July 12, 2017 / 12:56 PM / 10 days ago

Fitch Rates Digital Realty's Sr. Unsecured Notes 'BBB'; Outlook Stable

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(The following statement was released by the rating agency) NEW YORK, July 12 (Fitch) Fitch Ratings has assigned a 'BBB' rating to the guaranteed notes issued by Digital Stout Holding, LLC a subsidiary of Digital Realty Trust, Inc. (NYSE: DLR). The notes will be fully and unconditionally guaranteed by Digital Realty Trust, Inc. and Digital Realty Trust, L.P. The Rating Outlook is Stable. A full list of rating actions follows at the end of this release. KEY RATING DRIVERS On June 9, 2017, Digital Realty Trust announced an agreement to merge with DuPont Fabros Technology, Inc. and form an entity with a combined enterprise value of approximately $34 billion. The merger will be effected on a stock-for-stock basis. DLR's ratings and Outlook reflect the strengthening of the tenant profile post-merger and increased product offering and scale of the company's portfolio upon completion of the transaction. Fitch expects the company's credit metrics to remain relatively unchanged post-transaction. As the second largest data center REIT, Digital Realty exhibits credit strengths including a global platform, granular tenant base, good 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 and leveragability than other commercial property asset classes. Complementary Transaction: The DuPont merger strengthens DLR's existing portfolio in key markets such as Northern Virginia, Chicago and Silicon Valley. In addition, the company will obtain increased exposure to cloud service providers, potentially enabling DLR to further enhance top-line growth via its global presence and broad product offerings. Key Metrics Remain Appropriate for Rating: Fitch estimates pro forma leverage at 4.9x for the TTM ended March 31, 2017. Fitch expects that leverage (when excluding preferred stock) will remain between 5.0x and 5.5x over the next 12 to 24 months, consistent with the company's leverage historically. Fitch expects that leverage including 50% of preferred stock will be between 5.5x to 6.0x over our projection period. Fitch expects DLR's fixed-charge coverage will be in the high 3.0x's area over the next 12 to 24 months, driven by 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. Pro forma fixed-charge coverage is strong for the rating at 3.9x, compared with 3.5x and 3.2x for the years 2016 and 2015, respectively. Global Platform and Good Tenant Diversity: Pro forma for the merger, Digital Realty's product offering will consist of turn-key flex, powered base building, cloud-based computing, colocation and interconnection across its 157 operating properties spanning over 30 markets, 12 countries, and four continents. The company also benefits from a granular tenant roster which, pro forma for the merger, includes IBM (IDR 'A+'/Negative Outlook) at 6.2% of annual base rent, an undisclosed Fortune 50 software company at 6.0%, Facebook at 5.9%, CenturyLink, Inc. (IDR 'BB+' /Rating Watch Negative) at 4.6%, Rackspace (IDR 'BB-'/Positive Outlook) at 2.7% and Equinix, Inc. (IDR 'BB'/Stable Outlook) at 2.7%. Good Access to Most Capital Sources: Since 2006, the company has issued $4.8 billion of common equity, $1.9 billion of preferred equity, $3.5 billion of dollar-denominated unsecured bonds, GBP700 million of sterling-denominated unsecured bonds and EUR725 million of euro-denominated bonds. The company's sterling and euro-denominated bonds function as a natural hedge given the company's exposure to the United Kingdom and other European countries. Less Contingent Liquidity for Data Centers: Digital Realty's financial metrics are intrinsically strong for the 'BBB' rating category; however, the ratings are constrained by data center properties being a less-than-mature asset class and the less liquid market for trading and financing these assets. The company has shown consistent access to most capital sources, but 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. Despite the significant barriers to entry and favorable medium-term IT trends, data centers are specialized properties and technological obsolescence over the long term is possible. 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 reliable and consistent source of contingent liquidity. Digital Realty is committed to an unsecured funding profile. Pro forma for the merger, unencumbered assets (unencumbered NOI divided by a stressed capitalization rate of 10%) covered net unsecured debt by 2.2x as of March 31, 2017, which is adequate for the 'BBB' rating. Deep Management Bench; Conservative Mind-Set: The company's management team has strong real estate expertise and technical acumen as well as strong knowledge of the sector, including cloud services solutions. The company consistently funds large-scale acquisitions on a leverage-neutral basis, pre-funding the equity portion at transaction announcement to minimize capital markets execution risk. 