Fitch Assigns Initial Ratings to Hudson Pacific Properties, Inc.

NEW YORK--(BUSINESS WIRE)-- Fitch Ratings has assigned an initial Issuer Default Rating (IDR) of 'BBB-' to Hudson Pacific Properties, Inc. and its operating partnership Hudson Pacific Properties, L.P. (Hudson, HPP or the company). A full list of Fitch's ratings for Hudson can be found at the end of this release.

The Rating Outlook is Stable.

KEY RATING DRIVERS

Fitch's ratings for Hudson reflect the company's strong competitive market position in select densely populated and supply constrained office markets in Northern and Southern California and The Pacific Northwest. These markets have favorable demographics that include population growth, vibrant, highly-educated work forces and above average household income levels. The company's sizable unencumbered asset pool and appropriate leverage and fixed-charge coverage (FCC) metrics for the rating are additional credit strengths.

Tenant industry concentration risk is Fitch's principal credit concern that balances Hudson's ratings. Hudson strategically targets office properties that appeal to the fast growing technology and media sectors, which could exhibit more volatility than other industry types. In addition, Fitch views HPP's value-added acquisition growth strategy as riskier than purchasing stabilized 'core' properties, notwithstanding the potential for greater returns and the company's successful track record. Lastly, Hudson's access to unsecured debt capital is less developed than many of its investment grade REIT peers, primarily consisting of its unsecured credit facility.

Portfolio Acquisition Enhances Position

Fitch views Hudson's purchase of the EOP Northern California portfolio from Blackstone (the EOP portfolio) favorably. The combination more than doubled the company's size and strengthens HPP's existing presence in attractive, supply-constrained, west coast markets by making it the dominant office owner (25% market share) in select San Francisco Peninsula/Silicon Valley office submarkets. The total consideration paid for the EOP Northern California Portfolio before certain credits, proration, and closing costs included a cash payment of $1.75 billion and an aggregate of 63,474,791 shares of common stock of the company and common units in Hudson Pacific Properties, L.P.

HPP's strategic rationale for the acquisition centers on the irreplaceable nature of the assets (given regulatory supply constraints in California) and the upside to net operating income (NOI) from stabilizing occupancy and marking expiring leases to market, presumably through better asset management than under Blackstone's ownership. HPP has successfully repositioned several non-stabilized office assets it acquired during its short public tenure.

Leverage to Moderate

Fitch expects HPP's leverage to increase to the mid-8.0x range in 2015 (with only three quarters of income from the EOP portfolio and all of the debt) before improving to the low 6.0x range by 2017. Incremental NOI from signed, but uncommenced, leases and the lease-up and stabilization of select redevelopments within the company's portfolio are the principal factors that Fitch expects will drive HPP's leverage lower.

Fitch defines leverage as consolidated debt (net of Fitch-estimated readily available cash) to recurring operating EBITDA. Recurring operating EBITDA includes recurring cash distributions from unconsolidated joint ventures and straight line rents, but excludes non-cash above and below market lease income.

HPP's debt to market capitalization pro forma for the EOP portfolio transaction is approximately 35%, which compares favorably to the approximate 50% average for the Office REIT sector. Although net debt to recurring operating EBITDA is Fitch's preferred leverage metric for REITs, the sizable amount of non-stabilized properties in HPP's portfolio make debt to market capitalization a relevant secondary leverage metric.

Fitch expects HPP's FCC to improve to the mid-3.0x range by 2017, aided by mid-single digit cash same store net operating income (NOI) growth (excluding incremental NOI from non-stabilized properties included in HPP's same-store pool), incremental NOI from new developments and the refinancing of its preferred stock when it becomes callable in 4Q15. Fixed charge coverage could fall to the high 1.0x range in 2015 due to non-routine capex associated with stabilizing the company's portfolio. HPP's fixed charge coverage was 2.0x during 2014.

Fitch defines FCC as recurring operating EBITDA less non-cash revenues and recurring maintenance and leasing capital spending, divided by cash interest expense and preferred dividends.

Good Contingent Liquidity

The EOP portfolio acquisition provided Hudson with a high-quality pool of unencumbered assets with above average financibility and salability characteristics. Unencumbered NOI should represent approximately 70% - 75% of HPP's total pro-forma NOI that includes the EOP portfolio. Fitch estimates the company's unencumbered assets cover its net unsecured debt by 2.0x based on a direct capitalization approach of unencumbered NOI using a stressed 7.75% capitalization rate. Fitch views this level of coverage as adequate for the rating.

Adequate Liquidity

HPP maintains an adequate liquidity position. The company's sources cover its uses by 1.4x, based on Fitch's pro forma liquidity analysis for the April 1, 2015 to Dec. 31, 2016 period. HPP's liquidity coverage would improve to 1.6x assuming the company refinances maturing mortgages at 80% of current balances.

HPP has only $121.2 million of mortgage maturities and amortization remaining through 2016 and no unsecured debt maturities. Committed, unfunded (re)development expenditures and recurring and non-routine leasing and maintenance capex, primarily related to the stabilization of the EOP portfolio comprise the largest uses of capital through 2016 at roughly $450 million as estimated by Fitch.

Tenant Industry Concentration Risk

The company has a high proportion of technology and media related tenants in its portfolio, owing to its emphasis on select West Coast office markets. Tenants in these segments will comprise approximately 39% and 10% of annualized base rent, respectively, pro forma for EOP. Fitch views the company's outsized exposure to tech and new media tenants as a near-to-medium term positive given the outsized growth (roughly double the national average) in tech-related employment during this recovery.

