Fitch Ratings has placed the 'BBB' Long-Term Issuer Default Rating (IDR) and 'BB+' preferred rating of Spirit Realty Capital, Inc. and 'BBB' senior unsecured ratings and IDR of Spirit Realty L.P. on Rating Watch Positive.

Spirit Realty's agreement to be acquired by Realty Income will result in an enterprise value of approximately $63 billion for the combined company, enhancing Realty Income's size, scale and diversification to expand its runway for future growth.

The Rating Watch Positive is driven by Realty Income's size, scale and low leverage. The transaction is not subject to a financing condition and is expected to close in 1Q24, subject to customary closing conditions and approval by Spirit Realty's shareholders.

Key Rating Drivers

The following Key Rating Drivers were published pursuant to Fitch's most recent annual rating review on Jan. 23, 2023:

Strong Asset Quality: SRC's operational performance returned to pre-COVID levels with occupancy and collections at 99.8% as of June 30, 2023, compared to occupancy and collections of 99.7% as of Dec. 31, 2019. Occupancy remained above 99% through the pandemic highlighting the company's strong asset quality. Despite the company's exposure to discretionary and service retail, operations have been durable. The company's weighted average lease term is 10.3 years as of June 30, 2023.

Well Balanced Portfolio Diversification: As of June 30, 2023, SRC's top ten tenants represented 22% of ABR, which is appropriate for the 'BBB' category. The largest tenant exposures are Lifetime Fitness (4.2% of ABR) and Invited Clubs (2.8%). Fitch views SRC's portfolio as well-diversified by individual tenant, reflecting its successful portfolio refinement efforts following the SMTA spinoff. SRC's tenant diversification, contractual rent increases, and long-dated lease maturities improve the durability and predictability of operating cash flows and provide a cushion for the issuer to maintain its metrics in the event of tenant credit issues.

Fitch also views favorably the growing percentage of industrial and manufacturing assets (25.7% of ABR; up from 14.9% as of Dec. 31, 2020), and related decrease to retail sector (65.8%; down from 77.9% as of Dec. 31, 2020). Retail includes only 11.4% classified as non-discretionary retail, but the service retail and discretionary retail segments include categories such as pet supplies, home furnishings, pharmacies, quick service restaurants, and others that have performed relatively well through the pandemic.

Investment-Grade Credit Metrics: Fitch expects SRC's REIT leverage (net debt before preferred stock to operating EBITDA) to sustain in the low-to-mid-5x range consistent with the company's financial policy of below 5.5x as well as with historical leverage levels. Management has demonstrated a commitment to preserving the balance sheet as it resumed external growth activity, and issued $595 million in common stock in 2022 to partly fund $1.4 billion in acquisitions. Historically, the company has had good access to both bank debt and public bond markets in addition to equity: SRC issued $300 million in unsecured term loans in the first 6 months of 2023, $800 million in unsecured term loans in 2022, and $1.25 billion in unsecured notes over 2020-2021.

Largely Unencumbered Pool: SRC properties are generally unencumbered, with only two encumbered properties as of June 30, 2023; down from 88 properties as of Dec. 31, 2020. Fitch estimates the ratio of unencumbered assets to unsecured net debt at 2.0x, assuming a 10% stressed cap rate, a level which is appropriate for the rating and serves as an additional source of contingent liquidity.

Solid Execution of Acquisition Strategy: Fitch views SRC's portfolio transition favorably as over the last few years exposure to the industrial sector (25.7% as of June 30, 2023, compared to 4.4% as of YE 2018) has meaningfully increased. The portfolio has undergone a major transformation since YE 2017, including the gross acquisition of over $5 billion of assets through 2Q23 to support a stronger asset quality and tenant base. During the first six months of 2023, the company acquired $407.5 million in assets, comprised of 65% industrial and 14% retail with most of the remaining spending being revenue producing expenditures. Fitch expects the industrial/manufacturing exposure to continue to increase over time with additional acquisitions.

Derivation Summary

SRC's portfolio metrics, including weighted average lease term, occupancy, leverage is consistent with peers in the 'BBB' category.

Fitch rates the IDRs of the parent REIT and subsidiary operating partnership on a consolidated basis, using the weak parent/strong subsidiary approach and open access and control factors, based on the entities operating as a single enterprise with strong legal and operational ties. Fitch applies 50% equity credit to the company's perpetual preferred securities given the cumulative nature of coupon deferral. The instruments are subordinated to debt, lack material covenants and the terms of the change of control do not negate the equity credit judgement. Certain metrics calculate leverage including preferred stock.

Key Assumptions

The aforementioned acquisition is completed in 1Q24.

If the acquisition is not completed, the following key assumptions would apply to SRC as a standalone business:

Mid-single digits SSNOI throughout the ratings forecast, bolstered by 2% rent escalators and consistent high occupancy;

$1.5 billion of acquisitions and $250 million of divestitures in 2022, consistent with 3Q guidance;

Acquisitions made at a 7% cap rate in 2023 consistent with management expectations;

Dispositions made at a low to mid-5% cap rate consistent with historical disposition rates;

SRC manages its acquisitions, debt issuance, and equity issuance to keep REIT leverage within the 5x-6x range;

REIT FCC remains above 4.0x through the ratings forecast;

UA/UD remains above 2.0x through the ratings forecast.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Fitch expects the Rating Watch will be resolved with a positive rating action if the transaction is consummated as proposed. As part of the resolution, Fitch will endeavor to understand the combined entity's pro forma capital structure, financial policy, and structure, including but not limited to the relationship of subsidiaries to the parent.

If the acquisition is not completed, the following rating sensitivities would apply to SRC as a standalone business:

Fitch's expectation of leverage (as measured by net debt before preferred stock/EBITDA) sustaining below 5.0x;

Stable operating performance and track record, including maintaining occupancy levels and consistent tenant performance;

Fitch's expectation of FCC sustaining above 3.5x.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Fitch's expectation of leverage sustaining above 6.0x;

Sustained deterioration in operating fundamentals or asset quality;

Fitch's expectation of FCC sustaining below 3.0x;

UA/UD sustaining below 2.0x and/or deterioration in the quality, value and/or ability to finance the unencumbered pool.

Liquidity and Debt Structure

As of June 30, 2023, available liquidity was comprised of $174.6 million in cash and cash equivalents and the full $1.2 billion of borrowing capacity under the company's revolving credit facility and $200 million of availability under the delayed-draw 2023 term loans. The company has very few short- to medium-term debt maturities; the nearest material maturities are $800 million of total term loans due in 2025 ($600 million is currently outstanding).

Fitch defines liquidity coverage as sources of liquidity divided by uses of liquidity. Sources include unrestricted cash, availability under unsecured revolving credit facilities, and retained cash flow from operating activities after dividends. Uses include pro rata debt maturities, expected recurring capex, and forecast (re)development costs.

Issuer Profile

Spirit Realty Capital, Inc. is a net-lease REIT that primarily invests in single-tenant real estate assets, subject to long-term leases. As of June 30, 2023, Spirit's portfolio consisted of 2,064 retail, industrial and other properties.

Summary of Financial Adjustments

No material non-standard financial adjustments. Stock based compensation was considered a reduction to SG&A and an addback to EBITDA.

Sources of Information

The principal sources of information used in the analysis are described in the Applicable Criteria.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores.

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