Fitch Affirms EPR Properties' IDR at 'BBB-'; Outlook Stable
KEY RATING DRIVERS
Fitch's ratings reflect EPR's consistent cash flows generated by the company's triple-net leased megaplex movie theatres and other investments across the entertainment, education and recreation segments, resulting in maintenance of strong leverage and fixed-charge coverage metrics. EPR benefits from generally strong levels of rent coverage across its portfolio and structural protections including cross-collateralization among properties operated by certain tenants. While cinema attendee demand has remained consistent over a long time period and thereby improved the durability of operating cash flows, other investment segments lack a similar long-term track record. Credit concerns include significant, though very much improving tenant concentration and concerns about the company's investment in niche asset classes that are less proven and may be less liquid or financeable during periods of potential financial stress and/or have limited alternative uses.
EXPECTED INCREASE IN LEVERAGE
Leverage was strong at 5.1x over the trailing 12 months (TTM) ended March 31, 2015, up marginally from 5.0x at both year-end 2014 and 2013. The company has generally operated in the 4.5x to 5.0x range over the past five years, but Fitch projects leverage will increase as high as 5.4x in the near term and remain in the low 5x range through 2017. The projected uptick in leverage is driven by an increase in capital spending particularly for pre-leased build-to-suit investments, which require large capital outlays in advance of the assets producing cash flow, as well as the anticipation of development spending related to the Adelaar project. EPR and its partner, Empire Resorts, are expected to begin construction of the full-scale resort on the already cleared land parcel upon receiving official licensing from the New York State Gaming Commission. Despite the expected increase, leverage will remain appropriate for the 'BBB-' rating given EPR's niche property focus. Fitch defines leverage as net debt divided by recurring operating EBITDA.
STRONG FIXED-CHARGE COVERAGE
EPR's fixed-charge coverage is solid for a 'BBB-' IDR. Fixed charge coverage was 2.7x for the TTM ended March 31, 2015, flat from 2.7x in 2014 and up slightly from 2.6x in 2013. Fitch projects that EPR's fixed-charge coverage ratio will continue to improve and surpass 3.0x by year-end 2015, which would be strong for the 'BBB-' rating. The expected improvement is driven by an increasing level of high-yielding acquisitions and developments, partially offset by increased interest expense from unsecured bond issuances, though EPR has been achieving more favorable pricing each time it has issued via the unsecured bond market.
New investments will generally target equal weightings among the entertainment, education and recreation segments, and Fitch expects the company to have acquisition opportunities available within each respective segment. Fixed-charge coverage is defined as recurring operating EBITDA less recurring capital expenditures and straight-line rent adjustments, divided by cash interest incurred and preferred stock dividends.
FAVORABLE DEBT MATURITY PROFILE
Debt maturities are manageable through 2017, with no year representing more than 8.9% of total debt. Beyond 2017, the maturities represent unsecured debt offerings which are larger in size but still mostly well-spaced. Fitch expects the company will be able to effectively ladder its debt maturity profile, which should reduce refinancing risk in any given year. Fitch expects the company to repay all of its upcoming secured debt maturities with unsecured debt, resulting in a fully unencumbered portfolio. However, in certain instances the company may assume secured debt when acquiring assets.
MINIMAL LEASE EXPIRATION RISK
From 2018-2029, no more than 7% of total revenue expires in any single year. Megaplex theatres currently represent 56% of total revenues for TTM March 31, 2015. EPR's charter school segment represents 15% of total revenue and all leases expire after 2030, with the exception of one in 2017.
Historically, most tenants have chosen to exercise their renewal options, which has mitigated re-leasing risk and provided predictability to portfolio-level cash flows. Over the past several years some tenants have given back space, but more recently this trend has subsided. Rent renewal spreads can vary greatly depending on the operating performance of the asset.
ADEQUATE LIQUIDITY
Fitch calculates that EPR's liquidity coverage ratio is 1.9x for the period April 1, 2015 to Dec. 31, 2016. Subsequent to March 31, 2015, EPR amended and combined its unsecured revolving credit and term loan facilities, increasing the revolver to \\\\$650 million from \\\\$535 million and providing an additional \\\\$65 million of availability on the term loan. The revolver was undrawn at March 31, 2015 and the biggest weight on liquidity uses is \\\\$243 million of expected development expenditures over the forecast period. Fitch defines liquidity coverage as sources of liquidity (unrestricted cash, availability under the revolving credit facility, expected retained cash flows from operating activities after dividend payments) divided by uses of liquidity (debt maturities, development expenditures and capital expenditures).
EPR paid out 94% of its adjusted funds from operations (AFFO) in dividends in the first quarter of 2015, up materially from the two previous quarters, but not to a level of concern for Fitch. Fitch expects the company's payout ratio decline to the mid-80% range on a long term basis, and internally generated liquidity will be used in part to fund new investments.
APPROPRIATE UNENCUMBERED ASSET COVERAGE OF UNSECURED DEBT
EPR has solid contingent liquidity from its unencumbered asset pool. Unencumbered asset coverage of net unsecured debt (UA/UD) is 1.9x when applying a stressed 12% capitalization rate to unencumbered net operating income (NOI). This ratio is adequate for a 'BBB-' IDR. The company continues to unencumber megaplex theatre assets, improving the quality of the unencumbered pool as EPR transitions to a more unsecured funding model. Nonetheless, EPR's assets generally are less financeable and have fewer potential buyers than more traditional commercial real estate.
HIGH TENANT CONCENTRATION IS RECEDING
EPR's largest tenant, American Multi-Cinema, Inc. (AMC) (IDR of 'B+' with a Stable Outlook), accounted for 21% of total revenues in the first quarter of 2015, down from 24% the year prior. The exposure to AMC has consistently decreased since the company's inception and the company's top 10 tenants accounted for 66% of total revenue in the most recent quarter.
