October 30, 2017 / 2:01 PM / a year ago

Fitch Revises Gramercy's Outlook to Negative; Affirms IDR at 'BBB'

(The following statement was released by the rating agency) NEW YORK, October 30 (Fitch) Fitch Ratings has affirmed the ratings of Gramercy Property Trust (NYSE: GPT) at 'BBB'. The Rating Outlook has been revised to Negative from Stable. A full list of rating actions follows at the end of the release. KEY RATING DRIVERS The Negative Outlook primarily reflects Fitch's expectation that, absent deleveraging actions, GPT's leverage will remain in the low to mid-6.0x range throughout the ratings horizon, which is above Fitch's 6.0x negative rating sensitivity. In addition, GPT has unencumbered asset coverage of net unsecured debt (UA/UD ratio) that is low for the current rating and below that of its similarly rated peer group. GPT has the ability to maintain leverage below 6.0x and elevate UA/UD via the issuance of additional equity or asset dispositions to reduce debt. GPT continues its evolution toward a more unsecured funding model and has multiple unsecured borrowings outstanding but, to date has not issued any public unsecured notes. These credit weaknesses are offset by GPT's fixed-charge coverage ratio which remains strong for the 'BBB' rating, albeit driven in part by shorter-term but less costly bank financing than the average REIT, strong management team and granular portfolio of predominantly single-tenant, industrial assets that should generate consistent cash flows. Fitch expects asset quality to improve over the next several years as a result of Gramercy's asset repositioning strategy of disposing of select single- and multi-tenant assets primarily in the office sector, and reinvesting those proceeds into target industrial, and, to a lesser extent, specialty assets. Elevated Leverage: Fitch projects leverage (excluding the effects of preferred stock) will settle in the low- to mid-6.0x range through 2019, higher than Fitch's negative rating sensitivity. Leverage was in the high-5.0x range for the TTM ended June 30, 2017 but increases to the mid-6.0x range pro forma for acquisitions and capital markets activity through August-end. Leverage increases by approximately 0.1x when including 50% of the company's preferred stock as debt. Fitch projects that GPT's fixed-charge coverage ratio will sustain at the high-3.0x level through 2019, driven by accretive acquisitions and developments, and partially offset by increased interest expense from unsecured bond issuances. GPT's fixed-charge coverage is solid for its 'BBB' Issuer Default Rating (IDR) at 3.6x for the TTM ended June 30, 2017, although GPT's capital structure has more shorter-term, but less expensive, bank financing that the average REIT. Portfolio Repositioning: In conjunction with the closing of the Chambers Street Merger in December 2015, Gramercy began actively managing its portfolio to optimize future performance by repositioning the combined portfolio. As of second quarter 2017 (2Q17), pro forma for investment activity through August-end, GPT's portfolio will generate approximately 78% of cash NOI from industrial assets, 18% from office and 4% from specialty retail. In comparison, as of 1Q16, GPT generated 52% of its revenue from office, 43% from industrial, and 4% from specialty retail. Fitch views the industrial real estate sector positively given the secular shift in the distribution of consumer goods. Fitch expects that well-located industrial assets will reap benefits from the emphasis on omni-channel trade and the potential for convergence within the retail and industrial sectors. Further reduction in office building exposure should also result in a less capital intensive portfolio to manage over time. As of 2Q17, pro forma for investment activity through August-end, GPT's largest market, Chicago, represents 11.0% of annual base rents, followed by Dallas (6.7%), Atlanta (5.7%) and Los Angeles (5.4%). The portfolio is well diversified across over 350 different tenants and many industry classifications, and key tenant risk is moderate with the largest tenant, FedEx, accounting for 5.6% of pro forma revenues. Evolving Portfolio: GPT's investment strategy emphasizes investment in industrial assets versus a specific lease format such as long-term triple-net leased assets. Alternative formats to the triple-net lease model, such as net leased and modified gross leased assets, provide real estate owners greater upside (and downside) due to the exposure to operating and enhanced leasing risks. Triple-net leased tenants bear the risk of rising taxes, increased maintenance costs and insurance needs, versus the net lease and modified gross lease models, which shift some of the expense (and risk) to the property owner. Further, GPT's acquisition strategy includes assets with significantly shorter lease terms than typically seen in in long-term single-tenant net lease transactions, resulting in potentially higher cash flow volatility. GPT's weighted average lease term is 7.2 years, less than the net lease REIT average of approximately 10 years and more than a gross lease-focused industrial REIT which is typically in the mid-single digits. Fitch expects lease tenor to decline as the company completes its asset repositioning plans, targeting an average lease term of approximately 5-7 years across the portfolio. Transition to Unsecured Funding Model: As of 2Q17, approximately 80% of GPT's outstanding indebtedness is unsecured, up from 65.3% as of Dec. 31, 2015. Fitch expects GPT to continue its evolution toward a fully unsecured funding model; GPT currently has four series of unsecured notes totalling $500 million and $1.45 billion of unsecured term loans outstanding. Fitch expects GPT will continue to reduce its secured debt as existing mortgages mature and through new unencumbered acquisitions, which should improve financial flexibility going forward. GPT has significantly higher exposure to bank debt than the broader REIT universe. GPT's bank borrowing exposure - the sum of outstanding amounts on unsecured revolving facilities and term loans - represents approximately 60% of total debt versus the REIT sector average of approximately 16%. Fitch expects the company to repay a portion of this bank debt via unsecured bond issuance as the capital structure matures. Weak UA/UD Ratio: UA/UD is 1.7x when applying a stressed 9% capitalization rate to unencumbered NOI. Fitch considers a UA/UD