Fitch Affirms Vornado Realty Trust's Ratings at 'BBB'; Outlook Stable
KEY RATING DRIVERS
Vornado's ratings are supported by its high-quality portfolio of principally office assets in New York City and Washington, D.C. and street retail in Manhattan. The absolute and relative size of VNO's unencumbered pool provides exceptional contingent liquidity and largely offsets headline leverage and fixed-charge coverage metrics that are otherwise on the weaker end of the range for the 'BBB' IDR. The ratings affirmation acknowledges the effects that 220 Central Park South (220 CPS) will have on headline metrics over the rating horizon.
220 CPS TO WEAKEN HEADLINE METRICS
Fitch expects VNO's leverage will increase over the next 12 to 36 months to around 8x as it incurs at least \\$824 million of incremental capital expenditures to complete the 220 CPS condominium development. However, with pre-sales of \\$1.4 billion (40% of the building) noted in the 10-Q dated June 30, 2015 and \\$1.6 billion per the 2Q15 earnings call and sufficient liquidity to complete the project (detailed below), Fitch views it as highly probable that Vornado will complete the development and realize significant cash proceeds that will allow it to restore leverage back to its traditional levels.
Assuming the company closes on all existing units under contract, Fitch expects leverage would return to the mid 7x range. Selling the remaining units at current market values (implied total sales of \\$3.2 billion to \\$3.5 billion) would restore leverage back to the 6.5x - 7.5x range. VNO's 7.2x leverage for the trailing 12 months (TTM) ended June 30, 2015.
Fitch recognizes that the ultimate amount and timing of proceeds depend on several macro (e.g. foreign currency values and commodity prices impacting foreign buyer demand for Manhattan real estate) and micro factors (e.g. cost inflation, construction delays, certainty of closing based on contracts for pre-sales) that are challenging to forecast. Fitch's 'BBB' rating assumes that VNO will continue to operate with leverage in the 6x-7.5x range on a normalized basis.
Fitch defines leverage as total debt less readily available cash assuming \\$200 million of working capital requirements to recurring operating EBITDA including estimated recurring cash distributions from joint venture operations.
EXCEPTIONAL CONTINGENT LIQUIDITY VIA UNENCUMBERED ASSETS
The ratings are further supported by VNO's unencumbered property coverage of unsecured debt, which gives the company significant financial flexibility as a source of contingent liquidity. Consolidated unencumbered asset coverage of unsecured debt results in coverage of 9.5x on a net unsecured debt basis and 7.1x on a gross debt basis. The ratio is strong for the rating, particularly given the unencumbered Manhattan office and retail properties are highly sought after by secured lenders and foreign investors, resulting in stronger contingent liquidity relative to many asset classes. Fitch calculates unencumbered asset coverage as second-quarter 2015 unencumbered property EBITDA divided by a blended stressed capitalization rate of 7.4% divided by net unsecured debt. The strength of VNO's coverage ratio is driven by the quality of assets, the issuer's limited unsecured debt and the strategy of placing higher loan-to-value ratios on the properties that are encumbered.
SIMPLIFICATION LARGELY COMPLETE; HIGH QUALITY PORTFOLIO REMAINS
Over the past few years, VNO underwent a significant simplification. At present, VNO is focused on owning, operating and developing principally office assets in New York City and Washington, D.C. and street retail in Manhattan. For the second quarter 2015 (2Q15), New York office EBITDA totaled \\$169 million (42% of EBITDA), New York retail totaled \\$86 million (22%) and Washington, D.C. office totalled \\$75 million (19%).
VNO's simplification was achieved through the sale of both non-core (e.g. The Merchandise Mart business excluding Chicago) and non-real estate assets (e.g. shares in J.C. Penney, Inc.). In 1Q15, VNO completed the spin-off of substantially all of its remaining shopping center and regional mall real estate into Urban Edge. Fitch does not expect any additional material transactions going forward but recognizes that certain non-core investments remain on the balance sheet adding some structural complexity (e.g. shares of Lexington Property Trust, operating partnership units of Pennsylvania REIT and Urban Edge and an equity interest with no carrying value or earnings implications in Toys 'R' Us, Inc.)
