Nov 08 - Fitch Ratings has upgraded the following credit ratings of Associated Estates Realty Corporation (Associated Estates, NYSE and NASDAQ: AEC):
--Issuer Default Rating (IDR) to 'BBB-' from 'BB+';
--Senior unsecured revolving credit facility to 'BBB-' from 'BB+';
--Senior unsecured term loan to 'BBB-' from 'BB+';
--Senior unsecured notes (indicative) to 'BBB-' from 'BB+'.
The Rating Outlook has been revised to Stable from Positive.
The upgrade of Associated Estates reflects favorable multifamily fundamentals resulting in sustained fixed-charge coverage appropriate for the 'BBB-' rating, the company's primarily acquisition-driven increase in size that incrementally lessens asset concentration, and accelerated leverage reductions via follow-on common stock offerings. The rating action takes into account credit concerns including an increased development pipeline that hampers liquidity as well as heavy 2013 debt maturities. However, mitigating this concern are the company's recently demonstrated unsecured debt access and good contingent liquidity as measured by solid unencumbered asset coverage of unsecured debt.
As noted in the 2012 midyear outlook for multifamily REITs, Fitch expects that the positive operating environment will drive a material and sustained improvement in credit metrics going forward. For Associated Estates, improving occupancy and rent rollover rates are resulting in solid fixed-charge coverage. Strong demand and muted new supply remain in AEC's markets, leading to physical occupancy of 97.3% as of Sept. 30, 2012, up from 94.8% as of Sept. 30, 2011. Rental rates on new and renewal leases increased by 4.4% in the third quarter of 2012 (3Q'12). Despite difficult comparisons from 2011, leasing momentum continued after new and renewal spreads of 5% in 2Q'12 and 2.2% in 1Q'12.
Fixed-charge coverage was 2.8x in 3Q'12 (2.4x for the trailing 12 months ended Sept. 30, 2012) compared with 2.5x in 2Q'12 and 2.1x in fiscal year (FY)2011. Fitch defines fixed-charge coverage as recurring operating EBITDA less recurring capital expenditures divided by total interest incurred.
Fitch anticipates that positive leasing spreads will continue in the near term due to favorable supply-demand dynamics in AEC's markets. For the next 12-to-24 months, Fitch projects that fixed-charge coverage will remain in the 2.5x to 3.0x range due to organic growth and incremental NOI from acquisitions and development, which is appropriate for a 'BBB-' rating.
In a stress case whereby same-store NOI declines are similar to those experienced by AEC in 2009, fixed charge coverage would remain in the mid-2.0x range in the near term, which would be weaker for the 'BBB-' rating for a multifamily REIT of AEC's size. In a more adverse case than anticipated by Fitch, fixed charge coverage could approach 2.0x, which could place pressure on a 'BBB-' rating.
AEC's roots are in the Midwest, though recent acquisitions in other multifamily markets have broadened the company's geographic footprint. Key purchases over the past year were in greater Dallas, TX and Raleigh, NC, with capitalization rates ranging from the low 5% range to the mid 6% range. Moreover, AEC is selectively targeting submarkets with proximity to transportation and employment hubs while shedding older assets in Western Michigan and Duluth, GA, strengthening overall asset quality.
Despite its recent growth, AEC remains substantially smaller than most of its multifamily REIT peers, with gross undepreciated assets of approximately $1.5 billion, a total market capitalization of approximately $1.5 billion, and an equity market capitalization of approximately $750 million. The company's smaller size may limit capital markets access, given that REIT dedicated investors may not be able to acquire a meaningful investment in the company's securities. In addition, the company's small size results in certain assets contributing materially towards results. AEC's top five assets contribute approximately 25% of total NOI and the top 10 assets contribute approximately 40% of total NOI, highlighting asset concentration risk.
Fitch expects that AEC's leverage will sustain in a range appropriate for the 'BBB-' IDR. A follow-on common stock offering of $87.2 million in June 2012 and capital raises via ATM programs (including a new $75 million program) have funded acquisitions and development. Net debt to recurring operating EBITDA was 7.7x in 3Q'12 compared with 7.1x in 2Q'12 and 8.4x in FY2011.
