Federal Realty Investment Trust: Good Upside For A Conservative REIT (NYSE:FRT)


Non-American investors often ask me if I still invest in what they know as American real estate investments – REITs. The type of company doesn’t exist in Scandinavia – at least not in a legal sense (even if we have real estate companies). They, like anyone else, can see that REITs have taken an extreme dive, and almost as a whole, really haven’t recovered to pre-pandemic levels despite many domestic real estate companies now trading up significantly again.

To this, my answer is that I invest in the best of the breed to enjoy an excellent yield not typically found in domestic real estate, coupled with safety that can be found in domestic real estate. Their question then often becomes, what are the companies I look at.

My first answer then often is Federal Realty Investment Trust (FRT). In this article, I’ll show you why.

Federal Realty Investment Trust – What does the Company do?

For those unlikely few domestic NA investors who don’t know FRT (and the many European ones who actually likely don’t), it is a Real Estate Investment Trust (“REIT”) focusing on capital allocation into real estate. It owns, manages, develops and re-develops urban mixed-use properties and shopping centers, both indoor and open air.

FRT holds 104 properties, all of them focused on major metropolitan markets on both the east and west coast as well as Chicago and Miami. The REIT is a component of the S&P 500, and its properties hold 2900 different tenants renting 24 million square feet of space in 2800 different residential units across the United States of America. FRT is, as such, a domestic and truly non-international real estate company with a focus on attractive areas in its home markets.

Credit-wise, things are truly excellent.

(Source: 2Q20 Presentation)

The company is one of the extremely few REITs which not only has an A-grade credit rating, but it’s also the only REIT in existence to have a “Dividend King” status, meaning it’s been increasing its dividend for more than 50 years.

(Source: 2Q20 Presentation)

This is, of course, not a guarantee that it is an investment immune from trouble, but it does provide a certain amount of downside protection when a company has been active as long as this and has outperformed peers for as long as this in certain respects.

FRT knows its target markets.

(Source: 2Q20 Presentation)

It also develops in close accordance to demand drivers – including solutions such as open-air formats (which are less capital intensive) to more recent solutions catering to an increased e-commerce trend, such as Pick-up store concepts. The company offers tenants a well-capitalized – a quality that, in times such as these and the times we are moving towards, is an incredibly important quality.

The company also isn’t seeing any particular sort of overexposure to any one geography. Silicon Valley west coast locations are the highest in terms of portfolio exposure, coming in at 16% of the “Points of interest” (or POI). Its properties are being used either as retail locations, residential locations, office locations, or hotel locations. Over 75% of FRT’s centers/POIs have a grocery component or anchor, which tends to be a proven sort of successful strategy.

In terms of individual tenant exposure, FRT is far better than most peers, with the largest tenant being at most 2.6% of company ABR and top 25 tenants accounting for only 28% of ABR. In terms of segment exposure, the company’s operations are also impressive.

(Source: 2Q20 Presentation)

While the office category is a bit iffy with the work-from-home trends, few things in real estate are safer than residential incomes (cell towers and billboards, perhaps…). The point is illustrating the company’s impressively diversified income stream, which, in turn, is passed on to us – the shareholders.

Mentioning that, let’s talk COVID-19.

As of 2Q20, all shopping centers have remained open and operating during COVID-19. The pandemic effects have instead been tenant-specific. In terms of actual open tenants, numbers dropped down to 47% – less than half – during May 1, or 1Q20.

However, since then, the company has seen improvements, going up to 54% on June 1st, 2020, and at the time of 2Q20 (July 31st), 92% of its tenants were up and operating – if we exclude office-based tenants.

FRT’s rent collection is also seeing significant improvements.

(Source: 2Q20 Presentation)

The company deferred 10% of 2Q20 billed rents, with 92% of them slated to be repaid on December 31st 2021 or prior. So, while COVID-19 has definitely given FRT some pause in terms of quarterly rent collections, the company reacted quickly and has, as things stand, moved to essentially “fix” things.