Fitch's base case assumes same-store net operating income (SSNOI) growth of 1%-3% per year through 2017 assuming modest improvements in New York City office occupancy, continued strength in New York City retail leasing spreads and a stabilizing yet still weak market for Washington, D.C. office. VNO reported cash same-store EBITDA (a proxy for SSNOI) growth of 7.7%, 7.6% and 3.9% for its New York City portfolio in 2013, 2014 and year-to-date (YTD). Conversely, the Washington D.C. portfolio has experienced cash same-store EBITDA declines ranging from -2.3% to -9.8% across 2013, 2014 and YTD. The Washington, D.C. portfolio has been negatively affected by the Base Realignment and Closure statute (BRAC) and while the issuer believes the market may be bottoming, Fitch has tempered assumptions through 2017 of modest occupancy gains but continued negative leasing spreads.
Fitch projects VNO will operate with appropriate liquidity through the projection period. Fitch estimates sources of liquidity cover uses by 1x for the period July 1, 2015 through Dec. 31, 2016 assuming no access to the capital markets despite the 220 CPS development and 1.7x assuming 80% of secured debt is refinanced. Fitch calculates liquidity coverage as sources (unrestricted cash of \\$516 million less \\$200 million for working capital purposes, \\$2.1 billion of availability under the \\$2.5 billion of revolving credit facilities, retained cash flow from operating activities) to uses (secured debt maturities, remaining development expenditures net of construction financing and recurring maintenance capital expenditures) pro forma for transactions announced subsequent to the end of 2Q15.
VNO has the capacity to retain some operating cash flow after dividends. Fitch estimates VNO's dividends comprised 85%-90% of adjusted funds from operations (AFFO) in 2013, 2014 and YTD.
WEAK FIXED CHARGE COVERAGE
VNO's FCC has historically been weak for the 'BBB' rating. FCC was 1.7x for TTM ended June 30, 2015, in-line with past years and Fitch does not project a meaningful improvement through the projection period. FCC has traditionally been negatively influenced by the interest expense for the higher leverage, the issuer's use of preferred stock and the tenant improvement and leasing commissions associated with maintaining the portfolio.
PREFERRED STOCK NOTCHING
The two-notch differential between VNO's IDR and preferred stock rating is consistent with Fitch's criteria for corporate entities with an IDR of 'BBB'. Based on Fitch's research on 'Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis', available on Fitch's Web site 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 Rating Outlook is driven by Fitch's expectation that VNO's credit profile will maintain appropriate for the rating despite the anticipated temporary increase in leverage associated with 220 Central Park South and the continued headwinds associated with BRAC in the Washington, D.C. office portfolio.
Fitch's key assumptions within the rating case for VNO include:
--Operating fundamentals remain favorable with SSNOI growth in the low single digits;
--The 220 Central Park South development is completed on budget in 2018 with cash proceeds being recognized thereafter;
--The issuer will revert to its historical leverage and liquidity levels upon completion of the 220 Central Park South development;
--Secured debt maturities are refinanced for higher proceeds through 2017.
The following factors could result in positive momentum in the ratings and/or Outlook:
--Fitch's expectation of leverage sustaining below 6.0x for several quarters (leverage was 7.3x as of June 30, 2015);
--Fitch's expectation of fixed-charge coverage sustaining above 2.5x for several consecutive quarters (coverage was 1.7x for the TTM ended June 30, 2015).
Conversely, while the following factors may result in negative momentum in the ratings and/or Outlook, Fitch recognizes that leverage will likely exceed the sensitivities through the rating horizon as detailed above:
--Fitch's expectation of net debt to recurring operating EBITDA sustaining above 7.5x;
--Fitch's expectation of fixed-charge coverage sustaining below 1.8x;
--Fitch's expectation of a sustained liquidity coverage ratio below 1.0x.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings:
Vornado Realty Trust
--IDR at 'BBB';
--Preferred stock at 'BB+.
Vornado Realty, L.P.
--IDR at 'BBB';
--Unsecured revolving credit facilities at 'BBB';
--Senior unsecured notes at 'BBB'.