EPR's largest charter school tenant, Imagine Schools, Inc. (Imagine) accounted for 6% of total revenues in first quarter of 2015, decreasing as expected after the sale of four Imagine charter schools in Florida in April 2014. The sale not only reduced EPR's exposure to Imagine, but also helped demonstrate some degree of liquidity in the public charter school space. The company has been expanding its relationships with new charter school operators. EPR had 35 tenants during the 2014-2015 school year, 23 tenants during the 2013-2014 school year and just one tenant during the 2010-2011 school year.
While most of EPR's theatre leases and all of EPR's charter school leases for a given operator are cross-defaulted, a tenant bankruptcy could allow for the rejection of certain non-economic leases. Most of EPR's top tenants are either unrated or have below-investment grade ratings; thus the potential for corporate default, bankruptcy and lease rejection could reduce EPR's rental revenues. Mitigating this risk is that on a portfolio and property-level basis, EBITDAR covers rent payments by a healthy margin for nearly all of EPR's properties. Operator concentration risk is partially mitigated by the fact that the primary drivers of theatre box office consumer demand are location and which movies are showing at a particular theatre as opposed to theatre operator.
DURABLE THEATRE BUSINESS
North American box office revenue has proven highly resilient growing at a compound annual growth rate of nearly 4% over the past 25 years. While revenue was down in 2014 for the first time since 2011, 2015 Fitch expects box office revenue growth in 2015. The enhancement of the customer experience through a variety of amenities such as luxury seating and new beverage concepts within the theaters has both expanded revenue streams and increased the frequency of customer visits. EPR's theater portfolio is 100% leased and since the company's formation in 1997, no theatre tenant has missed a lease payment. Despite the lack of lease payment defaults, EPR has realized negative leasing spreads upon renewal from time-to-time, which partially reflects the limited alternative tenants and uses for the assets.
EDUCATION SEGMENT EVOLVING
EPR is highly focused on the burgeoning market for education investments. The company's education segment included investments in 63 public charter schools, six early childhood education schools and two private schools as of March 31, 2015. This portfolio consists of 3.5 million square feet and is 100% leased, with an additional seven public charter schools, 13 early education centers and one K-12 private school under development. EPR has been able to work through prior issues with Imagine, while reducing exposure to the operator, expanding to 35 operators during the 2014-2015 school year. The demand for enhanced education at an early age has begun to outpace the supply within the U.S. as the national waiting list currently holds over 1 million students. The largest investment risk in this segment is the mismatch between the charter renewal cycle (typically every two to four years) and the average lease term (25-30 years). Alternative uses for charter school facilities should the school lose its charter and EPR need to seek an alternative tenant is largely unproven.
NICHE SECTORS
The ratings reflect EPR's focus on investing in non-core property types that are likely less liquid or financeable during periods of market stress. While the company's theatre properties are typically well located and have high-quality amenities, alternative uses of space may be limited or may require significant capital expenditures to attract non-theatre tenants. The recreation and education facilities are also high-quality but the financeability of the assets is uncertain. The sale of four Imagine schools in April 2014 demonstrated some liquidity in the sector; however, the depth of mortgage financing is likely limited.
EPR has previously made some ill-timed non-core investments including entering the vineyard and winery business at the top of the market. Going forward, management intends on continuing to focus on its three investment segments which Fitch views positively. Management has a highly specialized knowledge within EPR's investment segments which helps shape the company's longer term strategy.
PREFERRED STOCK NOTCHING
The two-notch differential between EPR's IDR and its preferred stock rating is consistent with the 'Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis' Criteria Report dated Nov. 25, 2014, as EPR's preferred securities have cumulative coupon deferral options exercisable by EPR and thus have readily triggered loss absorption provisions in a going concern.
STABLE OUTLOOK
The Stable Outlook reflects that while leverage will increase to between 5.2x-5.4x through active capital investment spending, it will still stay below Fitch's negative sensitivity, while coverage should continue to increase to the low 3x range. These strong credit metrics are somewhat offset by the unique risks to EPR's specialty property types such as liquidity, financeability and alternative use. The Stable Outlook further reflects EPR's adequate liquidity coverage and minimal refinancing risk.
KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
--Annual same-store NOI growth of 2% between 2015-2017.
--Investments of \\\\$588 million, \\\\$650 million and \\\\$750 million in 2015, 2016 and 2017, respectively with a yield of 9%.
--Unsecured bond issuances of \\\\$450 million and \\\\$500 million in 2016 and 2017, respectively.
--Equity issuance of approximately \\\\$275 million, \\\\$300 million and \\\\$400 million in 2015, 2016 and 2017, respectively, used to fund external growth.
RATING SENSITIVITIES
The following factors may have a positive impact on the ratings and/or outlook:
--Fitch's expectation of leverage sustaining below 4.0x (leverage was 5.1x for the TTM ended March 31, 2015);
--Fitch's expectation of fixed-charge coverage sustaining above 3.0x (coverage was 2.7x for the TTM ended March 31, 2015).
The following factors may have a negative impact on the ratings and/or outlook:
--Fitch's expectation of leverage sustaining above 5.5x;
--Fitch's expectation of fixed-charge coverage sustaining below 2.2x;
--A liquidity coverage sustaining below 1.25x, coupled with a strained unsecured debt financing environment.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings:
EPR Properties
--Issuer Default Rating (IDR) at 'BBB-';
--Unsecured Revolving Line of Credit at 'BBB-';
--Senior Unsecured Term Loan at 'BBB-';
--Senior Unsecured Notes at 'BBB-';
--Preferred Stock at 'BB'.
The Rating Outlook is Stable.
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