We can, of course, see which tenants are the most heavily impacted by COVID-19. The segments and names we’re seeing on this list should come as no surprise.

(Source: 2Q20 Presentation)

Fitness, Experiential, Apparel, Houseware, Restaurants and Health and Beauty are all segments which are crucially linked to people not being under lockdown or afraid to meet up and go outside. The headwinds here will likely persist beyond COVID-19 numbers going down, given that people need to feel comfortable to visit such locations once again.

Färre beväringar ute på krogen - idrottar hellre på brigadområdet ...

(Source: Svenska Yle)

Where I live, in Sweden, such things are no longer observed. The gym I frequent recently did not refill/place out new disinfectant bottles, and the facility is as full as ever. While there is a vocal group of people in Sweden demanding more safety and face masks, people are moving about their daily life. I never stopped eating at restaurants, I never stopped going to the gym – no one I know did, and we’re back to normal as things are now (provided we don’t get a “spike”). I expect similar trends will take longer to materialize over there, but they will eventually come.

Aside from its existing properties, FRT is also busily planning redevelopments and expansions. These planned projects all fall into the categories of 1st ring suburbs in major metro markets – the company’s success formula. These properties – 3 in total for new development – are found in Boston, Washington, D.C, and San Jose, all slated to open to tenants and the public in 2020-2022.

The redevelopment pipeline is also strong, with 9 projects underway over the next 3 years and this commercial space already pre-leased at 66% or above.

(Source: 2Q20 Presentation)

A word or two about finances. The company’s balance sheet, which is A-rated, has a net debt/EBITDAre of 6.5X, with 91% of company debt being at fixed rates with a WAIR (weighted average interest rate) of 3.53% at an average maturity of 9 years. This is not the level of Castellum (OTCPK:CWQXF), my absolute favorite real estate investment, that averages below 1% interest rate, but FRT is an American REIT, and interest rates are higher. For US standards, a WAIR of 3.53% is excellent, and a testament to its fortress-like balance sheet and well-laddered maturities, with no more than $670 million at one time in the next 10 years.

Capital market availability is stellar for FRT, with the recent completion of term loans, notes, no outstanding balance on a $1 billion revolver, $2 billion in company liquidity, $340 million in upcoming maturities until 2021, and a breakeven cash collection after G&A, interest expenses and maintenance and leasing is around 60% – meaning the company is currently managing it.

Management at FRT is stellar, with Morningstar considering the company having “Excellent” management. FRT has not only outperformed other shopping center REITs by a factor of more than 100%, but it’s also outperformed the S&P 500 by 60 bps in terms of annual return since 2003.

That, dear readers, is Federal Realty Investment Trust, and that is how it has been doing. Has the company ever let any sort of financial, health or external crisis influence its operation or its dividend?

(Source: 2Q20 Presentation)

The answer is “No” – and with a recent dividend hike of 1%, it’s clear that COVID-19 will be no different for the time being.

Let’s look at its valuation.

Federal Realty Investment Trust – What is the valuation?

I measure REITs based on operating cash flow, or funds from operations (FFO) as well as FCF/Adjusted funds from operations (AFFO). When viewing the company through this lens, a few tendencies become clear over time.

First, FRT is trading at multi-year lows.

(Source: F.A.S.T. Graphs)

This makes a lot of sense, given that the current crisis is probably worse than the financial crisis for real estate companies specifically. We can also see, however, that the company tends to trade at closer to 20.1X FFO. It’s currently below 15X.

Secondly, while FFO might drop during this year (according to estimates), and the same is true for AFFO, there is no indication that FFO will encounter any sort of trouble when it comes to paying out FRT’s recently raised dividend. In fact, even annualizing the raised dividend to $4.24/share, the payout ratio for the expected FFO turns to just north of 80%, giving the company considerable leeway in terms of payout. This is also slated to go down below 75% once again once earnings and collections trend upward again.

So, while many REITs were forced to carve out slices from their dividend in order to preserve capital, FRT has not been one such company – it has raised its dividend.

