Feb 26 - Fitch Ratings has affirmed the credit ratings of Duke Realty Corp.
(NYSE: DRE) and its operating partnership, Duke Realty Limited
Partnership (collectively Duke, or the company) as follows:
Duke Realty Corp.
--Long-term Issuer Default Rating (IDR) at 'BBB-';
--$448 million preferred stock at 'BB'.
Duke Realty Limited Partnership
--Long-term IDR at 'BBB-';
--$850 million unsecured revolving credit facility at 'BBB-';
--$3 billion senior unsecured notes at 'BBB-'.
Fitch has also withdrawn the rating on the company's senior unsecured
exchangeable notes, as these securities are no longer outstanding.
The Rating Outlook is Stable.
Key Rating Drivers
The ratings affirmation takes into account Duke's appropriate leverage for the
'BBB-' rating, large pool of diversified industrial, office, and medical office
properties, strong access to various forms of capital, and adequate unencumbered
asset coverage of unsecured debt. These credit strengths are tempered by
challenging suburban office fundamentals - mitigated by the company's portfolio
realignment - as well as low fixed-charge coverage for the rating, increased
development activity that weighs on liquidity, and execution risk tied to
projected asset sales over the near-term.
Strong Portfolio Characteristics - Suburban Office Remains Weak
The company's geographically diversified portfolio of 774 bulk distribution,
suburban office, medical office, and retail properties is located across 18 core
markets. Duke's portfolio also benefits from a highly diversified tenant base
and well-staggered lease expiration schedule, limiting tenant credit risk and
lease rollover risk. DRE's 20 largest tenants represented just 17.6% of annual
base rents at Dec. 31, 2012. Additionally, lease expirations average 10% of
annual base rent over the next five years, and no more than 11% expire in any
given year, indicating long-term recurring cash flow stability across the
Duke has made substantial progress repositioning its portfolio to focus on
industrial and medical office assets while reducing exposure to Midwestern
suburban office and retail properties. Fitch has a negative outlook on suburban
office fundamentals, and a stable outlook for industrial and healthcare
fundamentals, and continues to view DRE's repositioning strategy positively.
Suburban office assets have continued to see tepid demand, elevated leasing
costs and stagnant rental rate growth, which Fitch expects to continue over the
near term. Occupancy in the same-store suburban office portfolio was just 84.7%
at Dec. 31, 2012. In addition, growth in net effective rent remains stagnant and
Duke continues to face elevated leasing capital expenditures. Fitch anticipates
that DRE's suburban office portfolio will continue to see weak fundamentals in
the near term, including weak rental rate growth and elevated leasing costs.
The company's leverage, pro forma for recent transactions, was 7.2x for the
trailing 12 months (TTM) ended Dec. 31, 2012, compared with 5.9x at Dec. 31,
2011 and 7.2x at Dec. 31, 2010. Pro forma leverage accounts for the January 2013
equity offering, subsequent line of credit repayment and preferred redemption.
Leverage was artificially low at Dec. 31, 2011, given timing of the Blackstone
sale. Over the medium term, Fitch expects leverage to trend toward the mid-6.0x
range, which is appropriate for the 'BBB?' rating.
In a stress case not anticipated by Fitch in which net operating income (NOI)
declines 4.7% in 2013 and 4.3% in 2014 (based on the worst two-year decline in
NOI for a balanced portfolio of office/industrial assets as reported by the
Portfolio and Property Research 54-market index), leverage would be 9.1x, which
would be more consistent with a lower rating.
Low Fixed-Charge Expected to Improve
DRE's fixed-charge coverage ratio was 1.5x for TTM Dec. 31, 2012, flat from 1.5x
in 2011. Fitch defines fixed-charge coverage as recurring operating EBITDA, less
recurring capital expenditures and straight-line rent adjustments, divided by
total interest incurred and preferred dividends. Coverage has remained in the
1.4x?1.6x range since 2007, and Fitch anticipates that the metric will grow
toward 2.0x over the next 12-to-24 months, driven by reduced preferred dividends
due to recent redemptions, moderate NOI growth, reduced recurring capex and
lower-cost debt financing.
