Fitch Rates Liberty Property Limited Partnership's Notes Offering 'BBB'; Outlook Stable
KEY RATING DRIVERS
The ratings reflect Liberty's appropriate leverage and fixed-charge coverage (FCC) for a 'BBB' rated REIT with the company's asset profile. Moderate liquidity pressure, partly due to Liberty's growing but manageable development pipeline, and a persistent high AFFO payout ratio balance the positive rating elements.
Appropriate Leverage & Coverage
Fitch expects Liberty's leverage to sustain between 5.5x - 6.0x through 2018, although leverage could migrate outside of that range by 2016-end, depending on the timing of asset sales. Asset sales proceeds should offset the expansion of Liberty's development pipeline and non-stabilized asset pool (primarily comprised of development and, to a lesser extent, under-leased acquisitions) and keep the company's leverage within a range consistent with a 'BBB' Issuer Default Rating (IDR).
The company's leverage was 6.0x as of June 30, 2016 compared to 5.6x and 5.8x for 2015 and 2014, respectively. Fitch defines leverage as debt, net of Fitch-estimated readily available cash over recurring operating EBITDA, including an estimate of recurring cash distributions from joint ventures (JVs). The inclusion of 50% of preferred units as debt, consistent with Fitch's hybrids criteria, has an immaterial impact on the company's leverage metrics.
Fitch expects Liberty's fixed-charge coverage (FCC) to sustain in the mid-to-high-2x range, which is appropriate for the rating. The company's FCC was 3.0x for the trailing 12 months (TTM) ended June 30, 2016 in comparison to 2.9x, 2.7x and 2.6x for 2015, 2014 and 2013, respectively. Fitch calculates FCC as recurring operating EBITDA, including an estimate of recurring cash JV distributions, less recurring capital expenditures and straight-line rents, divided by total interest incurred and preferred operating unit distributions.
Increasing Development Pipeline
Liberty has expanded the scope of its development activities, in tandem with the recent U. S. economic cycle. Liberty had 7 million square feet of wholly-owned development under construction as of June 30, 2016, representing a total estimated investment of $642.7 million (8.3% of gross assets). The projects were 40.6% pre-leased and had remaining funding requirements of $186 million (2.4% of gross assets). Liberty's development exposure as measured by cost-to-complete to gross assets has grown from a 0.9% cycle-low in 2012 and has been at its mid-2% trend range since 2013. Fitch expects LPT to have a low-single-digit development exposure, and expects development yields in the high single digits.
Fitch views Liberty's increased development exposure as a modest net positive given the market's current position in the commercial real estate cycle and supply/demand fundamentals in Liberty's markets. While growth in e-commerce demand (primarily big-box) is outpacing GDP growth, it represents an incremental and underserved form of demand that should be sustainable for the foreseeable future. Fitch expects Liberty to begin approximately $500 million to $700 million of new developments during 2016 with roughly two-thirds initiated on a speculative basis. Asset sales (predominantly from within the company's remaining suburban office portfolio) will likely represent the company's principal source of development funding.
Repositioning Should Improve Portfolio
Liberty's repositioning strategy will improve its portfolio by establishing a national industrial footprint, combined with sharpening its focus on office properties in a few key, core metro markets. Since a repositioning announcement in 2013, the company has grown its industrial platform via development and portfolio acquisitions.
Fitch views this repositioning strategy as positive, presuming it is fully executed. The strategy will enhance asset value and drive improved long-term cash flow growth and stability, as it should reduce the amount of recurring capex incurred for suburban office properties. The company's recently announced sale of 108 non-core suburban properties for $969 million is illustrative of the company's ability to dispose of higher capital expenditure assets.
Moderate Liquidity Pressure
Pro forma for the bond offering, Fitch's stressed liquidity analysis shows Liberty's uses of cash exceeding its internally generated sources of cash for the period July 1, 2016 to Dec. 31, 2017 excluding any projected asset sales. Unsecured bond maturities and elevated development funding commitments are the principal uses of Liberty's cash during the next two years. Fitch estimates the company's liquidity coverage will improve to 0.9x from 0.8x if the company refinances 80% of maturing mortgage debt. We expect the company will fund its development pipeline and some debt maturities with asset sales, which would mitigate the liquidity shortfall but introduces execution risk should the timing of asset sales not be sufficient to fund development.
