Fitch Ratings has affirmed the 'BBB+' Issuer Default Ratings (IDRs) of
Essex Property Trust, Inc. (NYSE: ESS) and BRE Properties, Inc. (NYSE:
BRE) following the announcement that the companies have entered into a
definitive merger agreement. The Rating Outlook for both companies is
Stable.
Under the terms of the agreement, each BRE common share will be
converted into 0.2971 newly issued shares of Essex common stock plus
$12.33 in cash and ESS will assume BRE's debt obligations. A full list
of rating actions follows at the end of this press release.
Fitch expects a parent-subsidiary relationship will be established
between ESS and BRE at the time of the merger's closing. As such, the
IDR and Outlook of each issuer is expected to be the same going forward.
The relationship is based on Fitch's assumption that BRE's unsecured
debt will rank pari passu to that of ESS and legal and operational ties
will be strong. Fitch expects the combined entity will a have similar
jurisdictional presence, common management, and a centralized treasury.
Key Rating Drivers
The rating affirmations reflect Fitch's expectation for meaningful
operating synergies and improved access to lower cost capital for the
combined company. The Stable Outlooks incorporate Fitch's view that the
combined company (herein: ESS) will continue to drive leverage lower
over the near-to-intermediate term through a combination of internal and
external property net operating income (NOI) growth, the formation of a
joint venture and opportunistic equity issuances.
Rating concerns include an initial increase in ESS' leverage, as well as
a reduction in its unencumbered asset coverage of unsecured debt (UA/UD)
as a result of the merger.
Combination Viewed Favorably
Fitch generally has a favorable view toward the merger of ESS and BRE,
notwithstanding the near-term deterioration in select credit metrics.
Merging with BRE will bolster ESS' existing market presence in
attractive, supply-constrained, West Coast markets, in which low
single-family housing affordability has historically supported strong
multifamily fundamentals.
Moreover, the agency expects the combined company will ultimately
benefit from improved access to lower cost capital due to its larger
size.
Elevated Leverage to Come Down
Fitch believes that ESS management remains committed to reducing
leverage below 7.0x. However, Fitch estimates ESS' leverage will
increase towards the mid-7.0x range as a result of the merger, up from
6.8x standalone as of Sept. 30, 2013 and 7.3x as of Dec. 31, 2012.
Fitch expects ESS will reduce its leverage to under 7.0x within
approximately one year after closing the merger through a combination of
same store net operating income (SSNOI) growth, incremental NOI from
development deliveries and opportunistic share issuance under the
company's at-the-market (ATM) equity program. Sustaining leverage above
7.0x remains a key rating sensitivity that could warrant a downgrade
and/or negative revision to ESS' Outlook.
The source of funds for the approximate $950 million cash component of
the transaction is a key sensitivity in Fitch's leverage estimate. ESS
is considering several funding options, including debt issuances, asset
sales and the formation of a joint venture.
Fitch views the formation of a JV as the company's preferred financing
path. The agency is comfortable with the execution risk the strategy
entails given ESS' successful track record of accessing private equity
capital and the high level of institutional interest in yield oriented
investments, including commercial real estate assets in core, supply
constrained coastal markets.
Fitch's financial projections assume that ESS successfully places $1
billion of assets into a newly formed JV with an institutional
investor(s). Fitch further assumes that ESS will retain a 50% stake in
the new JV and that the fund will employ 60% leverage, resulting in an
approximate $200 million equity requirement that ESS will need to fund,
either through additional borrowings or equity.
Funding its JV equity requirement with debt would result in leverage of
7.5x for the combined company. If ESS issues equity to fund its
obligation, leverage would be 7.3x.
Under both scenarios, Fitch has assumed that merger synergies offset
increased property taxes stemming from California Proposition 13 when
estimating the combined company's recurring operating EBITDA. Fitch
defines leverage as net debt to recurring operating EBITDA including
recurring operating cash distributions from joint ventures.
Lower Unencumbered Asset Coverage
Fitch estimates that ESS' unencumbered asset coverage of unsecured debt
(UA/UD) will decrease slightly below 2.0x as a result of the merger from
the low 2.0x range as of Sept. 30, 2013 which is a credit concern.
Higher property taxes and the assumed contribution of $1 billion of
unencumbered assets into a newly formed JV are the principal reasons for
the decline in UA/UD coverage. Fitch calculates the company's UA value
using a direct capitalization approach of unencumbered NOI, assuming a
stressed 7.5% capitalization rate.
Similar to leverage, Fitch expects internal growth and incremental NOI
from development deliveries to lift the company's UA/UD above 2.0x
within a year after closing the merger.
Strong Fixed Charge Coverage
Fitch expects ESS' fixed-charge coverage to be 3.0x on a trailing 12
month (TTM) basis for the combined company. This is consistent with
standalone ESS' TTM fixed charge coverage of 3.0x at Sept. 30, 2013 and
3.0x for the year ended Dec. 31, 2012.
Fitch defines fixed-charge coverage as recurring operating EBITDA less
recurring capital improvements divided by interest incurred and
preferred distributions.
Limited Execution Risk
The overlap in asset profiles and markets suggests only a moderate
amount of merger integration risk.
RATING SENSITIVITIES
The following factors may result in a negative revision to ESS' ratings
and/or its Outlook:
--Fitch's expectation of leverage sustaining above 7.0x (Fitch estimates
TTM leverage would be 7.3x for the combined company on a pro forma basis
assuming $200 million of new equity);
--Fitch's expectation of fixed-charge coverage sustaining below 2.5x
(TTM coverage was 3.0x on a pro forma basis);
--Fitch's expectation of UA/UD sustaining below 2.0x (UA/UD was 1.9x on
a pro forma basis as of Sept. 30, 2013).
Although Fitch does not anticipate any upwards rating momentum, the
following factors could result in a positive revision to ESS' ratings
and/or its Outlook:
--Fitch's expectation of leverage sustaining below 6.0x;
--Fitch's expectation of fixed-charge coverage sustaining above 3.5x;
--UA/UD sustaining above 3.0x.
Fitch has affirmed the following ratings:
Essex Property Trust, Inc.
--Issuer Default Rating at 'BBB+';
--Preferred Stock at 'BBB-'.
Essex Portfolio L.P.
--Issuer Default Rating at 'BBB+';
--Unsecured Line of Credit at 'BBB+';
--Senior Unsecured Notes at 'BBB+'.
BRE Properties, Inc.
--IDR 'BBB+';
--Unsecured revolving credit facility 'BBB+';
--Senior unsecured notes 'BBB+';
--Preferred stock at 'BBB-'.
In accordance with Fitch's policies Essex appealed and provided
additional information to Fitch that resulted in a rating action that is
different than the original rating committee outcome.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Recovery Rating and Notching Criteria for Equity REITs,' Nov. 19,
2013;
--'Corporate Rating Methodology: Including Short-Term Ratings and Parent
and Subsidiary Linkage,' Aug. 5, 2013;
--'Criteria for Rating U.S. Equity REITs and REOCs,' Feb. 26, 2013;
--'Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT
Credit Analysis,' Dec. 13, 2013.
Applicable Criteria and Related Research:
Recovery Rating and Notching Criteria for Equity REITs - Effective May
12, 2011 to May 3, 2012
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=628490
Corporate Rating Methodology: Including Short-Term Ratings and Parent
and Subsidiary Linkage
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715139
Criteria for Rating U.S. Equity REITs and REOCs
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=700091
Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT
Credit Analysis
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=696670
Additional Disclosure
Solicitation Status
http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=812739
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