That’s not to say that FRT is without its valuation-related challenges, however. Take a look at the chart below.

(Source: F.A.S.T. Graphs)

Awesome upside, right? Nearly 25% per year – that’s some class-A returns right there, especially from a Dividend King. Well, not really.

The estimate is based on a return to normal valuation in terms of FFO/AFFO. Previously, this was based on yearly FFO growth. That growth is expected to be no more than 1% on average over the next 3 years. Because of this, using the historical premium in P/FFO is, as I see it, disingenuous.

If we estimate how much a company which provides a 1% growth rate “should” grow, we come to a fair value of around 10X-11X P/FFO, in which case, the picture quickly takes on a very different tone.

(Source: F.A.S.T. Graphs)

With these estimates, we’re essentially looking at two extremes. I don’t believe either is fair or likely in the long term. I don’t see a company that only has essentially flat growth to justify a 20X FFO multiple – but I don’t see a Dividend King with 53 notches worth of dividend growth through thick and thin with the most premium locations on earth worth 10X FFO either.

We need to regulate our expectations in accordance with what the market may actually present us with. I don’t see FRT dropping down to $50-60/share in the long term as things recover, but given the trends in real estate, I don’t see a near-term reversion to the sort of premium FRT has typically traded at before. In fact, a reversion to such a premium may never happen, given what things the shopping/retail industry is going through.

Given the company’s history and record of outperformance, I see FRT being worth around 13X-15X P/FFO even with a low growth rate. I think it too optimistic to expect a higher one and too pessimistic to expect the company to drop much further.

This, at the very least, gives us around a 9-12% rate of annual return, at an estimated valuation of P/FFO of 14X-15X, and the current FactSet, S&P, and Infront earnings expectations (Source: FactSet, Infront, S&P). I also tend to view this as a quite conservative estimate given the company we’re looking at.

This gets us to an estimated fair value for a share of FRT at around $95-100/share, which lines up with the S&P analyst average, coming in at a low of $78/share and a max/high of $120/share. That sort of degree of conservativism is where I “want” to be given that we’re looking at real estate – and shopping, in addition to that.

This estimate is not based upon FRT performing any sort of miracles in terms of occupancy or profits – any such performance will then be a bonus. This is based upon FRT meeting its arguably minimal obligations as a Dividend King and a historically excellent company. And it still gives us an upside of over 25%.

Let’s look at how bears and bulls tend to view the stock.

Federal Realty Investment Trust – Bulls and Bears

The bull focus for FRT is upon the company’s strong, aforementioned fundamentals in the face of the short-term sector-specific issues. The focus is also on the incredibly pressured valuation, which at this time is at recession levels and well below its historical premium. Bulls also tend to point to the company’s current yield level, which is nearly 200 bps above the historical average, as another metric for investment. This is especially true with the recently raised dividend.

Frankly, the bull thesis for FRT nearly writes itself. It has virtually everything anyone should be looking for in a company.

A fortress-grade balance sheet with A-grade credit? Check.

Dividend history of over 50 years, making it a Dividend King? Yes, please.

Class-leading management, considered excellent both by peers and the industry? Gracias.

Sector-leading locations in only the most premier and sought-after districts? Danke sehr.

Record-level valuation, essentially a screaming buy? FRT has it.

The challenge here, and one I want to address, is moderating this bullishness with a dose of realistic expectations. While it’s entirely possible that FRT will once again trade at a sort of historical premium we’ve seen, any such expectation should be viewed as a bonus, not a reason for investing. In order to handle this conservatively, I argue that it may be that real estate kings like FRT will never trade at such premium multiples again, given the weak pricing and bargaining power we’re likely to see over the next few years as the retail landscape is remodeled. I wouldn’t want to go into FRT expecting 20%+ returns. I also haven’t gone into FRT prior to COVID-19, meaning my FRT position is actually at a considerable amount of capital appreciation at this time. I never invested in the “quality REITs” – at least not FRT – prior to this drop, expecting I could eventually load up much cheaper.

