Fitch Rates Digital Realty Trust's Series I Preferred Stock 'BB+'
KEY RATING DRIVERS
The rating reflects that while the acquisition of Telx moderately increases leverage in the near term, Fitch expects the company's metrics to improve in-line with longer-term historical trends, and consistent with a 'BBB' IDR for a diversified data center real estate investment trust (REIT). While the Telx transaction adds more operational intensity and decreases margins, the transaction has several benefits, including increased tenant and revenue diversity and complementary business lines.
As the largest data center REIT, Digital Realty exhibits credit strengths including a global platform, granular tenant base, strong access to multiple sources of capital, adequate liquidity, and a deep management bench. The rating takes into account the niche asset class in which the company operates, resulting in a less liquid investment market than other commercial property asset classes and also low unencumbered asset coverage for the rating.
Key Metrics Remain Appropriate for Rating
Fitch estimates pro forma run-rate leverage at 5.5x for the trailing 12 months (TTM) ended June 30, 2015, compared to 5.1x for stand-alone DLR. The initial increase in leverage is due to the company acquiring Telx using approximately 8.6x leverage. Fitch forecasts that leverage will remain between 5.0x and 5.5x over the next 12-24 months and DLR has consistently maintained leverage between 4.4x and 5.6x since 2009. Fitch defines leverage as debt net of readily available cash divided by recurring operating EBITDA.
Fixed-charge coverage is good for the rating at 2.8x pro forma, compared with 2.9x and 2.9x for the years 2014 and 2013, respectively. Fitch expects DLR's fixed-charge coverage will be between 2.7x and 2.9x over the next 12-24 months, driven by same-store net operating income (NOI) growth offset by higher fixed charges. Fitch defines fixed-charge coverage as recurring operating EBITDA less straight-line rents divided by total interest incurred and preferred stock dividends.
Strategy Focused on Improving Unlevered Cash Flow
The lease-up of existing inventory is one of the company's top priorities. Tenants across the social media, mobility, analytics, and cloud segments are driving the majority of new demand for Digital Realty's properties. Portfolio occupancy increased 70 basis points (bps) year over year to 93.5% as of June 30, 2015, and quarterly stabilized same store year-over-year cash NOI growth averaged 3.1% for the TTM due primarily to a renewal leasing spread of 10.3% and a retention rate of 82% for TTM ended June 30, 2015. During that period, renewal activity represented 58.3% of leased square footage. Comparisons for renewals were challenging for a time due to the rolldown of peak rental rates signed prior to the financial crisis; however, the company has recently been effective in leasing up its existing properties and maintaining its tenant base. Over the next several years, Fitch projects 2.5% to 4.7% same-store NOI growth, driven primarily by developments coming on line and efficient management of the aggregate portfolio post-close of the Telx acquisition.
Same-store NOI growth, cash flow from the lease-up of developments, and increased cash flow from joint ventures, offset by a reduction of EBITDA from the sale of non-core assets, should drive fixed-charge coverage in the high 2.0x range over the next two years, appropriate for a 'BBB' rating given Digital Realty's niche property focus.
Global Platform
Pro forma for the transaction, Digital Realty will be able to offer Turn-Key Flex, Powered Base Building, colocation and interconnection space, and its 132 operated properties, including 103 throughout North America, 23 in Europe, three in Australia and three in Asia. Top markets as of June 30, 2015 were London (12.7% of annualized base rent), Northern Virginia (10.9%), Dallas (10.8%), New York (9.4%), and Silicon Valley (9.4%).
The company also benefits from a granular tenant roster, which includes IBM (Fitch IDR of 'A+', Stable Outlook) at 7.6% of rent before effect of the Telx transaction, CenturyLink, Inc. (IDR of 'BB+', Stable Outlook) at 7%, Equinix Operating Company, Inc. at 4%, Facebook, Inc. at 2.4% and AT&T (IDR of 'A-', Stable Outlook) at 2.1%.
Good Access to Capital but Limited Secured Debt Market for Data Centers
Since 2006, the company has issued $3.4 billion of common equity, $1.8 billion of preferred equity including most recent issuance, $2.5 billion of dollar-denominated unsecured bonds, and GBP700 million of sterling-denominated unsecured bonds. The company's sterling-denominated bonds function as a natural hedge given the company's exposure to the United Kingdom.
In September 2014, the company formed a joint venture with an affiliate of Griffin Capital Essential Asset REIT, Inc. (GCEAR). This was the company's second large institutional joint venture following the venture with an investment fund managed by Prudential Real Estate Investors in September 2013. The GCEAR venture arranged a $102 million five-year secured bank loan at LIBOR plus 225 basis points, representing a loan-to-value ratio of 55%.