Under Fitch's base case projections, AEC's leverage will sustain in the 7.0x to 7.5x range over the next 12-to-24 months as the company grows earnings via acquisitions and development, while funding such activity with approximately 45% debt and 55% equity.
In a stress case whereby same-store NOI declines are similar to those experienced by AEC in the 2009 period, leverage would sustain around 8.0x, which would be more appropriate for a 'BB+' rating. In a more adverse case than anticipated by Fitch, leverage could sustain above 8.5x in the near term, which would be weak for a 'BB+' rating.
AEC's development pipeline consists of one active project, San Raphael Phase II in Dallas, as well as three future projects in Dallas, Bethesda, MD and Los Angeles. Draws on the company's $350 million unsecured revolving credit facility to fund these projects have weakened liquidity coverage to 1.2x (defined as liquidity sources divided by uses) for the period from Oct. 1, 2012 to Dec. 31, 2014. Sources of liquidity include unrestricted cash, availability under unsecured revolving credit facility, and projected retained cash flows from operating activities after dividends and distributions. Uses of liquidity include debt maturities, projected recurring capital expenditures, and projected development expenditures. Debt maturities are heavy in 2013, however, totaling 21.1% of total debt pro forma for the recent unsecured term loan modification.
Assuming an 80% mortgage refinance rate on upcoming secured debt, liquidity coverage would improve to 3.4x, but Fitch views this scenario as unlikely as the company endeavors to continue unencumbering the portfolio via equity offerings and unsecured debt.
AEC's contingent liquidity is good as measured by unencumbered asset coverage of unsecured debt. Third quarter 2012 annualized unencumbered NOI divided by a stressed capitalization rate of 7.5% covered unsecured debt by 2.9x, which is strong for a 'BBB-' rating. Pro forma for the repayment of mortgage debt on select assets with an unsecured bond offering, unencumbered asset coverage would be 2.5x, which is also solid for the 'BBB-' rating.
Pro forma for an additional unsecured bond offering in 2013 and the repayment of mortgage debt on other assets, unencumbered asset coverage would be 2.1x, which would be adequate for a 'BBB-' rating.
Unencumbered NOI represented 58% of 3Q'12 NOI and Fitch anticipates unencumbered NOI will represent 62% NOI pro forma for an initial unsecured bond offering and 74% pro forma for a subsequent unsecured bond offering in 2013, compared with 45% in 2011 and 34% in 2010. This positive trend is indicative of the company's commitment towards growing its unencumbered pool, to the benefit of unsecured creditors.
AEC has a limited recent track record as an unsecured borrower, but it amended its $350 million unsecured revolving credit facility in January 2012 and recently upsized its unsecured term loan to $150 million from $125 million. In addition, the covenants in AEC's unsecured debt agreements do not restrict financial flexibility.
The Stable Outlook reflects that the 'BBB-' rating is not likely to change in the near-to-medium term. Fitch anticipates that AEC will continue growing in a measured manner via acquisitions and development while maintaining fixed charge coverage in the 2.5x-to-3.0x range and leverage in the 7.0x to 7.5x range over the next 12-to-24 months.
Fitch does not anticipate positive rating momentum in the near term. However, the following factors may result in positive rating and/or Outlook momentum:
--Undepreciated assets sustaining above $2 billion (undepreciated assets were approximately $1.5 billion as of Sept. 30, 2012);
--Fitch's expectation that fixed-charge coverage sustains above 3.0x given the company's size (fixed-charge coverage was 2.8x for 3Q'12);
--Fitch's expectation that net debt to recurring operating EBITDA sustains below 7.0x given the company's size (as of Sept. 30, 2012 leverage was 7.7x based on 3Q2012 annualized recurring operating EBITDA).
The following factors may result in negative rating and/or Outlook momentum:
--Fitch's expectation that fixed-charge coverage ratio sustains below 2.0x;
--Fitch's expectation that leverage sustains above 8.0x;
--A base case liquidity coverage ratio that excludes the impact of refinancing activities sustaining below 1.0x (base case liquidity coverage is 1.2x for Oct. 1, 2012 to Dec. 31, 2014).