Well, my bullish thesis is based on loading up this cheaply, and it’s based on the company not actually returning to the sort of massive premiums other investors may hold as a cost basis. This makes it, in my opinion, a very downside-protected bullish view, and one that is very risk-conscious. Even with this, however, the bullish thesis for FRT is incredibly convincing.

The bearish focus – and this is a hard one, I admit – is based upon continued deterioration of certain key segments in the company’s tenants. At a conservative estimate, the portion of tenants experiencing trouble make for around 10-11% of total rent, which suffers due to low access to capital and very limited cash reserves. With many of these tenants forced to shut down, similar to what’s happening to Tanger Factory Outlet Centers (SKT), this creates vacancies. These vacancies will be fought over tooth and nail by the nation’s REITs and real estate companies, creating very much a buyer’s market.

Additionally, bears have access to the very real argument that even during the last financial recession, company same-center rent actually saw increases. Not so the case today – not even close. A decline of 10-20% can be expected on an annual basis, and even if FFO covers the dividend, AFFO/Free cash flow may indeed fall short of this.

The bear thesis built by many investors is based on April/May collection rates. That these troubles would persist is a situation that’s already been “debunked,” as it were. Rent collection is up already, and payments of rents are expected to be good, with a well-below-90% FFO payout ratio.

However, bears do point to a combination of high CapEx and a downturn which, frankly, could not have come at a worse time – as the company is already battling with E-commerce players.

The company has already affirmed and performed the announced dividend raise in the 1Q20 earnings call. As such, I hold that the worst of the potential bear case no longer stands on any sort of solid ground or has much validity.

What we still do have, however, is a situation where FRT could see many vacancies, closures and bankruptcies, and issues forcing it to stand on the street (so to speak) and try to attract the attention of potential tenants – while most other REITs in the same sector are doing the same. The result would be further muted FFO growth, a higher-trending payout ratio if the company wants to keep raising the dividend, and overall a much longer recovery period than expected. The share price could drop, and this valuation could become a sort of “new normal” for FRT.

That, as I see it, is a somewhat realistic bearish thesis for the company, but not one I see as all that likely in the longer term.

Thesis

During the worst of 2020, Simply Safe Dividends and other services were quick to downgrade FRT in terms of its dividend safety. Unlike Realty Income Corporation (O), FRT isn’t even considered “Safe” at this time, but “Borderline Safe” due to the abysmal collection rates in 1H20. While I don’t necessarily agree with this, especially given the recent dividend increase, it does dictate FRT as a class 3 stock in terms of how I measure things; but then again, almost all shopping REITs have experienced the same. Even O is now a class 2 stock.

In my investments, I now only view the very best of breed as investable when it comes to shopping/retail exposure. FRT is inarguably, as I see it, one of the foremost among these. Another example is Realty Income. Beyond these, I invest in very few pure shopping plays anymore, and anyone who asks me what I think gets a similar answer. I recently wrote an article on one of my holdings, Tanger Factory Outlet Centers, where despite its massive undervaluation, I argue against investing in the company and focus on companies like this instead.

The very first priority for me isn’t a high dividend – it’s the safety of the invested capital, and the best possible potential for capital appreciation and a respectable dividend while staying conservative and diversified. It’s my view that FRT has a place in a portfolio focused upon this – along with other similar companies, both in the shopping sector and other REIT sub-segments.

As I said in the valuation portion, I view FRT as being around 25% undervalued to what I consider to be a conservative upside estimate, and it is therefore a “Buy.” I recently bought more, and I intend to buy even more, extending my 0.6% position toward a target of 1.5% of my entire portfolio.

Thank you for reading.

Stance

Federal Realty Investment Trust is one of few shopping REITs I consider buyable at this time, with a 25% undervaluation. FRT is a “Buy.”

Disclosure: I am/we are long FRT, O, CWQXF, SKT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment.

I own the European/Scandinavian tickers (not the ADRs) of all European/Scandinavian companies listed in my articles.

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