Federal Realty Investment Trust: Not Recovered Yet (NYSE:FRT)

I last wrote an article focused on Federal Realty Investment Trust (NYSE:FRT) about a year ago. At the time it seemed likely to be a couple years or more before it would make sense to do that again.

I did put FRT in my Buy, Hold, and Go Fishing portfolio last winter. But they seemed backed into a corner as far as growth goes (as is explained below).

Some indications in recent articles have been they got out of the corner in a hurry. Net Debt/EBITDA has been plunging and payout fraction of Funds From Operations (“FFO”) has improved.

Let’s see how far they have come. You can tell from the title that it is not yet far enough to soon support noticeable dividend growth.

Background on Federal Realty

You can see basic details and copies of a lot of presentation slides in one of their investor presentations and in most of the 13 articles on them published so far this year. All those articles have had ratings of strong buy, buy, or hold.

My frequent readers are used to deeper looks from me. That is the idea once again here.

An updated version of my summary of basic positive attributes is this:

• Moat from locations in first-ring suburbs of major cities
• Highest household income among peers: $151k in a 3-mile radius
• Highest population density among peers: ~180k within a 3-mile radius
• 75% of centers have a grocery component
• 37% of centers are mixed use including residential and/or office
• Diverse portfolio by category and by tenant
• Only 8 tenants pay > 1% of total average base rent
• Active and profitable development and redevelopment
• NAREIT FFO/sh growth of 4.3% from 2005
• Credit ratings of BBB+ or equivalent
• Ample liquidity and otherwise excellent balance-sheet metrics
• Well laddered debt maturities
• Dividend King: A 55-year CAGR of 7% for dividends

For some years, Federal has been emphasizing mixed-use projects. In these, residential and office properties complement their traditional retail. A stellar example is Pike & Rose in North Bethesda.

Recently, Federal has also been highlighting their 3% per year rent bumps. These get them higher total rent and more modest rent increases on rollover compared to other common approaches.

As I said last year, “what this all adds up to is spectacular management performance.”

Investors who look only backward at stock prices or total return will likely avoid FRT now. There is a lot of history as to why prices suffered and why dividend raises slowed, discussed in my article last year.

I like looking backward at financial details, to understand the operations of any company. But for future earnings increases that will ultimately drive price growth, it makes more sense to me to look forward.

And I generally could care less about historic market returns. Forward economic returns are what matters.

Beyond that, the macro environment for retail in general has markedly improved. Dane Bowler has a nice discussion of that here.

With that background, let’s get our hands dirty in the details.

Earnings and Distributions

I compiled cash flows from the 10-K and 10-Q filings and a few other items from TIKR. For 2023 the numbers are TTM from June 30, since seasonal variations make specific forward projections difficult. The FFO for 2023 is from guidance.

Here are two simple earnings measures and distributions. For distributions I included all dividends and net distributions to noncontrolling interests.

We see that FFO/sh has recovered to above its pre-pandemic level. Also, it is not far from per share Cash from Operations, or CfO, as should be true if GAAP is not misleading us. (I did not probe the curious difference between these two in the teens.)

FFO/sh growth has slowed this year, with a current guided midpoint for growth of 3.2%. That is still pretty good for a REIT at the moment, as most of them are suffering impacts of higher interest rates on their floating-rate debt. Here is the debt for Federal:

The increased interest expense on that $600M term loan (gray bar in 2024) will have been comparable to the net increase in FFO/sh, making the EBITDA growth in the ballpark of 6%. Operationally, this will have been a stellar year for them.

This debt profile totals to of 42% of gross real estate. There are no concerns about their ability to handle this debt and eventually roll it as a stabilized interest rate.

The distributions appear well covered on the plot above showing them. But we should know that operating properties impose costs that are not accounted for in FFO or CfO. FFO payout ratios have little meaning for REITs with operating properties.

To explore this I took recurring capex, or RCX, to include non-developmental capex, costs associated with property sold under threat of condemnation, and leasing costs from the cash-flow statements. The difference between CfO and RCX is label here as FAD, or Funds Available for Distribution. This is pretty much the same as the usual Adjusted FFO, or AFFO.

Here we more clearly see lingering impacts of the pandemic. CfO (green line) as a fraction of NOI has dropped about 100 bps since 2018. That reflects real cost increases in operations (interest expenses being only part of that).

RCS (golden line) has increased by 5% of NOI across the same period. This reflects the spending to re-tenant the portfolio following the pandemic. Such increased re-tenanting costs are clearly not done yet.

The result is that FAD (red line) has dropped from above 60% of NOI to below 50%. The latter is pretty low for a shopping-center REIT normally. We can expect that ratio to come back up over time, but again it is not there yet.

The growth of the RCX changes the story on the distributions. You can see that here:

The decision taken during the pandemic to sustain the dividend, which I would have made too, is still having consequences. The payout ratio of FAD remains up around 110%.

Another consequence of that decision to sustain the dividend is that debt went up and so did Net Debt/EBITDA:

You can see that Net Debt/EBITDA went up over 7. This presumably is what cost them their A- credit rating.

Federal says they expect to get that down to the mid-5 range within a year. The 15 to 20 analysts tracked by TIKR are not quite that optimistic. In any event, with growing earnings NetDebt/EBITDA will keep coming down.

We must wait for RCX/NOI to come down and for FFO and CfO to further increase before the payout ratio on FAD will come back to the 80% ballpark that is healthy. At that level the distribution will be well covered in truth and able to grow faster.

