Fitch Ratings has revised Howard Hughes Corporation's (HHC) Rating Outlook to Stable from Negative, and has affirmed the company's Long-Term Issuer Default Rating (IDR) at 'BB' and its unsecured bonds at 'BB'/'RR4.

Fitch also affirmed the 'BBB-'/'RR1' rating of the company's senior secured debt.

The Outook revision to Stable reflects Fitch's expectation that HHC's leverage will decrease to around the low-8x level in 2022, driven by operating asset NOI stabilization, increased condo sales and execution of dispositions. Nothwithstanding unevenness in the condo and MPC land sales segments, Fitch expects leverage to return to levels consistent with the 'BB' rating.

The rating reflects HHC's strong portfolio asset quality within its core markets in and around strategic master planned communities (MPC), in select Sunbelt markets and other mid-Atlantic and Hawaii assets. The ratings also consider the company's strategic land portfolio, development capability and track record, with the expectation HHC will add to recurring NOI from contractual rents through its operating assets portfolio.

Key Rating Drivers

Key Assets in Attractive Markets: HHC owns strategic asset positions in select Sunbelt and mid-Atlantic markets, which benefit from migration and job growth but also face lower physical and zoning barriers to entry. Through its operating asset, MPCs, and strategic development segments, the company is able to plan and grow its communities over multi-year periods while increasing its base of recurring income.

The company's MPCs total approximately 118,000 gross acres of land with 25,000 residential acres of land remaining to be developed and 13,000 acres designated for commercial development or non-compete users. Despite a rising mortgage rate and inflationary environment, HHC's markets continue to experience elevated housing demand, leading to homebuilders' ongoing purchase of additional lots in the company's MPCs at appreciating prices.

Land and Condo Development Volatility: Fitch views HHC's rental income risk profile as below average relative to its equity REIT peers, generally consistent with high speculative grade category. The company generated approximately 31% of 2021 revenues contractual rents from its operating portfolio properties, which include predominantly office, multifamily, retail properties located in and adjacent to its master planned communities. This figure was down from 53% of revenues in 2020 as the company's other segments, notably MPCs and Strategic Developments performed relatively stronger in 2021.

The company's development-for-sale segments provide incremental cash flow but possess increased volatility. Fitch anticipates an increase in earnings for these segments in 2022, with a drop in 2023 and subsequent rebound later into the forecast period. This volatility is due to the timing of the future Ward Village condo development deliveries.

High Income-Based Leverage: HHC's net debt to recurring operating EBITDA leverage is high relative to low-investment-grade-rated equity REIT peers, partly due to the company's development focus and related non-income producing assets. Moreover, the company generates a high percentage of income from non-recurring asset sales within its MPC and strategic developments segments, which Fitch views as more volatile than contractual rental income.

The Operating Asset segment NOI recovered in 2021 and surpassed pre-pandemic levels. Fitch foresees a modest decline in this segment in 2022, partially due to the sale of the company's hotel assets in 2021 in addition to higher expected deliveries of condo projects. As revenues stabilize and development assets are completed, Fitch anticipates leverage declining to the low to mid 7x level over the forecast period.

Fitch also considers HHC's net debt/capital, a supplemental metric commonly used to analyze homebuilders, which was 55.5% for the quarter ended June 30, 2022, and 50.7% for the full year ended Dec. 31, 2021. Fitch expects this metric to sustain around the mid 50% range during the forecast period through 2024.

Prefunded Development Mitigates Risk: HHC prefunds all development with non-recourse secured debt. The company does not begin construction until all necessary cash is on the balance sheet. Fitch views this strategy as mitigating unfunded development pipeline risk. As of June 30, 2022, projects under construction had an estimated total cost of $3.5 billion, with $980 million remaining to be spent, including $638 million of committed debt to be drawn.

As of June 30, 2022, unfunded development cost to complete represented 2.2% of undepreciated assets. Fitch generally views development cost to complete as a percentage of undepreciated assets over 10% as a concern. The company only develops core MPCs, which Fitch views positively.

In May 2021, HHC received approval from NYC Landmarks Preservation Commission for the proposal of redeveloping the 250 Water Street (Seaport District) parking lot to condos, affordable housings, and community/office space. After receiving final approvals in December 2021, the company plans to break ground on the development in 3Q22. Fitch believes this will contribute positively to the Seaport District in the forecast years.