ratio less than 2.0x as below investment-grade. Internal Growth / Earnings: Fitch expects 2017 same store NOI (SSNOI) growth to be negative; the company's SSNOI was down 1.9% in 2Q17 after increasing 0.2% in 1Q17. The declines in 2Q17 SSNOI were primarily caused by vacancies in the company's industrial portfolio. Fitch expects SSNOI growth to turn positive in 2018 based on estimated contractual rent increases ranging from 1.0%-2.0% for the portfolio and on stabilizing occupancy. Experienced Management: Senior management has significant experience in commercial real estate, investing, and asset management. The team is led by Gordon DuGan and Benjamin Harris, who have experience working together at W.P. Carey, a net-lease REIT. Together the two carry more than 40 years of direct real estate investment and management experience, while Gramercy's eight senior officers have an average of approximately 20 years of real estate experience. Negative Outlook: The Outlook revision to Negative principally reflects Fitch's expectation that the company's leverage will settle in the low- to mid-6.0x range through 2019, higher than Fitch's negative rating sensitivity of 6.0x and higher than comparable 'BBB' rated peers. In addition, the company's UA/UD ratio of 1.7x, which is down from 2.1x as of June 30, 2016, is weak for the rating. GPT has the ability to reduce leverage below 6.0x and elevate UA/UD with the issuance of additional equity or via asset sales to reduce debt. The company has access to the equity capital markets as evidenced by the public equity raise of over $270 million of capital in April 2017 and the utilization of its at-the-market (ATM) equity issuance program that has raised an additional $20 million in 2017. The company's common stock currently trades at an estimated 10% premium to consensus net asset value according to SNL Financial, allowing management to issue additional equity accretively. DERIVATION SUMMARY GPT's closest rated peer is Lexington Realty Trust (LXP; BBB/Stable). LXP is focused on industrial and office properties and has a similar leverage policy to GPT, although LXP's leverage is currently below 6.0x; both companies are well diversified by tenant, industry and geography. GPT is further along in an asset repositioning program to reduce office exposure, and has more industrial real estate exposure, which Fitch considers a positive given the underlying strength and future prospects for that sector. Liberty Property Trust (LPT; BBB/Stable) has also reduced its suburban office exposure and sought to become a majority industrial property company. LPT's rating is driven by expected leverage sustaining in the 5.5x-6.0x range along with proven longstanding access to the public unsecured bond market. STAG Industrial's (BBB/Stable) portfolio is focused on secondary U.S. industrial markets. Fitch expects STAG to operate through the cycle with leverage sustaining in the low- to mid-5.0x range. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: --Annual same-store NOI growth of negative 1.5% in 2017 due to declining same store occupancy and positive 1.5%-2.0% growth in 2018 and 2019 reflecting flat same store occupancy, contractual rent escalations and positive rent spreads; --Net acquisitions of $1 billion in 2017 and $800 million in 2018 and 2019; --Equity issuance of $560 million and $500 million in 2017 and 2018, respectively, used to fund external growth on a leverage-neutral basis; --Common share dividends of $230 million in 2017 are expected to grow by $30 million-$40 million per year as the company issues additional equity; --$900 million of unsecured bond issuances in 2018 and $500 million in 2019; --Approximately $100 million of maintenance capital expenditures in 2017 and 2018 declining to $35 million per year in 2019. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Negative Rating Action: --Fitch's expectation of leverage sustaining above 6x; --Fitch's expectation of FCC sustaining below 2.5x Future Developments That May, Individually or Collectively, Lead to Revising the Outlook to Stable at a 'BBB' IDR: --Fitch's expectation of leverage sustaining at or below 6x (pro forma 2Q17 leverage was is in the mid-6.0x range at June 30, 2017; --Fitch's expectation of FCC sustaining above 3.5x (FCC was 3.6x for the TTM ended June 30, 2017); --Fitch's expectation of a 2.0x UA/UD ratio at a 9% stressed cap rate. LIQUIDITY Adequate Liquidity: Fitch calculates GPT's liquidity coverage ratio is 1.2x for July 1, 2017 to Dec. 31, 2018, pro forma for recent acquisitions and dispositions subsequent to June 30, 2017. Fitch defines liquidity coverage as sources of liquidity (unrestricted cash, availability under the unsecured revolving credit facility, expected retained cash flows from operating activities after dividend payments) divided by uses of liquidity (debt maturities, development expenditures and recurring capital expenditures). Debt maturities are manageable through 2020. No year represents more than 11% of total debt, except for the company's $850 million revolver expiring in 2020; $750 million of term loans come due in 2021. GPT recently amended and upsized its existing $175 million unsecured term due in January 2023 to $400 million; the term loan will have lower spreads and a swapped fixed rate of approximately 3%. The company's payout ratio has increased significantly over the past two years, with GPT paying out 85.3% of its adjusted funds from operations (AFFO) in dividends in 2Q17, compared with 76.9% for 4Q16 and 50.3% in 2015. The higher payout ratio is the result of a combination of lower AFFO per share and an increase in the company's quarterly dividend per share to $0.375 from $0.33 effective 4Q16. Fitch expects the company's payout ratio to sustain in the 70% range on a long-term basis. FULL LIST OF RATING ACTIONS Fitch has affirmed the following ratings: Gramercy Property Trust: --Issuer Default Rating (IDR) at 'BBB'; --Preferred stock at 'BB+'. GPT Operating Partnership LP --Senior unsecured revolving credit facility at 'BBB'; --Senior unsecured term loans at 'BBB'; --Senior unsecured notes at 'BBB'; --Senior unsecured convertible notes at 'BBB'. GPT Property Trust LP: --Senior unsecured revolving credit facility at 'BBB'; --Senior unsecured term loans at 'BBB'; --Senior unsecured notes at 'BBB'. The Rating Outlook is Negative. Contact: Primary Analyst Christopher G. 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