Fitch Affirms Equity Residential on Portfolio Disposition Announcement
KEY RATING DRIVERS
The affirmation of the ratings is based on Fitch's expectation that EQR's metrics will remain relatively unchanged and appropriate for the rating. A portion of the proceeds from the $5.365 billion sale to Starwood, combined with additional expected 2016 asset dispositions, will be used to repay debt and pay a special dividend to shareholders.
CONSOLIDATION WITHIN CORE, COASTAL MARKETS
Through these transactions, the company will dispose of non-core, primarily suburban assets, completing the exit from two markets and consolidating the portfolio within the markets that it wishes to focus long term. The portfolio was sold to Starwood at a 5.5% capitalization rate, reflective of a strong transaction market. These older, generally suburban assets have limited access to public transportation and services, and likely have a lower long-term net operating income (NOI) growth trajectory relative to the remainder of EQR's portfolio. 98% of EQR's pro forma portfolio will be in the Boston, Los Angeles (incl. Orange County), New York, San Diego, San Francisco, Seattle and Washington, D.C. markets which Fitch views as generally having above average growth and liquidity through-the-cycle.
Qualitatively, these disposition transactions reflect positively on management strategy, by illustrating that the company is willing to shrink the portfolio (approximately 20% of the company's asset base will be sold) by selling assets at strong valuations and returning capital to shareholders, and also willing to maneuver to hold headline credit metrics at current levels. Further, Fitch views positively the higher concentration of the portfolio in primary coastal, higher barrier-to-entry markets.
NEUTRAL TO CREDIT METRICS
For the trailing 12 months (TTM) ended Sept. 30, 2015, EQR's leverage was 6.1x and fixed charge coverage was 3.0x, both of which are good for the rating. Pro forma for the disposition transactions and the application of use of proceeds, Fitch expects primary credit ratios to be largely unchanged. Fitch assumes that EQR continues maintaining a robust development pipeline, such that leverage will sustain in the 6.5x-7.0x range over the long term.
GOOD CONTINGENT LIQUIDITY
EQR's unencumbered cash NOI stressed at a 7% capitalization rate covered its net unsecured debt by 3.0x as of Dec. 31, 2014, and this ratio is relatively unchanged pro forma for the disposition transactions. The company has consistently maintained adequate net UA/UD above 2.5x. The quality of the unencumbered portfolio is consistent with the quality of the overall portfolio, based on location and age.
WEAK WASHINGTON, D.C. EXPECTATIONS
Washington, D.C. is EQR's second largest market at 18.8% of pro forma NOI and may continue to weigh on the overall portfolio performance. SSNOI declined by 0.2% in first half 2015 (1H15) and 1.8% during 2014, the only market to post a decline within the company's portfolio. Although Washington, D.C. was one of the strongest real estate markets during the global financial crisis, the metro district has been hurt by an abundance of new supply (likely in response to the early cycle growth) coupled with tepid job growth and uncertainty surrounding near-term government job growth. Fitch expects this market to continue to lag the remainder of the portfolio for the next several years.
FOCUSED DEVELOPMENT PIPELINE
EQR acquired several attractive development sites through the Archstone transaction, which should provide growth opportunities over the next several years. The unfunded development pipeline as a percentage of gross assets was 3.3% at Sept. 30, 2015, down from 4.1% at year-end (YE) 2014, and up from 2.8% at YE 2013. This ratio increases to 3.7% pro forma at Sept. 30, 2015, given the smaller size of the company's asset base. The company's total development pipeline and unfunded development pipeline as a percentage of gross assets remains smaller than many of its closest peers, with projects focused within its core markets of Los Angeles, New York, Northern California, and Seattle.
ADEQUATE LIQUIDITY; STRONG CAPITAL ACCESS
Fitch calculates that EQR's sources of liquidity (unrestricted cash, availability under its unsecured revolving credit facility, expected retained cash flows from operating activities after dividends and distributions, and a portion of expected proceeds from asset sales) divided by uses of liquidity (debt maturities, unfunded development costs and recurring capital expenditures) results in a pro forma liquidity coverage ratio of 1.5x for the period Oct. 1, 2015 to Dec. 31, 2017, which is appropriate for the rating. The pro forma ratio accounts for over $2 billion of debt repayment as a result of the dispositions. The company has demonstrated strong access to nearly all forms of capital to fund its business and address debt maturities.
PREFERRED UNIT NOTCHING
The two-notch differential between EQR's IDR and preferred stock rating is consistent with Fitch's criteria for corporate entities with an IDR of 'A-'. Based on Fitch Research on 'Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis, dated Nov. 25, 2014 and 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 Outlook reflects Fitch's expectation that EQR the company's leverage should remain level or improve slightly in the short term, and maintain within the expected 6.5x-7x range over the longer term. The proceeds from the asset sales will allow EQR to pay down significant upcoming debt maturities and the company is a market leader in access to capital.
Fitch's key assumptions for EQR in Fitch's base case include:
--SSNOI growth is in the low single digits for 2015-2017;
--$500 million of annual acquisitions at a 5% capitalization rate;
--Other than the announced transactions, $500 million of annual dispositions a at 6% capitalization rate;
--$600 million of development completions in each of the three years of the forecast period;
--Adjusted funds from operations payout ratio between 69%-77%;
--Secured debt is refinanced dollar for dollar in all three years of the forecast period.
The following factors may have a positive impact on EQR's ratings or Outlook:
--Combined with EQR management's commitment, Fitch's expectation of leverage sustaining below 6.5x throughout cycles (Fitch expects leverage to sustain between 6.5x-7.0x on a longer-term basis; leverage was 6.1x as of Sept. 30, 2015);
--Fitch's expectation of FCC sustaining above 3.5x (coverage was 3.0x for TTM ended Sept. 30, 2015).
The following factors may have a negative impact on EQR's ratings or Outlook:
--A deviation from EQR's current portfolio, capitalization or financing strategy that may result in a deterioration in the company's market-leading access to capital on an absolute or relative basis;
--Fitch's expectation of leverage sustaining above 7.5x;
--Fitch's expectation of FCC sustaining below 2.5x;
--A liquidity coverage ratio sustaining below 1.0x.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings:
--Long-term IDR at 'A-';
--Unsecured revolving term loan at 'A-';
--Preferred stock at 'BBB'.
ERP Operating Limited Partnership
--Long-term IDR at 'A-';
--Short-term IDR at 'F2';
--Unsecured revolving credit facility at 'A-';
--Senior unsecured notes at 'A-';
--Commercial paper notes at 'F2'.
The Rating Outlook is Stable.