Speculative Grade Capital Access: HHC has demonstrated capital access to the unsecured bond market as the company issued $750 million and $1.3 billion senior unsecured notes in 2020 and 2021, respectively. Nonetheless, the company maintains secured debt at over 50% of total debt as it continues to refinance mortgages, which is more consistent with the capital structure of below-investment-grade real estate companies.

Strategic Management Shift Completed: Upon management's 2019 shift, HHC implemented a transformation plan, which aimed to substantially reduce G&A expenses, dispose of $2 billion gross ($600 million net) in non-core assets, and refine development focus to only core MPCs. Fitch believes the company has substantially completed this plan, given its G&A reduction, $578 million of net asset sales and exit from non-core assets, such as the hospitality segment, 110 North Wacker in Chicago and Riverwalk outlets in New Orleans.

Derivation Summary

Although HHC has not elected REIT status, Fitch views select U.S. equity REITs and, to a lesser extent, U.S. homebuilders as comparable peers, notwithstanding the company's differentiated business model that includes ownership of multiple commercial property types in and around select MPCs, as well as its high exposure to sales income from developed lots and merchant developments. In 2021, The company generated approximately one-third of its revenue from contractual rents from its operating portfolio properties, including office, multifamily, retail and, to a lesser extent, hotels located in and adjacent to its MPCs.

HHC's portfolio is more diversified by property type than higher-rated, Sunbelt-focused multifamily REIT peers Camden Property Trust (A-/Stable) and Mid-America Apartment Communities (A-/Stable); however, the company operates at considerably higher net debt/recurring operating EBITDA leverage with reliance on non-contractual residential land sales. HHC's portfolio is somewhat similar to American Assets Trust (AAT; BBB/Stable) in that it has a diversified portfolio of office, retail and multifamily assets with a U.S. West Coast focus and some additional Hawaii exposure; however, AAT's revenues are 100% derived from owned real estate and Fitch expects the company to operate at around 6x leverage through the forecast horizon.

Fitch considers debt to capitalization as a secondary leverage measure given HHC's high level of non-income-producing land and homebuilding industry exposure. Fitch expects the company will operate with a debt capitalization ratio of approximately 55% over the forecast period, which is considerably above the 35% to 40% range for homebuilding peer Toll Brothers, Inc. (BBB-/Positive).

Key Assumptions

Fitch's Key Assumptions Within the Rating Case for the Issuer

--Operating Asset segment decline of 2% in 2022, followed by SSNOI growth of low-single through the remainder of forecast period;

$300 billion of dispositions in 2022;

Strategic Development Revenues of $675 million in 2022, $0 in 2023 and returning to $600 million in 2024;

Development deliveries of approximately $600 million at around 8% yields through the forecast period.

RATING SENSITIVITIES

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

REIT leverage (net debt to recurring operating EBITDA) sustaining below 7x, assuming a similar or modestly greater percentage of NOI from contractual rents;

REIT fixed-charge coverage sustaining above 2.5x;

Growth in HHC's operating assets resulting in NOI from recurring contractual rental income comprising 70% of net operating income;

Growth in unencumbered assets and/or UA/UD coverage improving to 1.75x, or greater.

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

Fitch expectations of net leverage (net debt to recurring operating EBITDA) sustaining above 9x and/or a net debt to capital ratio sustaining above 55%;

Expectations of REIT fixed charge coverage sustaining below 1.5x;

Expectations of deteriorating access to capital markets.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Adequate Liquidity: Fitch estimates HHC's base case liquidity coverage at 1.1x through YE 2023 and improves to 1.4x, assuming 80% secured refinancing. The company's sources include approximately $350 million in estimated retained cash flow, $85 million availability on its secured credit facility and approximately $573 million of cash on hand. As of June 30, 2022, projects under construction had an estimated total cost of $3.5 billion, with $980 million remaining to be spent, including $638 million of committed debt to be drawn on existing development projects.

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 flows from operating activities after dividends. Uses include pro rata debt maturities, expected recurring capex and forecast (re)development costs.

Issuer Profile

The Howard Hughes Corporation (NYSE: HHC) owns, manages and develops commercial, residential and mixed-use real estate throughout the U.S. Key holdings include its portfolio of master planned communities, as well as operating properties and development opportunities.

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

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This 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. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

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