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Fitch on Forest City: REIT conversion plan requires disposition of assets to lower leverage

A 1/26/15 press release from Fitch Ratings,  Fitch: Forest City REIT Plans to Stress IDR; Potential Catalyst for Conservatism Longer-Term:
NEW YORK--(BUSINESS WIRE)--Forest City Enterprises, Inc.'s (Forest City) plan to convert to a real estate investment trust (REIT) in 2016 may initially pressure its 'BB-' IDR [Issuer Default Rating], according to Fitch Ratings.
A rating action will be conditional upon Forest City's stated efforts to reduce leverage and development exposure ahead of the conversion. Over the longer term, the conversion may be a catalyst for positive momentum on the ratings should Forest City adjust its capitalization to coincide with its materially less levered REIT peers.
Fitch typically ascribes a one-notch uplift to real estate operating companies (REOCs) such as Forest City relative to comparable REITs given the latter's dividend requirements. REITs are required to pay at least 90% of taxable income as dividends to shareholders, limiting the extent to which REITs can retain capital and self-fund. Thus, REITs need consistent access to the capital markets to fund net investment activity and refinance debt obligations.
In the conversion announcement, Forest City stated that it plans to sell non-core assets in excess of historical averages to reduce leverage and will provide additional guidance to the market by mid-2015. In 2012 and 2013, Forest City's dispositions totaled $2.15 billion combined, or $1.08 billion per year. Over the trailing 10 years (2004-2013), dispositions averaged $500 million per year. Dispositions of this magnitude can materially change Forest City's capitalization and liquidity profile; thus it is premature to assess what, if any, impact the conversion will have until the post-conversion capitalization is known.
Forest City could maintain its 'BB-' IDR should it reduce leverage below 10x on a sustained basis through-the-cycle, although the conversion would likely result in a downgrade absent any further delevering. The company's leverage was 9.9x as-reported and 11.1x pro-rata at Sept. 30, 2014. Fitch had previously stipulated sustaining leverage below 10x could result in positive momentum on the ratings, and thus the leverage reduction would largely offset the loss of the one-notch REOC uplift.
Fitch will also consider whether Forest City's conversion will further influence its behavior. Should Forest City cater to the preferences of dedicated REIT shareholders, Fitch would expect Forest City's structure and the scale and scope of its developments will also be focal points.
Additional positive consequences of the conversion may include a higher valuation (assuming lower leverage, more stabilized revenues and lower risk profile results in a higher multiple) and access to a dedicated REIT investor base. Combined, these factors may increase Forest City's willingness to issue equity more than it has in past years (e.g. via senior unsecured convertible notes).
Fitch currently rates Forest City as follows:
--IDR 'BB-';
--Bank revolving credit facility 'BB-';
--Convertible senior unsecured notes 'BB-'.
The Rating Outlook is Stable.
(Emphases added)

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