In a stress case not anticipated by Fitch, in which same store NOI declines 4.7%
in 2013 and 4.3% in 2014, coverage would be 1.3x, which would be more consistent
with a 'BB+' rating.
Increasing Development Pipeline
The company continues to increase its development pipeline - the cost to
complete represented 3.1% of undepreciated book assets as of Dec. 31, 2012,
compared with 2.1%, 1.8% and 0.7% during the prior three years, respectively.
That said, the current level represents a stark decline from the market peak.
Fitch does not foresee material funding risk over the near term given Duke's
strong access to capital and projected asset sales during 2013.
New development starts have also been focused on build-to-suit projects, thus
minimizing lease-up risk. Fitch would view negatively a material increase in
Adequate Financial Flexibility
Duke has strong contingent liquidity from a pool of 461 unencumbered properties
as of Dec. 31, 2012. Unencumbered asset coverage of unsecured debt based on
applying an 8.5% cap rate to unencumbered NOI was adequate for the 'BBB-' rating
at 2.0x, pro forma for the January 2013 repayment of outstanding borrowings on
the line of credit. The average cap rate for asset sales over the past two years
has been approximately 8.2%.
DRE's liquidity coverage was only 0.9x for the period Jan. 1, 2013 through Dec.
31, 2014, or 1.1x assuming DRE is able to refinance 80% of maturing mortgages.
This risk is offset by Duke's demonstrated access to various forms of capital
and aforementioned unencumbered asset profile. Fitch defines liquidity coverage
as sources of liquidity divided by uses of liquidity. Sources of liquidity
include unrestricted cash, availability under the unsecured revolving credit
facility, and projected retained cash flow from operating activities after
dividends. Uses of liquidity include pro rata debt maturities, expected
recurring capital expenditures, and remaining development costs.
The Stable Rating Outlook is based on Fitch's expectation that leverage will
trend lower to the mid-6.0x range, that coverage will grow toward 2.0x, and that
the company will maintain adequate financial flexibility over the near-to-medium
Preferred Stock Notching
The two-notch differential between DRE's IDR and preferred stock rating is
consistent with Fitch's criteria for corporate entities with a 'BBB-' IDR. 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 following factors may have a positive impact on the ratings and/or Rating
--Fitch's expectation of leverage sustaining below 6.5x (as of Dec. 31, 2012,
leverage was approximately 7.2x pro forma for the January 2013 equity issuance);
--Fitch's expectation of fixed-charge coverage sustaining above 2.0x (LTM
coverage was 1.5x).
The following factors may have a negative impact on the ratings and/or Rating
--Fitch's expectation of leverage sustaining above 8.0x;
--Fitch's expectation of fixed-charge coverage sustaining below 1.3x;
--Liquidity coverage including development sustaining below 1.0x
(liquidity coverage is 0.9x through Dec. 31, 2014).
Additional information is available at 'www.fitchratings.com'. The ratings above
were unsolicited and have been provided by Fitch as a service to investors.
Applicable Criteria and Related Research:
--'Criteria for Rating U.S. Equity REITs and REOCs' (Feb. 26, 2013);
--'Treatment and Notching of Hybrids in Nonfinancial Corporates and REIT Credit
Analysis' (Dec. 13, 2012);
--'Recovery Ratings and Notching Criteria for Equity REITs' (Nov. 12, 2012);
--'Corporate Rating Methodology' (Aug. 12, 2012);
--'Parent and Subsidiary Rating Linkage' (Aug 8, 2012).
Applicable Criteria and Related Research
Parent and Subsidiary Rating Linkage
Corporate Rating Methodology
Recovery Ratings and Notching Criteria for Equity REITs
Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit