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

Fitch Ratings has affirmed the ratings for Digital Realty Trust (NYSE: DLR), including the Long-Term Issuer Default Rating (IDR) at 'BBB'. The Rating Outlook is Stable. See the full list of rating actions at the end of this release.

KEY RATING DRIVERS

The rating reflects expected good revenue growth from organic operations, the ramp up of cash flow from Telx assets due to increased leasing activity, as well as the recently announced acquisition of eight of Equinix's European assets. The acquisition of Equinix's assets also provides DLR with a foothold in Western Europe, specifically within Germany, which accomplishes a publicly stated goal of the company while increasing its overall capacity, reach, and interconnectivity. In the short-term, Fitch expects the company's metrics will improve beyond its longer-term historical trends towards the stronger end for the 'BBB' IDR.

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 and also relatively low unencumbered asset coverage for the rating.

Key Metrics Appropriate For Rating; Expected to Improve

Fitch calculates run-rate leverage at 5.3x for the quarter ended March 31, 2016, and at 5.7x for the trailing 12 months (TTM) ended March 31, 2016. Pro forma for the acquisition of Equinix's assets and May 2016 equity offering, TTM leverage would improve to 5.2x assuming the additional $300 million of proceeds from the common equity issuance were utilized to repay debt. Fitch forecasts that leverage will decline and remain near 5x through the next 12-24 months.

Fitch recently revised the treatment of REIT cumulative perpetual preferred stock to 50% equity credit from 100%. DLR's run rate leverage based on net debt including 50% of preferred stock was 5.8x for the quarter ended March 31, 2016, compared with 6.5x and 5.6x in 2015 and 2014, still appropriate for the 'BBB' rating. Fitch forecasts leverage, inclusive of 50% preferred stock, will be in the mid-5x's area through the next 12-24 months.

Fixed charge coverage is strong for the rating at 3.1x for the TTM ended March 31, 2016 versus 3x and 2.8x for full years 2015 and 2014. Pro forma for the Equinix transaction, TTM coverage would improve to 3.3x. Fitch expects DLR's fixed charge coverage will approach the mid-3x range over the next 12-24 months, driven by same-store net operating income (NOI) growth and additional ramp up in revenues from Telx and Equinix's European assets. Fitch defines fixed charge coverage as recurring operating EBITDA less straight-line rents divided by total interest incurred and preferred stock dividends.

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 is down from the low 90%'s, and stood at 90.9% as of March 31, 2016, as a result of consolidating newly acquired Telx properties operating at occupancy levels well below the rest of DLR's portfolio. Quarterly stabilized same store year-over-year cash NOI growth averaged 3.7% in the last 12 months due primarily to strength in the cash releasing spreads on DLR's Power Base Building and colocation assets at 9.0% and 4.6%, respectively, for the TTM ended March 31, 2016.

Comparisons for renewals were challenging for a time due to the roll down of peak rental rates signed prior to the financial crisis; however, the company has recently been effective in leasing up its existing properties and maintaining its tenant base. Over the next several years, Fitch projects 2% to 3% same-store NOI growth, driven primarily by good releasing spreads, developments coming on line and efficient management of the aggregate portfolio inclusive of Telx.

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 in the mid-3x range over the next 12-24 months, which is good for a 'BBB' rating given Digital Realty's niche property focus.

Global Platform

Digital Realty offers Turn-Key Flex, Powered Base Building, colocation and interconnection space via its 140 operating properties, including 109 throughout North America, 24 in Europe, three in Australia and four in Asia. Top markets as of March 31, 2016 were New York (13.1% of consolidated annualized base rent), Dallas (10.7%), Northern Virginia (10.5%), London (10.2%), and Silicon Valley (8.8%).

The company also benefits from a granular tenant roster, which includes IBM ('A+' IDR/Stable Outlook) at 7.7% of annualized base rent, CenturyLink, Inc. ('BB+'/Stable Outlook) at 6.1%, Equinix, Inc. ('BB'/Stable Outlook) at 4.1%, Facebook, Inc. at 2.3% and AT&T ('A-'/Stable Outlook) at 2.2%.

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

Since 2006, the company has issued $4.8 billion of common equity (inclusive of the May 2016 forward sales agreements), $1.9 billion of preferred equity, $3.5 billion of dollar-denominated unsecured bonds, GBP700 million of sterling-denominated unsecured bonds, and EUR600 million of euro-denominated bonds. The company's euro- and sterling-denominated bonds function as a natural hedge given the company's exposure to Western Europe and the United Kingdom.

