NEW YORK--(BUSINESS WIRE)--Fitch Ratings has assigned a 'BBB+' credit rating to the $250 million aggregate principal amount 4.125% coupon senior unsecured notes due 2026 issued by Realty Income Corporation (NYSE: O, Realty Income). The notes were priced at 99.499% of par to yield 4.178% to maturity, or 160 basis points over the benchmark treasury rate.
Net proceeds from the offering totaling $247.1 million are expected to be used to redeem $220 million of 6.75% class E preferred stock, to repay a portion of the borrowings outstanding under the company's unsecured credit facility, and for other general corporate purposes and working capital purposes, which may include acquisitions.
In addition to the 2026 notes, Fitch currently rates Realty Income as follows:
--Issuer Default Rating (IDR) 'BBB+';
--$1.5 billion unsecured revolving credit facility 'BBB+';
--$3.5 billion of senior unsecured notes 'BBB+';
--$409.4 million of preferred stock 'BBB-'.
The Rating Outlook is Stable.
KEY RATING DRIVERS
Realty Income's 'BBB+' IDR is supported by the geographic diversity of the company's predominantly retail net lease property portfolio, limited tenant concentration and moderate tenant credit risk. Fixed charge coverage is strong for the 'BBB+' rating, and Realty Income's management team has been and remains cognizant of maintaining consistent credit metrics despite fluctuations attributable to mergers and acquisitions. Liquidity is appropriate for the rating and the company continues to demonstrate strong access to capital. Credit concerns include pro forma leverage that is weak for the 'BBB+' rating at 5.9x; leverage sustaining above 6.0x could result in negative momentum on the ratings and/or Outlook. In addition, the company's recent focus on investing outside of net lease retail has less of a track record within the context of Realty Income's long history.
Diverse Net Lease Portfolio
As of June 30, 2014, Realty Income's portfolio consisted of 4,263 properties across 49 U.S. states and Puerto Rico, protecting bondholders from possible regional supply-and-demand imbalances. The most significant portfolio transaction over the past two years was the acquisition of American Realty Capital Trust, Inc. (ARCT) that closed in January 2013, totaling 501 properties for $3.2 billion.
Fitch views the portfolio's tenant industry diversification favorably. The portfolio includes 47 tenant industries, and top segments based on the second quarter of 2014 (2Q'14) revenues were convenience stores (10.2%), dollar stores (9.8%), drug stores (9.5%), casual dining and quick service restaurants (8.8%) and health and fitness (7%). Industry expansion is consistent with Realty Income's strategic plan to be less concentrated in net lease retail to improve diversification and to be more focused on improving tenant credit quality going forward to reduce the risk of tenant bankruptcy risk.
Improving Tenant Credit
The company has 228 tenants and its top 15 tenants comprised 45.8% of 2Q'14 rent, which is somewhat concentrated. The top three tenants at June 30, 2014 were Walgreens at 5.2%, FedEx at 5% of rent, and Dollar General at 5%. The company has materially reduced the percentage of annualized rental revenue derived from properties leased to speculative-grade companies since 2010 and, somewhat relatedly, property-level cash flow coverage has also improved in recent years. In addition, the company's weighted average remaining lease term is long at 10.6 years, signaling durability in the cash flow that supports the ratings, absent tenant bankruptcies.
Solid Fixed-Charge Coverage
Fixed charge coverage is solid for the rating at 3.3x in 2Q'14 pro forma for recent acquisitions, proceeds from the senior unsecured notes due 2026 and the redemption of series E preferred stock, up from 3.0x for the trailing 12 months ended June 30, 2014 and 2013. EBITDA growth from acquisitions as well as contractual rent increases and occupancy gains in the same-store portfolio, partially offset by increased fixed charges associated with debt incurred to fund a portion of those acquisitions, drove the increase. Fitch defines fixed charge coverage as recurring operating EBITDA less straight-line rent adjustments less recurring capital expenditures divided by total interest incurred and preferred dividends.
Fitch's base case projections are predicated on contractual base rent increases (1.5% same-store rent growth) and additional acquisitions (assumed to be $1.4 billion in 2014), which should result in coverage sustaining between 3.0x and 3.5x over the next 12 to 24 months, which remains consistent with the 'BBB+' rating. In a stress case not anticipated by Fitch in which tenant bankruptcies similar to the Friendly's and Buffets bankruptcies in 2011-2012 reduce annual rent by approximately 5%, fixed charge coverage would remain above 2.5x and remain appropriate for a 'BBB+' rating.