However, the company's tenant industry concentration is a moderate negative to Fitch's ratings, which are designed to look 'through the cycle' and, therefore, incorporate the near certainty of a future tech downturn. Fitch recognizes that many of today's leading tech companies provide less capital intensive services and solutions to a diverse industry set. This could reduce the correlation of their business performance and cause future tech down cycles to be less volatile than in the past. However, access to (venture) capital remains an inherent tech-sector risk, in Fitch's view, notwithstanding the greater diversity of end industries served.

Value Add Strategy Risk

HPP's external growth strategy principally centers on the acquisition and stabilization of office assets, primarily through some combination of lease-up and property redevelopment. Fitch views the relative risk/reward of value add acquisitions as being in between 'core' investments and ground-up development.

HPP had two properties under construction at March 31, 2015 with an estimated total investment of $382 million, representing 6.5% of undepreciated gross assets. The unfunded component was $187.3 million, representing 3.2% of gross assets. The company's Element LA redevelopment is 100% leased to tech tenant Riot Games, reducing the risk of this project. Moreover, HPP had $202.6 million of committed construction financing in-place at March 31, 2015 available to fund its remaining (re)development spending commitments.

Weak Dividend Coverage

Fitch expects HPP to target a common dividend payout ratio of approximately 90% of adjusted funds from operations (AFFO) over the rating horizon. However, HPP has historically paid a common dividend in excess of the company's AFFO, primarily due to the non-stabilized nature of many of its assets and the related high level of capex associated with repositioning and releasing them. HPP's payout ratio was 182% for the TTM ended March 31, 2015 and 153.1% and 1,387% during 2014 and 2013, respectively.

Less Seasoned Unsecured Borrower

HPP has a short track record as a public company, having gone public in June 2010. This track record is balanced by the extensive office real estate and public REIT management experience of HPP's executive team. To date, the company has demonstrated limited access to long-term unsecured debt capital through its unsecured credit facility, which includes a $400 million revolving line of credit, $550 million, five-year unsecured term loan, $350 million, seven-year unsecured term loan and a $550 million, two-year unsecured term loan used to facilitate an expedited closing of the EOP transaction. Fitch expects the company to refinance the latter with longer-term unsecured borrowings, possibly through an inaugural public unsecured bond offering during 2015. Fitch views HPP's limited track record for sourcing long-term unsecured debt capital as a moderate credit negative given the enhanced financial flexibility that this capital source affords corporate borrowers.

Preferred Stock Notching

The two-notch differential between HPP's IDR and its preferred stock rating is consistent with Fitch's criteria for corporate entities with an IDR of 'BBB-'. Based on Fitch's research on 'Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis,' 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 Rating Outlook

The Stable Outlook reflects Fitch's expectations that leverage and fixed charge coverage will improve over the next 12 - 24 months, but remain appropriate for the rating.

KEY RATING ASSUMPTIONS

--Strong technology sector employment growth and limited new supply support continued strong office fundamentals in Hudson's west coast office markets;

--HPP successfully integrates the EOP portfolio acquisition properties with its existing portfolio;

--The company further develops its access to unsecured debt capital, which could include an inaugural public bond offering to refinance shorter-term borrowings used to close the EOP portfolio transaction;

--The company continues to unencumber assets as mortgages mature;

--Positive office fundamentals and the stabilization of value-added acquisitions help the company reduce leverage from upwards of 8.0x in 2015 to the low 6.0x range in 2017.

RATING SENSITIVITIES

The following factors could collectively or individually result in an upgrade to HPP's ratings and/or Outlook:

--Successful operational and financial integration of the EOP portfolio acquisition;

--Fitch's expectation of leverage sustaining below 6.5x for several quarters;

--Fitch's expectation of fixed-charge coverage sustaining above 3.0x for several consecutive quarters;

Conversely, the following factors may result in negative momentum in the ratings and/or Outlook:

--Fitch's expectation of net debt to recurring operating EBITDA sustaining above 7.5x;

--Fitch's expectation of fixed-charge coverage sustaining below 2.0x;

--Fitch's expectation for dividends as a percent of AFFO to sustain above 100%;

Fitch assigns the following ratings:

Hudson Pacific Properties, Inc.

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

--Preferred Stock 'BB'.

Hudson Pacific Properties, L.P.

--IDR 'BBB-';

--$400 million unsecured revolving credit facility 'BBB-';

--$550 million unsecured term loan 'BBB-';

--$350 million unsecured term loan 'BBB-';

--$550 million unsecured term loan 'BBB-'.

Fitch assigns the following expected ratings:

Hudson Pacific Properties, L.P.

--Senior unsecured bonds at 'BBB-'(exp).

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);

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

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

Applicable Criteria and Related Research:

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

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

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

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

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

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=984431

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Fitch Ratings
Primary Analyst
Stephen Boyd, CFA, +1-212-908-9153
Director
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Steven Marks, +1-212-908-9161
Managing Director
or
Committee Chairperson
Michael Paladino, CFA, +1-212-908-9113
Managing Director
or
Media Relations
Francoise Alos, Paris, +33 1 44 29 91 22
[email protected]
Sandro Scenga, New York, +1-212-908-0278
[email protected]

Source: Fitch Ratings

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