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 "Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis", available 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 through the forecast period. DERIVATION SUMMARY Digital Realty Trust is the second largest data center REIT by enterprise value. The company has strong market position, providing services to some of the largest global cloud and information technology customers, from which the company generates consistent cash flow via long-term leases and relatively minimal tenant turnover. Fitch expects the company will maintain leverage (excluding preferred stock) at an absolute level that is low for the rating, at approximately 5.0x. This low leverage is offset by less availability of mortgage financing for its asset class relative to other REITs with similar leverage and cash flow profiles that have higher ratings. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: --Low single-digit same-store NOI growth through the forecast period; --DuPont Fabros transaction closes in the second half of 2017 on terms substantially similar to those announced by the company; --The company funds additional growth and development on a leverage-neutral basis, resulting in leverage (excluding preferred stock) ranging between 5.0x to 5.5x, and 5.5x to 6.0x when including 50% of preferred stock as debt. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action --Increased mortgage lending activity in the data center sector, demonstrating contingent liquidity for the asset class; --Leverage, excluding preferred stock, sustaining below 4.5x (TTM ended March 31, 2017 leverage was 5.1x; 4.9x pro forma for the DuPont merger); --Fixed charge coverage sustaining above 3x (Quarter ended March 31, 2017 coverage was 3.8x, TTM coverage pro forma for the DuPont merger was 3.9x). Future Developments That May, Individually or Collectively, Lead to Negative Rating Action --Leverage, excluding preferred stock, sustaining above 6x; --Fixed charge coverage sustaining below 2.5x; --Base case liquidity coverage sustaining below 1x (pro forma liquidity coverage was 1.9x); --Sustained declines in rental rates and same-property NOI.. LIQUIDITY Liquidity coverage (defined as pro forma liquidity sources divided by uses) is adequate at 1.9x for the period from April 1, 2017 to Dec. 31, 2018. Sources of liquidity include unrestricted cash less working capital requirements, availability under DLR's global unsecured revolving credit facility, and projected retained cash flows from operating activities after dividends and distributions. Pro forma uses of liquidity include debt maturities as well as projected recurring capital expenditures and cost-to-complete active development. DLR's standalone adjusted funds from operations (AFFO) payout ratio fell from the mid 80% range to the high 60% range beginning in 2016, enabling the company to retain more than $270 million during the year and putting it on pace to retain more than $280 million in 2017. FULL LIST OF RATING ACTIONS Fitch currently rates Digital as follows: Digital Realty Trust, Inc. --Long-Term IDR 'BBB'; --Preferred stock 'BB+'. Digital Realty Trust, L.P. --Long-Term IDR 'BBB'; --Unsecured revolving credit facility 'BBB'; --Senior unsecured term loans 'BBB'; --Senior unsecured notes 'BBB'. Digital Stout Holding, LLC --Unsecured guaranteed notes 'BBB'. Digital Euro Finco, LLC --Unsecured guaranteed notes 'BBB'. The Rating Outlook is Stable. Contact: Primary Analyst Steven Marks Managing Director +1-212-908-9161 Fitch Ratings, Inc. 33 Whitehall Street New York, NY 10004 Secondary Analyst Stephen Boyd, CFA Senior Director +1-212-908-9153 Committee Chairperson John Culver Senior Director +1-312-368-3216 Date of Relevant Rating Committee: June 9, 2017 Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below: --Historical and projected recurring operating EBITDA is adjusted to add back non-cash stock based compensation and include operating income from discontinued; --Fitch has adjusted the historical and projected net debt by assuming the issuer requires $10 million of cash for working capital purposes that is otherwise unavailable to repay debt; --Fitch has included 50% of the company's cumulative perpetual preferred stock as debt. 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