Despite the company's strong access to capital, the availability of mortgage capital for data centers is not as deep compared with other commercial real estate property types, limiting the sources of contingent liquidity.
Deep Management Bench
The company has a strong management team in areas such as real estate expertise as well as technical acumen, and it continues to work collaboratively with its business partners such as VMare and Compunext to provide accommodative data center solutions (e.g., direct connections to VMware vCloud Air, creation of the Global Cloud Marketplace with various cloud service providers). Fitch expects that most of Telx's employees will join DLR to manage the colocation and interconnection business.
Less Contingent Liquidity for Data Centers
Data centers are specialized properties and technological obsolescence over the long term is possible. However, there are significant barriers to entry and medium-term IT trends are favorable. Compared with other real estate assets, data centers have a less liquid investment market with fewer potential buyers, making these assets potentially more difficult to divest or borrow against in a depressed market. These market characteristics can reduce the ability of data centers to serve as a source of contingent liquidity. Digital Realty's financial metrics are intrinsically strong for the 'BBB' rating category; however, the ratings are constrained by the data center properties being a less-than-mature asset class and the less liquid market for trading and financing these assets.
Digital Realty is committed to an unsecured funding profile. However, the company's unsecured debt incurrence has outpaced the growth of the unencumbered pool. Unencumbered assets (unencumbered NOI divided by a stressed capitalization rate of 10%) covered net unsecured debt by 2.1x as of March 31, 2015, which is low for a 'BBB' rating. This ratio further declines to 1.9x pro forma for the Telx transaction.
Higher Operational Intensity from Telx Transaction
Fitch estimates that pro forma EBITDA margins will decline to 54% from approximately 57% due to lower Telx margins, and, pro forma for the transaction Telx's colocation and interconnection business will represent approximately 10% of DLR's total EBITDA. Telx owns only two assets, with the remaining seven locations leased from third-party property owners. As a result, DLR will become a tenant at these locations, which increases lease renewal risk and adds a degree of operating risk into the company's business. Fitch's negative rating sensitivities for leverage may decline if the company further increases its exposure to business segments with higher operating risk.
Adequate Liquidity Coverage Ratio
Liquidity coverage (defined as liquidity sources divided by uses) is adequate at 1.8x for the period from July 1, 2015 to Dec. 31, 2016. Sources of liquidity include unrestricted cash, availability under the company's unsecured revolving credit facility, and projected retained cash flows from operating activities after dividends and distributions. Uses of liquidity include debt maturities as well as projected recurring capital expenditures and cost-to-complete future development.
The company's adjusted funds from operations (AFFO) pay-out ratio was 84.2% in second quarter 2015 (2Q15), compared with 87.6% in 2014 and 83.9% in 2013, all of which are indicative of the company's ability to generate and retain moderate organic liquidity. Based on the current AFFO pay-out ratio, the company retains approximately $90 million annually.
Preferred Stock Notching
The two-notch differential between DLR'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.
Stable Outlook
The Stable Outlook reflects Fitch's expectation that metrics will remain appropriate for the rating and that DLR will finance the Telx transaction on terms currently contemplated by Fitch.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for DLR include:
--Approximately $900 million of other financing transactions prior to Telx transaction closing;
--$850 million of annual development starts;
--$750 million of annual development deliveries.
RATING SENSITIVITIES
The following factors may result in positive momentum in the rating and/or Outlook:
--Increased mortgage lending activity in the data center sector;
--Fitch's expectation of fixed-charge coverage sustaining above 3x (TTM fixed-charge coverage was 3.0x, and pro forma coverage is 2.8x);
--Fitch's expectation of leverage sustaining below 4.5x (TTM leverage is 5.1x and pro forma run-rate leverage is 5.5x).
The following factors may result in negative momentum in the rating and/or Outlook:
--Sourcing the Telx transaction with more than 50% debt;
--Sustained declines in rental rates and same-property NOI;
--Fitch's expectation of fixed-charge coverage sustaining below 2.5x;
--Fitch's expectation of leverage sustaining above 6x;
--Base case liquidity coverage sustaining below 1x.
FULL LIST OF RATINGS
Fitch currently rates Digital as follows:
Digital Realty Trust, Inc.
--IDR 'BBB';
--Preferred stock 'BB+'.
Digital Realty Trust, L.P.
--IDR 'BBB';
--Unsecured revolving credit facility 'BBB';
--Senior unsecured term loan facility 'BBB';
--Senior unsecured notes 'BBB'.
Digital Stout Holding, LLC
--Unsecured guaranteed notes 'BBB'.
The Rating Outlook is Stable.
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