Fitch Affirms EPR's IDR at 'BBB-'; Rates 2024 and 2026 Notes
KEY RATING DRIVERS
Fitch's ratings reflect EPR's consistent cash flows generated by the company's triple-net leased megaplex movie theatres and other investments across the entertainment, education and recreation segments, resulting in maintenance of 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.
While cinema attendee demand has remained relatively consistent over a long time period -- supporting the durability of EPR's operating cash flows -- other investment segments lack a similar long-term track record. Credit concerns include significant, though improving tenant concentration and concerns about the company's investment in niche asset classes that are less proven and may be less liquid or financeable during periods of potential financial stress and/or have limited alternative uses.
HEADLINE METRICS REMAIN APPROPRIATE
Fitch projects leverage (excluding the effects of preferred stock) will remain in the low 5x range through 2018, consistent with where the company has operated over the past five years. Leverage was strong at 5.1x over the trailing 12 months (TTM) ended June 30, 2016, compared with 5.3x and 4.9x at year-end 2015 and 2014, respectively. When including 50% of the company's preferred stock as debt, leverage increases by approximately 0.4x, which remains appropriate for the 'BBB-' rating. Fitch defines leverage as net debt divided by recurring operating EBITDA.
Fitch projects that EPR's fixed-charge coverage ratio will sustain in the low 3.0x range through 2018, driven by an increasing level of high-yielding acquisitions and developments, partially offset by increased interest expense from unsecured bond issuances. EPR's fixed-charge coverage is solid for a 'BBB-' IDR. Fixed charge coverage was 3.1x for the TTM ended June 30, 2016, up from 2.9x and 2.8x in 2015 and 2014, respectively. Fitch defines FCC as recurring operating EBITDA less straight-line rent adjustments and recurring capital expenditures divided by total interest incurred and preferred dividends.
FAVORABLE DEBT MATURITY PROFILE
Debt maturities are manageable through 2018, with no year representing more than 6.7% of total debt. Beyond 2018, maturities represent solely unsecured debt offerings which are larger in size but still mostly well-spaced. Fitch expects the company will be able to effectively ladder its debt maturity profile, which should reduce refinancing risk in any given year. Fitch expects the company to repay all of its upcoming secured debt maturities with unsecured debt, resulting in a fully unencumbered portfolio. However, in certain instances the company may assume secured debt when acquiring assets.
MINIMAL LEASE EXPIRATION RISK
From 2016 - 2029, no more than 6% of total revenue expires in any single year. EPR's education segment represents 19% of total revenue and all leases expire after 2030, with the exception of two immaterial lease expirations in 2016 and 2017.
Historically, most tenants have chosen to exercise their renewal options, which has mitigated re-leasing risk and provided predictability to portfolio-level cash flows. Over the past several years some tenants have given back space, but more recently this trend has subsided. Rent renewal spreads can vary greatly depending on the operating performance of the asset.
Fitch calculates that EPR's liquidity coverage ratio is 1.7x for the period June 30, 2016 to Dec. 31, 2017, pro forma for the $340 million note issuances in July 2016. 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).
EPR paid out 84% of its adjusted funds from operations (AFFO) in dividends in the second quarter of 2016, up marginally from the two previous years, but not to a level of concern for Fitch. Fitch expects the company's payout ratio to sustain in the mid-80% range on a long term basis, and internally generated liquidity will be used in part to fund new investments.
APPROPRIATE UNENCUMBERED ASSET COVERAGE OF UNSECURED DEBT
EPR has solid contingent liquidity from its unencumbered asset pool. Unencumbered asset coverage of net unsecured debt (UA/UD) is 1.8x when applying a stressed 12% capitalization rate to unencumbered net operating income (NOI). This ratio is adequate for a 'BBB-' IDR. The company continues to unencumber megaplex theatre assets, improving the quality of the unencumbered pool as EPR continues to utilize a predominantly unsecured funding model. Nonetheless, EPR's assets generally are less financeable and have fewer potential buyers than more traditional commercial real estate.
HIGH TENANT CONCENTRATION IS RECEDING
EPR's largest tenant, American Multi-Cinema, Inc. (AMC) (IDR 'B+'/Negative Outlook), accounted for 18% of total revenues in the second quarter of 2016, down from 21% the year prior. The exposure to AMC has consistently decreased since the company's inception and the company's top 10 tenants accounted for 64% of total revenue in the most recent quarter, down from 68% a year ago.
EPR's largest charter school tenant, Imagine Schools, Inc. (Imagine) accounted for 5% of total revenues in second quarter of 2016, decreasing as expected after recent sales. These sales not only reduce EPR's exposure to Imagine, but also help demonstrate some degree of liquidity in the public charter school space. The company has been expanding its relationships with new charter school operators. EPR had 48 tenants during the 2015 - 2016 school year, compared with just one tenant during the 2010 - 2011 school year.