Forward-Looking Strategic Planning
Realty Income has a long track record of growth since its formation in 1969, having increased the portfolio to 4,263 properties across 47 tenant industries in 2Q'14 from 630 properties across five industries in 1994. The original initiatives of generating monthly income from retail properties leased on a long-term triple-net basis (1969 to 1994) evolved towards being attuned to portfolio diversity as well as focusing on cash flow coverage and underwriting (1997 to 2007). Following the recession, the company has concentrated on improving tenant credit and pursued new industries while re-underwriting and ranking the portfolio.
Realty Income's strategy centers on owning real estate net leased to stronger credit tenants, with a preference for services over goods. The company owns both discretionary and non-discretionary retail as well as non-retail. However, its experience owning non-retail such as industrial and distribution (10.6% of 2Q'14 revenue), office (6.8%), manufacturing (2.5%) and agriculture (2.4%) properties is somewhat limited.
Appropriate Liquidity and Strong Access to Capital
Liquidity coverage pro forma is appropriate for the rating at 1.8x for the period July 1, 2014 to Dec. 31, 2016. Fitch defines liquidity coverage as sources of liquidity (unrestricted cash, availability under the unsecured revolving credit facility pro forma for the equity and bond offerings, and projected retained cash flows from operating activities after dividends and distributions) divided by uses of liquidity (debt maturities and projected recurring capital expenditures).
Longer term, debt maturities are manageable with 1.2% maturing during the remainder of 2014 followed by 5.5% in 2014 and 10.5% in 2016 pro forma. Contingent liquidity is adequate for the rating with unencumbered asset coverage of net unsecured debt of 2.5x at March 31, 2014 pro forma (assuming a stressed 8% capitalization rate). The company intends to further unencumber the portfolio when prepayment penalties on secured debt assumed as part of the ARCT become less onerous.
Fitch anticipates that the company's adjusted funds from operations (AFFO) payout ratio will remain in the mid-to-high 80% range (85.9% in 2Q'14, although this ratio increased to 88.4% in 2013 as a result of the dividend increase associated with the ARCT acquisition). Recent AFFO payout levels indicate the company's ability to generate a modest amount of internal liquidity.
Elevated Leverage
Net debt to recurring operating EBITDA was 5.9x at 2Q'14 pro forma, down from 6.0x in 2013 and 6.6x in 2012. The 2026 notes offering and redemption of series E preferred stock will increase leverage from 5.5x during 2Q'14 to 5.9x pro forma, as Fitch treats REIT preferred shares as 100% equity. Leverage sustaining above 6.0x could result in negative momentum on the ratings and/or Outlook. Leverage was skewed upward in 2012 due to the incurrence of debt prior to the close of the ARCT transaction. Under Fitch's base case, leverage is forecast to remain around 5.5x in 2014-2015, which would remain appropriate for the rating. In a stress case (principally a material tenant bankruptcy) scenario not anticipated by Fitch, leverage could sustain above 6.0x, which would be weak for the rating.
Preferred Stock Notching
The two-notch differential between Realty Income'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', 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.
RATING SENSITIVITIES
The following factors may result in positive momentum in the ratings and/or Rating Outlook:
--Fitch's expectation of fixed-charge coverage sustaining above 3.0x (pro forma fixed charge coverage is 3.3x);
--Fitch's expectation of leverage sustaining below 4.0x (pro forma leverage is 5.9x);
--Fitch's expectation of unencumbered assets-to-unsecured debt sustaining above 3.0x (this ratio is 2.5x pro forma).
The following factors may result in negative momentum in the ratings and/or Rating Outlook:
--Fitch's expectation of fixed-charge coverage sustaining below 2.5x;
--Fitch's expectation of leverage sustaining above 6.0x;
--Tenant bankruptcies resulting in a weakening of the company's credit metrics.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology' (May 28, 2014);
--'Rating U.S. Equity REITs and REOCs (Sector Credit Factors) (Feb. 26, 2014);
--'Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis' (Dec. 23, 2013);
--'Recovery Ratings and Notching Criteria for Equity REITs' (Nov. 19, 2013).
Applicable Criteria and Related Research:
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393
Rating U.S. Equity REITs and REOCs (Sector Credit Factors)
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=737957
Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=726863
Recovery Ratings and Notching Criteria for Equity REITs
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=722363
Additional Disclosure
Solicitation Status
http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=874914
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