AHH - Armada Hoffler: A Diversified Investment Grade Yield

Summary

• Armada Hoffler is paying out a 5.6% yield on its common shares that's well covered by FFO.
• This has been on an upward path since it was cut by 50% in the pandemic.
• Whilst the preferreds offer a yield on cost that's 180 basis points higher than the commons, I'd expect them to underperform in the medium to long term.

Office REITs, once a non-controversial REIT asset class in the pre-pandemic era, suddenly found themselves seemingly faced with existential dread after the pandemic. Working from home had more thoroughly entered the national lexicon to discombobulate office occupancy rates and instill deep uncertainty across the space. However, unlike its peers, Armada Hoffler (AHH) would notch total returns of -1.57% last year, against pure office REIT peers currently nursing double-digit losses.

The Virginia Beach, Virginia-based REIT has built out a diversified portfolio of not just high-quality office space but retail and multifamily properties centered around the Mid-Atlantic and Southeastern US. The REIT last declared a quarterly dividend of $0.19 per share , in line with the prior payout, and for a 5.6% yield.

The pandemic was rough as stay-at-home orders forced the REIT to cut its payout in half to $0.11 per share. It's been on a material upward recovery since then with the current payout sitting 13.6% below the immediate pre-pandemic peak. This continued recovery sets the bullish backdrop for taking a position in the commons.

Rising FFO As Fed Funds Rate Increase

Armada Hoffler's recent earnings for its fiscal 2022 fourth quarter saw revenue come in at $55.69 million , a growth rate of 12.6% over the year-ago quarter and a beat by $1.49 million on consensus estimates. This came on the back of a 97% portfolio occupancy exiting the quarter with positive renewal spreads across office, retail and multifamily.

Fourth quarter funds from operations came in at $0.35 per share, a beat by $0.03 on consensus estimates and was a growth rate of 13% over the year-ago quarter. This forms a 54% payout ratio on the most recently declared dividend. Lease rates on office lease renewals grew by 6.1% on a GAAP basis with lease rates on retail lease renewals growing by 10.3%. The REIT is guiding for FFO to come in between $1.23 to $1.27 for fiscal 2023, which would represent a very modest growth of around 5% over FFO of $1.21 for the full year 2022.

The core takeaway from the earnings is the continued transformation of its balance sheet debt towards fixed rates with the REIT recently receiving a BBB investment grade credit rating. Management was upbeat on the potential of this during their earnings call. It will allow the REIT to refinance existing debt to lower rates with management planning to raise funds through private placements to convert approximately $1.1 billion in existing debt from short-term variable rates to long-term fixed rates. Overall, this will see variable rate debt as a per cent of total debt drop from 55% to 10% over the next five to ten years. Critically, this will help move Armada Hoffler into a stronger footing as the Fed funds rate continues to move higher and is set for at least two more 25 basis point hikes this year.

The Series A Preferreds

Armada Hoffler 6.75% Series A Cumulative Perpetual Preferred Stock ( AHH.PA ) pays out a $1.69 annual coupon for a 7.4% yield on cost and with a quarterly distribution schedule. They're with no stated maturity and are perpetual but could come up for redemption next year on June 18, 2024. This provides Armada Hoffler with the option but not the obligation to fully buy back the full issue which started trading in 2019.

It's unlikely that the REIT will redeem its preferreds on the back of what's now a higher Fed funds rate and the need to optimize liquidity against what could still be a broadly uncertain macroeconomic period next year. I like that the yield on cost is 180 basis points ahead of the commons and that this is from a security that provides a higher claim to earnings.

The preferreds are currently trading at $22.80, an 8.8% discount to their $25 par value to set up a yield to call of 18.9%. They also include a cumulative clause that means any unpaid distribution accrues as a liability to be paid back at a future date. This heavily reduces the likelihood of a suspension of its distributions. However, this is a prospect that would require a material deterioration of current macro conditions, likely in excess of the 2008 crisis.

Total returns for the preferreds versus the commons are mixed with the Series A down 7.66% over the last 12 months versus a loss of 1.57% for the commons. Over the last three years, the preferreds sport a gain of just under 8% versus a loss of 15.68% for the commons. I think medium to long-term total return performance from the commons will be greater as the Fed funds rate peaks and the company's dividends continue to climb up. I'm neutral on starting a position in both securities now, but Armada Hoffler is a good company for further consideration.

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