While most of EPR's theatre leases and all of EPR's charter school leases for a given operator are cross-defaulted, a tenant bankruptcy could allow for the rejection of certain non-economic leases. Most of EPR's top tenants are either unrated or have below-investment grade ratings; thus the potential for corporate default, bankruptcy and lease rejection could reduce EPR's rental revenues. Mitigating this risk is that on a portfolio and property-level basis, EBITDAR covers rent payments by a healthy margin for nearly all of EPR's properties. Operator concentration risk is partially mitigated by the fact that the primary drivers of theatre box office consumer demand are location and which movies are showing at a particular theatre as opposed to theatre operator.
The ratings reflect EPR's focus on investing in non-core property types that are likely less liquid or financeable during periods of market stress. While the company's theatre properties are typically well located and have high-quality amenities, alternative uses of space may be limited or may require significant capital expenditures to attract non-theatre tenants. The recreation and education facilities are also high-quality but the mortgage financeability and depth of the asset transaction market of the assets is uncertain. Going forward, management intends on continuing to focus on its three investment segments which Fitch views positively. Management has a highly specialized knowledge within EPR's investment segments which helps shape the company's longer term strategy.
SOFTENING THEATRE DEMAND TRENDS
Given the limited fungibility of the real estate, Fitch considers the operating environment for EPR's key tenants. North American box office revenue has proven resilient growing at a compound annual growth rate of nearly 4% over the past 25 years. In 2015, box office revenue was up 8% from $10.4 billion in 2014, and reached a record high in nominal dollars. However, Fitch expects the exhibitor industry's attendance growth will remain challenging and ticket price growth, which had previously offset attendance declines, has been decelerating.
To counter these factors, exhibitors have been improving the customer experience through a variety of amenities such as luxury seating and new beverage concepts within the theatres has both expanded revenue streams and increased the frequency of customer visits. Moreover, EPR's theatre portfolio is 100% leased and since the company's formation in 1997, no theatre 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.
EDUCATION SEGMENT EVOLVING
EPR is highly focused on the burgeoning market for education investments. The company's education segment included investments in 69 public charter schools, 21 early childhood education schools and three private schools as of June 30, 2016. This portfolio is 100% leased, with an additional seven public charter schools, 14 early education centers and one K-12 private school under development. EPR has been able to work through prior issues with Imagine, while reducing exposure to the operator, expanding to 48 operators during the 2015 - 2016 school year. The demand for enhanced education at an early age has begun to outpace the supply within the U. S. as the national waiting list currently holds over 1 million students. The largest investment risk in this segment is the mismatch between the charter renewal cycle (typically every five to ten years) and the average lease term (25 - 30 years) and the potential for charter renewals to be based on political or budget factors rather than performance factors. Alternative uses for charter school facilities should the school lose its charter and EPR need to seek an alternative tenant is largely unproven.
PREFERRED STOCK NOTCHING
The two-notch differential between EPR's IDR and preferred stock rating is consistent with Fitch's criteria for corporate entities with an IDR of 'BBB-'. Based on Fitch research titled 'Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis', 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 EPR will operate within its targeted metrics through the rating horizon and the issuer will have sufficient capacity to address any potential tenant credit issues.
Fitch's key assumptions within the rating case for EPR include:
--Annual same-store NOI growth of 2.0% in 2016 - 2018. These increases reflect both contractual rent escalations and participation by way of overage rents;
--Annual investments between $700 - 800 million from 2016 - 2018, with a yield of 9.0%;
--No further unsecured bond issuances for 2016. $400 million and $300 million of unsecured bond issuances for 2017 and 2018, respectively;
--Annual equity issuances between $200 - 300 million from 2016 - 2018 though Fitch notes issuance is at management's discretion;
--Approximately $5 million of capital expenditures each year from 2016-2018. Capital expenditures are low due to primarily triple net lease structure and long-term leases;
--Annual divestments between $100 - 200 million from 2016 - 2018.
The following factors could result in positive momentum in the ratings and/or Outlook:
--Fitch's expectation of leverage sustaining below 4.0x (leverage was 5.1x for the TTM ended June 30, 2016);
--Fitch's expectation of fixed-charge coverage sustaining above 3.0x (coverage was 3.1x for the TTM ended June 30, 2016).
The following factors could result in negative momentum on the ratings and/or Outlook:
--Fitch's expectation of Leverage sustaining above 5.5x;
--Fitch's expectation of fixed-charge coverage sustaining below 2.2x;
--A liquidity coverage sustaining below 1.25x, coupled with a strained unsecured debt financing environment;
-- In addition, meaningful, operational deterioration in the movie exhibitor and/or charter school segments may also pressure the ratings.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings:
--Issuer Default Rating (IDR) at 'BBB-';
--Unsecured Revolving Line of Credit at 'BBB-';
--Senior Unsecured Term Loan at 'BBB-';
--Senior Unsecured Notes at 'BBB-';
--Preferred Stock at 'BB'.
Fitch has assigned the following rating:
--$148 million Senior Unsecured Notes 'BBB-';
--$192 million Senior Unsecured Notes 'BBB-'.
The Rating Outlook is Stable.