Additionally, the company holds a $2 billion global revolving credit facility, refinanced in January 2016, which provides for borrowings in Australian dollars, British pounds sterling, Canadian dollars, Euros, Hong Kong dollars, Japanese yen, Singapore dollars, and U.S. dollars with the ability to add additional currencies in the future subject to certain conditions.

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.

Less Contingent Liquidity for Data Centers

Data centers are specialized properties and technological obsolescence over the long term is possible. Data centers are highly improved real estate with per square foot investment values generally exceeding more traditional alternative commercial real estate uses (i.e. office) by a wide (2x-5x) margin. 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. Unencumbered assets (unencumbered NOI divided by a stressed capitalization rate of 10%) covered net unsecured debt by 2.1x as of March 31, 2016, which is low for a 'BBB' rating. This ratio has not changed meaningfully over the last two years.

Deep Management Bench

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 VMware 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). Most of Telx's employees have joined DLR to manage the colocation and interconnection business.

Margins Initially Pressured via Telx and European Acquisitions

Fitch estimates that EBITDA margins will decline 100+bps to 56% from approximately 58% due to lower Telx margins and capital requirements related to the underutilized European assets being acquired from Equinix. Prior to the acquisition of Equinix's assets, Telx's colocation and interconnection business represented approximately 11% of DLR's total EBITDA. Telx owned only two assets, leases seven locations from third-party property owners, and leased 11 properties from DLR prior to the merger. The recently-announced European portfolio transaction will add seven leased assets to the portfolio out of eight locations acquired. As a result, DLR has become a tenant at most of these locations, which increases lease renewal risk and adds a degree of operating risk into the company's business. Fitch's negative rating sensitivities for leverage may decline if the company further increases its exposure to business segments with higher operating risk.

Adequate Liquidity Coverage Ratio

Liquidity coverage (defined as liquidity sources divided by uses) is adequate at 1.7x for the period from April 1, 2016 to Dec. 31, 2017. Sources of liquidity include unrestricted cash less working capital requirements, availability under the company's global unsecured revolving credit facility, 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 77.5% for the TTM ended March 31, 2016, compared with 81.4% in 2015 and 87.6% in 2014, all of which are indicative of the company's ability to generate and retain moderate organic liquidity. Based on the current AFFO pay-out ratio, the company retains approximately $140 million annually.

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 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.

Stable Outlook

The Stable Outlook reflects Fitch's expectation that metrics will remain appropriate for the rating through the forecast period.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:

--Low single-digit same-store growth through the forecast period;

--$910 million acquisition of EQIX's eight European assets, inclusive of estimated transaction fees and expenses, will close in 2016, funded almost entirely via common equity issuance;

--Average of $210 million in common equity issued annually 2016-2018, excluding the issuance related to EQIX acquisition; however, equity issuance is at management's discretion;

--Approximately $170 million in annual maintenance capex;

--Development expenditures of approximately $600 million in the remainder of 2016, and $900 million in each 2017 and 2018;

--About $500 million in development completions annually from 2016-2018 at high single-digit and low double-digit yields;

--Recurring EBITDA margin declines 100bps initially upon acquisition of the European portfolio, then stabilizes near current levels by the end of 2018.

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, demonstrating contingent liquidity for the asset class;

--Fixed charge coverage sustaining above 3x (TTM ended March 31, 2016 coverage was 3.1x, 3.3x pro forma for Equinix transaction);

--Leverage, excluding preferred stock, sustaining below 4.5x (1Q16 run rate leverage was 5.3x and TTM ended March 31, 2016 leverage was 5.7x; 5.2x pro forma for Equinix transaction).

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

--Sustained declines in rental rates and same-property NOI;

--Fixed charge coverage sustaining below 2.5x;

--Leverage, excluding preferred stock, sustaining above 6x;

--Base case liquidity coverage sustaining below 1x (liquidity coverage was 1.7x for the period April 1, 2016-Dec. 31, 2017).

FULL LIST OF RATING ACTIONS

Fitch has affirmed the following ratings:

Digital Realty Trust, Inc.

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

--Preferred stock at 'BB+'.

Digital Realty Trust, L.P.

--IDR at 'BBB';

--Unsecured revolving credit facility at 'BBB';

--Senior unsecured term loan facility at 'BBB';

--Senior unsecured notes at 'BBB'.

Digital Stout Holding, LLC

--Unsecured guaranteed notes at 'BBB'.

Digital Euro Finco, LLC

--Unsecured guaranteed notes at 'BBB'.

The Rating Outlook is Stable.

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.

Additional information is available on www.fitchratings.com.

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362

Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis (pub. 29 Feb 2016)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=878264

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1005239

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1005239

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