressed capitalization rate used.
EPR's leverage was 5.1x for the quarter ended June 30, 2017; FCC was 3.1x for the TTM ended June 30, 2017.
EPR's closest peers by asset type - focusing on a variety of service-based retail tenants such as restaurants, theaters, convenience stores and general merchandise - are similarly rated and include VEREIT, Inc. (BBB-/Stable), Spirit Realty Capital (BBB-/Stable), and STORE Capital Corp. (BBB/Stable). EPR's leverage metrics, low near-term lease expirations, consistent and stable tenant EBITDAR coverage of rent, and respectable earnings growth place it solidly in the 'BBB' category. The company's focus on property types such as entertainment, recreation and educational facilities, which have fewer mortgage financing options and have weaker contingent liquidity relative to its peers, are credit concerns.
Fitch's key assumptions within our rating case for the issuer include:
--Annual same-store NOI growth of 1%-2% through 2020. These increases reflect both contractual rent escalations, rental renewal rates and occupancy assumptions;
--Net annual investments of $1.15 billion in 2017 and $625 million annually from 2018-2020 with a yield of 8%;
--Unsecured bond issuances of $450 million for 2017, $400 million in 2019, and $1 billion in 2020;
--Equity issuance of $850 million in 2017 and $300 million in both 2018 and 2019;
--Approximately $5 million-$10 million of capital expenditures annually through 2020. Capital expenditures are low due to the primarily triple-net lease structure and long-term leases.
Future Developments That May, Individually or Collectively, Lead to Positive Rating Action
-Fitch's expectation of leverage sustaining below 4.0x (leverage was 5.1x for the quarter ended June 30, 2017);
-Fitch's expectation of fixed-charge coverage sustaining above 3.0x (coverage was 3.1x for the TTM ended June 30, 2017);
- Increased mortgage lending activity in the theater, recreation and education property sectors, demonstrating contingent liquidity for the asset classes.
Future Developments That May, Individually or Collectively, Lead to Negative Rating Action
-Fitch's expectation of leverage sustaining above 5.5x;
-Fitch's expectation of fixed-charge coverage sustaining below 2.2x;
-Liquidity coverage sustaining below 1.25x, coupled with a strained unsecured debt financing environment;
-Material operational deterioration in the movie exhibitor and/or charter school segments.
Solid Liquidity: EPR's sources of cash exceed its uses by a ratio of 2.6x for the period beginning July 1, 2017 through Dec. 31, 2018, pro forma for the refinancing of the company's credit facility, which refinanced a $350 million term loan with a new $400 million term loan, and increased the size of the revolver to $1 billion ($210 million of which was outstanding post-closing) from $650 million. This results in a liquidity surplus of approximately $600 million over the period. Fitch defines liquidity coverage as sources of liquidity (unrestricted cash, availability under the revolving credit facility, expected retained cash flows from operating activities after dividend payments) divided by uses of liquidity (debt maturities, development expenditures, and capital expenditures).