Fitch Affirms Digital Realty Trust's IDR at 'BBB'; Outlook Stable

NEW YORK--(BUSINESS WIRE)--

Fitch Ratings has affirmed the credit ratings for Digital Realty Trust, Inc. DLR and its subsidiaries Digital Realty Trust, L.P. and Digital Stout Holding, LLC (collectively, Digital Realty or the company) as follows:

Digital Realty Trust, Inc.

--Issuer Default Rating (IDR) at 'BBB';

--$1 billion preferred stock at 'BB+'.

Digital Realty Trust, L.P.

--IDR at 'BBB';

--$2 billion unsecured revolving credit facility (RCF) at 'BBB';

--$1 billion senior unsecured term loan facility at 'BBB';

--$1.7 billion senior unsecured notes at 'BBB'.

Digital Stout Holding, LLC

--GBP700 million unsecured guaranteed notes at 'BBB'.

KEY RATING DRIVERS

The affirmation of Digital Realty's IDR at 'BBB' reflects the expected implementation of the company's strategy to improve return on invested capital (ROIC) through leasing existing data center space, developing new assets, and selling non-core assets. This strategy should result in strong fixed-charge coverage for the 'BBB' rating. 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. Credit concerns center on Fitch's expectation that the company will increase leverage over the next several years and low unencumbered asset coverage for the rating.

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 was flat year over year at 93% as of Sept. 30, 2014, but quarterly stabilized same store year-over-year cash net operating income (NOI) growth averaged 3.9% for the trailing 12 months (TTM) due primarily to new leasing activity. New leasing activity represented 55.7% of leased square footage for the TTM ended Sept. 30, 2014. Comparisons for renewals remain challenging due to the rolldown of peak rental rates signed prior to the financial crisis. Over the next several years, Fitch projects 2% to 3% same store NOI growth, driven primarily by occupancy gains and contractual rental rate increases, offset by some rental rate rolldowns on renewals.

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 of 2.8x over the next two years, appropriate for a 'BBB' rating given Digital Realty's niche property focus. Fixed-charge coverage was 2.9x for the TTM ended Sept. 30, 2014 compared to 2.9x in 2013, 3.1x in 2012, and 3.1x in 2011. Fitch defines fixed-charge coverage as recurring operating EBITDA including recurring cash distributions from unconsolidated entities less recurring capital expenditures less straight-line rent adjustments divided by total cash interest incurred and preferred stock dividends.

Global Platform

Digital Realty offers Turn-Key Flex, Powered Base Building, and colocation space, and its 131 properties span 33 markets across 10 countries and four continents. This significant market presence gives the company strong tenant relationships; approximately 58% of the company's customers occupy space in the company's data centers across multiple markets. Top markets as of Sept. 30, 2014 were London (12.2% of annualized rent), Dallas (10.5%), New York (9.5%), Northern Virginia (9.5%), and Silicon Valley (8.8%). The company also benefits from a granular tenant roster, which includes CenturyLink, Inc. (Fitch IDR of 'BB+' with a Stable Outlook) at 7.4% of rent, IBM (IDR of 'A+' with a Stable Outlook) at 6.7%, TelX Group, Inc. at 4.3%, Equinix Operating Company, Inc. at 3.2% and AT&T (IDR of 'A' on Negative Rating Watch) at 2.2%.

Strong Access to Capital but Limited Secured Debt Market for Data Centers

Since 2006, the company has issued $2.7 billion of common equity, $1.6 billion of preferred equity, $2.9 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 August 2013, the company refinanced its global RCF, increasing its total borrowing capacity to $2 billion from $1.8 billion and also refinanced the senior unsecured multi-currency term loan facility, increasing its total borrowing capacity to $1 billion from $750 million.

In September 2014, the company formed a joint venture with an affiliate of Griffin Capital Essential Asset REIT, Inc. (GCEAR). This is 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.

Adequate Liquidity

Liquidity coverage (defined as liquidity sources divided by uses) is adequate at 1.4x for the period from Oct. 1, 2014 to Dec. 31, 2016. Sources of liquidity include unrestricted cash, availability under the company's unsecured RCF, 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) payout ratio was 86.8% in 3Q'14, compared with 83.9% in 2013 and 83.7% in 2012, all of which are indicative of the company's ability to generate and retain moderate organic liquidity. Based on the current AFFO payout ratio, the company retains approximately $70 million annually.

Deep Management Bench

In November 2014, the company announced that A. William Stein was appointed Chief Executive Officer and to the board of directors. Mr. Stein has been serving as interim CEO since March 2014 and is currently the company's Chief Financial Officer. Mr. Stein joined the company's predecessor private equity fund in April 2004 and, having overseen the company's growth and achievement of investment-grade credit ratings, is well-positioned to serve in this role, in Fitch's view.

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).

Expected Increase in Leverage

Leverage is low for the 'BBB' rating, with debt net of readily available cash as of Sept. 30, 2014 to recurring operating EBITDA for the TTM of 5.1x, compared with 5.6x as of Dec. 31, 2013 and 5.5x as of Dec. 31, 2012. In April 2014, the company's exchangeable debentures were exchanged into common equity, which constituted one element of the leverage reduction.

Fitch's base case anticipates that the company will fund upcoming debt maturities and development with debt, and to a lesser extent, proceeds from asset sales, which should result in leverage rising back towards approximately 5.5x over the next 12-to-24 months, which would remain appropriate for a 'BBB' rating. In a stress case not anticipated by Fitch in which the company experiences low single-digit same-store NOI declines, leverage reaches 6x, which would be weak, albeit adequate, for a 'BBB' rating.

Separately, in October 2013, the company's board of directors authorized a $500 million share repurchase program, although it has yet to be utilized. Fitch does not expect Digital Realty to use this program actively; should it do so, it would weaken the position of unsecured bondholders and could result in negative rating actions, depending on the magnitude of the buyback.

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 1.9x as of Sept. 30, 2014, which is low for a 'BBB' rating.

Exchangeable Senior Debentures Rating Withdrawal

Fitch has withdrawn the 'BBB' rating for the Digital Realty Trust, L.P.'s exchangeable senior debentures. In April 2014, these debentures were exchanged into common equity and these ratings are no longer relevant to the agency's coverage.

Preferred Stock Notching

The two-notch differential between Digital Realty Trust, Inc.'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.

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 is 2.9x);

--Fitch's expectation of leverage sustaining below 4.5x (TTM leverage is 5.1x).

The following factors may result in negative momentum in the rating and/or Outlook:

--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.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis' (Nov. 25, 2014);

--'Recovery Ratings and Notching Criteria for Equity REITs' (Nov. 18, 2014);

--'Corporate Rating Methodology' (May 28, 2014);

--'Rating U.S. Equity REITs and REOCs: Sector Credit Factors' (Feb. 26, 2014).

Applicable Criteria and Related Research:

Rating U.S. Equity REITs and REOCs (Sector Credit Factors)

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=737957

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393

Recovery Ratings and Notching Criteria for Equity REITs

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=813628

Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=821568

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=951435

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.