Conservative Leasing Profile
Liberty's lease maturity schedule is reasonably well balanced through 2021. On average, leases representing less than 11% of the company's wholly-owned annual base rent (ABR) expire per year through 2021 with a maximum of 14% of base rents expiring in 2019. Fitch expects Liberty's average occupancy to increase by 1% to 2% during 2016 to 2018, due to strength in its industrial portfolio, offset by modest occupancy losses in its office portfolio.
Liberty's rents are expected to grow by 1% to 4%, on average, during 2016 on a GAAP basis, with mid - to low-single-digit negative suburban office lease spreads partially offsetting positive mid-single-digit industrial rent spreads and low-single-digit flex property spreads.
Modest Internal Growth
Fitch anticipates only moderate same-store net operating income (SSNOI) growth during the next two years, despite strengthening industrial fundamentals. Liberty's GAAP SSNOI is expected to be flat to up 3% in 2016, and to remain around 2% for 2017 and 2018 as the company disposes of most of its office portfolio. Liberty's SSNOI change was 2.2% for the quarter ended June 30, 2016 and 2.6%, -1%, 1.3% and -0.8% for 2015, 2014, 2013 and 2012, respectively.
Slightly low UA/UD Coverage
Fitch estimates Liberty's unencumbered asset coverage of unsecured debt (UA/UD) around 1.8x as of June 30, 2016. This level of coverage is slightly low for the 'BBB' rating - most Fitch-rated REITs have coverage exceeding 2.0x. Fitch calculates UA/UD under a direct capitalization approach of unencumbered NOI that assumes a stressed 8.5% cap rate.
Weak Dividend Coverage
Liberty's AFFO payout ratio was in the low 90%'s for the TTM ended June 30, 2016 and 94% and 98.5% for 2015 and 2014, respectively. The company continues to reduce its exposure to commodity suburban office properties in favor of less capital-intensive industrial assets and metro/CBD office (i. e. Philadelphia and Washington, D. C.). Although the REIT model is not reliant on internally generated cash flow as a source of funds, Fitch generally views persistently high AFFO payout ratios as a weakness in corporate governance that is evidence of a focus on shareholders over bondholders.
Cycle-Tested Management; Some Shareholder-Friendly Actions
The ratings also reflect the strength of Liberty's management team, including senior officers and property and leasing managers. The company has upgraded its portfolio historically by selling lower-growth assets, such as secondary-market suburban office and flex properties. Liberty has used the proceeds to acquire and develop industrial distribution assets, which have exhibited stronger demand characteristics and are less capital intensive. These positives are offset in part by shareholder-friendly activities, such as a persistently high AFFO payout ratio and recently engaging in share buybacks, both to the detriment of unsecured bondholders.
Preferred Stock Notching
The two-notch differential between Liberty's IDR and preferred stock rating is consistent with Fitch's criteria for corporate entities with an IDR of 'BBB'. Based on Fitch research on '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 Liberty's credit metrics will remain consistent for the 'BBB' rating over the rating horizon.
Fitch's key assumptions within our rating case for the issuer include:
--SSNOI growth of 2% during 2016, 2017 and 2018;
--Land acquisitions of $50 million per year during through 2018;
--Development spending of $550 million in 2016 and $450 million in 2017 and 2018;
--Development deliveries of $400 million per year through 2018 at yields of 7%;
--Dispositions of $1 billion during 2016, $300 million in 2017, and $200 million in 2018 at an average cap rate of 8.3%;
--$400 million of unsecured bond issuance in 2017 and $300 million in 2018;
--No equity issuance.
The following factors may result in positive momentum in the rating and/or Outlook:
--Fitch's expectation of leverage sustaining below 5.5x (leverage was 6.0x as of June 30, 2016);
--Fitch's expectation of fixed charge coverage sustaining above 3.0x (FCC was 3.0x for the TTM ended June 30, 2016);
--UA/UD sustaining above 2.3x.
The following factors may result in negative momentum in the rating and/or Outlook:
--Fitch's expectation of leverage sustaining above 7x for several quarters;
--Fitch's expectation of FCC sustaining below 2.3x for several quarters;
--Fitch's expectation of an AFFO dividend payout ratio sustaining above 100%.
FULL LIST OF RATING ACTIONS
Fitch currently rates LPT as follows:
Liberty Property Trust
Liberty Property Limited Partnership
--Unsecured revolving credit facility 'BBB';
--Medium-term notes 'BBB';
--Senior unsecured notes 'BBB';
--Preferred operating units 'BB+'.
The Rating Outlook is Stable.