What the Cash Flows Tell Us

As usual, we can see a lot about the business model of a REIT by looking at cash flows. First we look for retained earnings by plotting CfO (green bar) against distributions (blue) and RCX (tan):

We can see that the difference between the source and these uses of cash is always small. What’s more, it has been mostly negative from 2020 on (and note that for FRT 2021 was the year of big deferred-rent revenues).

Now it is useful to take the difference of the above as net retained earnings and look at that as part of all the significant cash flows:

Here the left stacked bar of each pair has up to five sources of funds. These are retained earnings (green), dispositions (light blue), new common stock issuance (red), preferred issuance (dark green), and net new debt (gray).

You can see that the retained earnings part is usually small and has been negative post-pandemic, as we saw in more detail above. The contrast with REITs that have smaller payout ratios, such as NNN REIT (NNN), is considerable.

Those sources cover two types of cost. These are capex for development and redevelopment (purple) and acquisitions (yellow).

We can see that the development and redevelopment capex has been relatively steady. Development projects are big part of who Federal is.

We can also see that most of the development activity is covered by retained earnings plus dispositions, though not as well since the pandemic. Viewing it this way makes sense as development is long-term.

Any shortfall in funding development is covered by new stock issuance and new debt. But most of those funds go to support acquisitions.

So this is what we have here. Federal Realty has long run a combination of two components:

• development activity supported mainly by dispositions and retained earnings, and
• acquisitions supported almost entirely by funds from stock issuance and new debt

The first of these is an internal growth component while the second is a classic external growth component driven by stock issuance. From my previous analyses, I had not appreciated these two components as largely independent. Looking in this way as the elements of cash flow really helps one see how the company functions.

The internal growth part still needs some post-pandemic repair, which will happen as discussed above. After that, they can continue the internal growth component indefinitely and independent of the stock market. It would be better supported if Federal would hold off on larger dividend raises until the payout ratio to FAD comes down well below 80%.

In contrast, the external growth component only adds to shareholder value when there is a high enough stock price. They can do some of that today but it is not very efficient, as we will discuss shortly.

Earnings Growth Potential

We can run through some quick calculations to ballpark the growth rates FRT might achieve. The point here is not to read tea leaves about 2024, but rather to get some idea how things might go after the capital and real estate markets settle into some new normal. [All the math for the external growth and total growth calculation is at the end of my recent article on NNN REIT.]

For the internal growth part, we can find an estimated growth potential as follows. Typical spreads between dispositions of strong properties and development run around 150 bps. Use that.

Assume there is $300M of development, funded 75% by dispositions and 25% from retained earnings. Suppose that the stabilized cap rate from development is 6.5%. Then the new NOI is $8.3M which might make $5M of new FAD once the pandemic recovery is complete.

That outcome is about 6 cents/share, in the ballpark of 1% growth. This is a significant boost to a growth rate in the 3% ballpark from rent bumps. If retained earnings could cover half of that development cost, then the growth from this source would increase to about 1.5%

For the external growth we care about investment yields. With the ratios to FAD of G&A, interest expenses, and RCX being 8%, 20%, and 20%, respectively, we get the ratio of FAD to NOI as 52%. This is right in line with what we saw above.

Then for an acquisition cap rate of 6% and a ratio of new debt to new equity of 40%, the implied investment yield is 5.2%. The current FAD (or AFFO) yield is about 4.4%. This is near the dividend yield now because the payout ratio is near 100%.

One would like a larger spread than that 800 bps, because of impacts of dilution. To see this, suppose Federal wants to do $400M of new acquisitions, which has been a typical annual rate.

At 40% leverage, that will require an increase in the share count of 3%. This is at the high end of typical for them. If the internal growth rate is 4%, one finds a total growth rate of FAD/sh, using the numbers above, of 4.4%.

So the external growth part makes a pretty anemic net addition, at 0.4%. Still the total of 4.4% is near the high end of their FFO/sh growth over various intervals during this century.

My guess would be that their rent bumps are bigger than they used to be, since they are such an active topic of promotion recently. But I did not go look.

Good Progress but Still Waiting

I had thought Federal Realty might be closer to having fully recovered, because of a couple trends discussed in recent articles. These were the rapid drop in FFO payout ratio and the decreasing Debt/EBITDA.

But those authors unfortunately did not know enough history and did not dig deep enough to really understand the present. With distributions still above 100% of FAD, Federal has still got a fair way to go in recovering from the pandemic. And Debt/EBITDA has at least a year to get back to target, as well.

In contrast to that disappointing news, applying what has become my standard analysis of cash flows to this REIT produced positive news. It showed that they do have a capacity to get modest growth out of their development activity, without issuing any stock.

Their growth model is not a purely external one fueled by issuing stock, which had been my previous impression. So they are less stuck than I had thought.

As to valuation, today’s seemingly positive P/FFO of 15.7x is actually a P/FAD of about 31x. For earnings that grow indefinitely from the present moment at 4%, that would require a discount rate below 3.5%.

On top of that, subtract something like 12% from the price for the delay in dividend growth. Through this lens, FRT looks more expensive than 10-yr Treasuries at the moment. It surely does not look like an upside play to me.

Federal likes to brag about their 55-year, 7% CAGR of dividend raises, and no wonder. But if you really look at their slide on that, there have been extended periods of low growth interspersed with occasion years of stellar growth.

In the near future, we can expect de minimal dividend increases until affairs are in better order as described above. Then it looks like raises in the ballpark of 4% for the foreseeable future. These are likely to come up in response to inflation, as rents adjust with a few-year lag. After that, who knows?

FRT remains a good stock for investors seeking a modest yield (4.2% now) that will eventually grow more or less with inflation. This certainly includes retirees whose main goal is to go fishing rather than tend their investments.