Nov 21 -
Summary analysis -- Piedmont Office Realty Trust Inc. ------------- 21-Nov-2012
CREDIT RATING: BBB/Stable/-- Country: United States
Primary SIC: Real estate
Credit Rating History:
Local currency Foreign currency
16-Jul-2007 BBB/-- BBB/--
Our ratings on Piedmont Office Realty Trust Inc. and its operating partnership, Piedmont Operating Partnership L.P. (together, Piedmont), acknowledge the REIT's "modest" financial risk profile, which is characterized by low leverage and solid debt coverage metrics. A well-diversified portfolio of high-quality office properties and above-average tenant credit quality, provide support for Piedmont's "satisfactory" business risk profile. However, these strengths are tempered by our expectation that net operating income (NOI) will continue to decline over the next year as the REIT continues to contend with portfolio vacancy and meaningful rent concessions following several years of elevated lease expirations. Additionally, Piedmont derives about 66% of its base rent from 52 leases for space in excess of 100,000 sq. ft., and these large blocks of space can be more difficult and expensive to re-tenant if the existing lessee leaves. Piedmont's business risk profile also reflects the REIT's external growth strategy, which relies partially on opportunistic acquisitions and dispositions in lower barrier-to-entry markets.
Atlanta-based Piedmont is a publicly traded REIT with an undepreciated real estate value of approximately $4.6 billion. The company began operating in 1998, and owned and operated a consolidated portfolio of 74 office properties totaling 20.5 million sq. ft. as of Sept. 30, 2012. The REIT also has joint-venture ownership interests that in aggregate hold five properties comprising about 688,500 sq. ft. Originally externally advised, Piedmont has been internally managed since 2007. In our view, the company's assets are primarily institutional-quality office properties, about two-thirds of which are located in central business districts (CBDs) and urban infill locations.
While Piedmont's portfolio is currently located in 17 markets across 17 states and Washington, D.C., the company has articulated an external growth strategy that will concentrate the majority of its portfolio rents in five markets: Boston, Los Angeles, the New York metro area, Washington, D.C. and San Francisco. Piedmont expects to use selective acquisitions to build its portfolio in these markets to represent about 60%-70% of annualized lease revenues, up from the current level of about 47%. Piedmont has identified an additional seven markets (Atlanta, Chicago, Dallas/Houston, Central/South Florida, Minneapolis, Nashville, Tenn., and Phoenix) as "opportunistic" markets. In these markets, Piedmont will focus on strategically timed investments to take advantage of market cycles. Piedmont considers the remaining markets noncore and believes they will likely be a source of assets sales over the next few years.
Piedmont has made substantial progress in releasing space following several years of elevated lease expirations. As of Sept. 30, 2012, Piedmont's wholly owned portfolio was 87% leased, up 200 basis points (bps) sequentially, reflecting the REIT's significant level of third quarter leasing activity. Excluding the impact of partially leased or vacant buildings acquired over the past year, Piedmont's portfolio was 90.1% leased at Sept. 30, 2012, up 130 bps over the prior year. Remaining 2012 and 2013 lease expirations are more manageable than the past three years, comprising 3% and 9.7% of base rent, respectively. We expect recent leasing activity will result in economic occupancy gains for Piedmont over the next year; however, rent declines and leasing concessions associated with re-tenanting are expected to negatively impact same store NOI growth until the latter half of 2013. Rents for leases signed during the first nine months of 2012 for spaces vacant less than one year declined 13.5% on a cash basis, reflecting still weak office market fundamentals. Piedmont's tenant credit quality is stronger than most of its office peers, as tenants with 'A' or better credit ratings represented about 54% of rents at Sept. 30, 2012. The U.S. government is Piedmont's largest customer (13.3% of rents; AA+/Negative/A-1+) followed by BP Corp. (5.8% of rents; A/Stable/A-1).
Piedmont's credit metrics remain strong for the current rating. Debt-to-undepreciated real estate assets of 32% is low for its rated office REIT peer group. Though the company's total debt ($1.4 billion) at Sept. 30, 2012, consisted primarily of mortgage debt ($988 million), Piedmont has increased its use of unsecured debt ($449 million) over the past few years. Year-to-date, Piedmont has repaid approximately $185 million of mortgage debt, financed in part with proceeds from a $300 million unsecured term loan issued in November 2011. Piedmont's debt-to-market capitalization at Sept. 30, 2012, of 33% does not change when unconsolidated joint ventures are included, given the relatively modest investment ($37 million, less than 1% of book assets at Sept. 30, 2012) and lack of debt on assets held in the joint ventures. Debt coverage metrics are also better than similarly rated peers, as fixed-charge coverage (FCC) totaled 4.7x at Sept. 30, 2012. Coverage of all obligations on a trailing-12-month basis, including Piedmont's common dividend, totaled 1.4x at the end of the first quarter. This metric has strengthened following the REIT's February 2012 dividend cut, which lowered the common dividend to 80 cents per share on an annual basis, down from $1.26 per share. Piedmont's exposure to variable-rate debt is limited to borrowings under its unsecured credit facility that totaled $148.5 million at Sept. 30, 2012.
In our opinion, Piedmont's liquidity is adequate, with available sources that are sufficient to cover uses by more than 1.2x over the next 18 months.
We estimate that Piedmont will generate about $235 million to $245 million of funds from operation (FFO) annually over the next two years.
In addition, the REIT had $20.8 million of unrestricted cash at the end of the third quarter, and $327.1 million of availability under its unsecured revolving credit facility at Oct. 31, 2012.
Piedmont's replaced its existing $500 million unsecured revolving credit facility, with a new unsecured $500 million revolver in August 2012. The new facility matures in August 2016 (excluding two 6 month extension options). The interest rate for LIBOR-based loans is plus 117.5 bps and the annual facility fee is 22.5 bps.
Following the repayment of the remaining mortgage loan on 500 West Monroe Street in January 2012, and $45 million of mortgage debt in May, and the refinancing of its line of credit in August 2012, Piedmont's has no debt maturities until 2014.
Given Piedmont's meaningful leasing activity in 2012, we expect leasing and tenant improvement costs to exceed historical levels. Total capital expenditures for the first nine months of 2012 totaled $116 million compared to $70 million for the first nine months of 2011. Partly in anticipation of higher capital and leasing costs, Piedmont reduced its annual common dividend in January 2012 to 80 cents per share, down from $1.26 per share in 2011. We expect this reduction in common dividend payments to result in approximately $80 million in annual savings.
Following the receipt of favorable court rulings in August and October 2012, Piedmont has agreed to a settlement of the outstanding litigation arising from its 2007 internalization of management for approximately $7.5 million in aggregate, the majority of which is anticipated to be covered by insurance. This is substantially less that the REIT's previous estimate of $159 million for the maximum gross reasonably possible loss associated with this litigation.
The outlook is stable. We expect the company's credit metrics, which are currently much stronger than most of its similarly rated REIT peers, to support modest declines in FFO. As such, we currently see limited downside risk at the current rating. If FCC were to fall substantially to the low 3x area, perhaps due to larger than anticipated occupancy or rent declines, we could consider lowering the rating. We could also lower the rating if Piedmont were to pursue substantial debt-funded acquisitions, causing a meaningful rise in leverage and decrease in debt coverage metrics. We do not anticipate any near-term upward momentum for the credit rating, given expectations for negative same store NOI growth over the next year due to portfolio vacancy and rent abatements, and our expectations that Piedmont may continue to pursue a more opportunistic acquisition strategy over the next year.