AHH - Armada Hoffler: The 7.4% Yielding Preferred Shares Still Offer An Excellent Risk/Reward Ratio

Summary

• Armada Hoffler posted an excellent fourth quarter and a very encouraging 2023 guidance.
• The NOI will continue to increase in 2024 and beyond, which bodes well for the FFO, despite the worsening interest rate climate.
• The REIT needs less than 10% of its pre-dividend FFO, so I consider the preferred dividends to be very well-covered.
• I have no position in the common units, but I am looking to increase my position in the preferred shares.

Introduction

Back in December, I turned bullish on Armada Hoffler Properties ( AHH ) preferred shares, which are trading with ( AHH.PA ) as ticker symbol. I thought the recent correction of the preferred share price created an opportunity as I liked the risk/reward ratio offered by the preferred shares which obviously rank senior to the common units.

2022 was a good year

As a reminder, Armada Hoffler focuses on three specific asset types: retail, office and multifamily properties. I’m lukewarm on office assets so it’s important to keep an eye on how this segment in Armada’s portfolio is doing as the relative contribution of the office portfolio will continue to increase over the next few years. Offices contributed just 26% of the NOI in FY 2021 but this will increase to 34% this year. The retail assets remain the most important contributor to the NOI.

During the final quarter of the year, Armada Hoffler reported a total FFO attributable to the common stockholders and Operating Partner unit holders of $29.4M. After making some adjustments, the normalized FFO was $30.6M . Considering there are 88.3 million unit-equivalent outstanding, the normalized FFO per share came in at just under $0.35 (this was rounded to $0.35 in the results).

Keep in mind this includes the impact of the operating partnership units, which accounts for about 23% of the 88.3M units outstanding.

From the perspective of a preferred shareholder, I am very happy with the coverage level of the preferred dividends. Keep in mind the start of the FFO calculation was the reported net income, and this already includes the preferred dividend payments. As you can see below, the total amount of preferred dividends was $2.9M which means the total FFO excluding the preferred dividends was approximately $33.5M, indicating the REIT needed less than 10% of the Q4 FFO to cover the preferred dividends. A very healthy coverage ratio, indeed.

Even if you would look at the AFFO result ($0.28 per share in Q4 and $0.99 for the entire year 2022) the preferred dividends are very well covered as they represent just $0.033 per common unit.

The outlook for 2023 is pretty decent as well

Armada Hoffler has also released an initial guidance for next year. The REIT expects to generate a NOI of approximately $158M while it should also make about $12M in the construction segment.

The FFO guidance calls for a normalized FFO of $1.23-1.27 per diluted share, so the midpoint would be $1.25 per share. This actually makes the common units pretty attractive as well, as they are trading at just around 11 times the normalized FFO for 2023. Assuming the share count doesn’t change, the $1.25 normalized FFO guidance implies a total FFO of $110M. This includes the $12.5M in preferred dividends which again means the total coverage ratio of the preferred dividends will exceed 1,000% and that’s obviously totally fine with me.

Keep in mind 2023 is just a stepping stone towards further increases in the NOI as Armada Hoffler continues to develop its pipeline. As you can see below, Armada is guiding for another double digit percentage increase of the NOI in 2024 followed by a mid-single digit increase once the portfolios are fully stabilized.

This means we should expect further improvements in 2024 and beyond and while a higher interest expense (the cost of debt is fully hedged for 2023, so I’m not expecting a major near-term impact) will for sure weigh on the conversion from NOI to FFO, Armada Hoffler actually is in a pretty good shape and especially from the perspective of a preferred shareholder, I am feeling very comfortable with my long position.

Investment thesis

These preferred shares have a fixed preferred dividend of 6.75% based on the $25 principal value of the preferred security and this works out to $1.6875 paid per share in four quarterly installments of $0.421875. These securities can be called by Armada from June 2024 on. The preferred shares are currently trading at $22.80 for a current yield of 7.4%. The yield to call is in excess of 11% but at this point I’m not betting on Armada calling the preferred shares as 6.75% is a pretty fair cost of equity.

I initiated a long position in the preferred shares shortly after the publication of the December article. Given the strong performance in 2022 and the very encouraging outlook for 2023, I would like to add to my preferred share position on weakness.

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