VNQ - Federal Realty: Our Favorite Dividend King For 2024 (Rating Upgrade)

2024-01-16 04:17:14 ET

Summary

• Federal Realty is the Dividend King we currently like the most, with undervalued shares and solid fundamentals.
• The company has a strong competitive advantage thanks to the excellent locations and quality of its properties.
• Federal Realty has a strong balance sheet, high and improving occupancy rates, and a track record of increasing dividends for 56 consecutive years.
• The company's negotiating leverage with retailers is improving, and it is now meaningfully increasing rents for renewals and new leases.

We recently took a look at the current list of Dividend Kings in the US, companies that have raised their dividends for fifty years or more, and Federal Realty ( FRT ) is the one we currently find most attractive. About a year ago, we started following the company and wrote that its shares were reasonably valued.

Shares remain at a similar level despite the company making progress on a number of areas, but the general real estate market faced significant headwinds from the increase in interest rates. This led popular real estate ETFs like the Vanguard Real Estate ETF ( VNQ ) to massively underperform the S&P 500 index ( SPY ). Federal Realty underperformed VNQ by a few percentage points, but we believe its shares have shifted from being reasonably valued to attractively valued.

This lackluster performance does not reflect the solid fundamentals. For example, the company reported strong funds from operations (FFO) per share in the third quarter, above expectations despite numerous headwinds. The $1.65 FFO per share it delivered was 4% higher compared to the previous year despite significantly higher interest expense and the Bed Bath & Beyond ( BBBYQ ) bankruptcy impact.

Company Overview

Federal Realty is a REIT centered around leasing high quality retail properties in the first ring suburbs of some of the most dynamic cities in the US. It has further diversified into high quality office, and mixed-used developments, including high-end apartment buildings.

We believe the company has a strong competitive advantage based on the excellent location and quality of its properties. The company likes to say that higher density, higher incomes and real barriers to entry give the company a competitive advantage. A powerful statistic to illustrate this point is that 70,000 households with annual household incomes of over $150,000 sit within three miles of its retail properties.

The graph illustrates how the company's properties have a density and customer purchasing power advantage, over competitors like Kimco ( KIM ), Regency Centers ( REG ), Brixmor Property Group ( BRX ), and others.

Financials

We do see some evidence in the financials, that the competitive advantage of having superior locations is real, as the company has higher returns on equity than competitors like Realty Income ( O ), Kimco, Regency Centers, etc.

Occupancy

Federal Realty is doing relatively well with respect to occupancy too, with an overall occupancy rate of 92.3% at the end of the last quarter, and the leased percentage at 94.0%. The company has a significant percentage of leases that have been signed, but the spaces have not yet been occupied. This represents around 2.5% of future occupancy, 10% of which should have been occupied in the fourth quarter of 2023, and most of the balance should be occupied over the course of 2024.

Federal Realty expected the Bed Bath & Beyond closings to reduce occupancy in the quarter 100 basis points compared to the previous year. However, their overall occupancy declined just 30 basis points on a lease basis and 50 basis points on an occupied basis. This was possible in part thanks to small shop occupancy increasing around 50 basis points to 90.7% on a lease basis, and 80 basis points on an occupied basis.

During the most recent earnings call , the company said that their exposure to some of the retailers experiencing issues like Rite Aid ( RADCQ ), Big Lots ( BIG ), Joanne, and Express represent a very small amount of their total rent exposure, roughly 25 basis points. CEO Donald Wood sounded optimistic during the call that the company can potentially gain another 2% in occupancy over the next 18 to 24 months, as long as they are not surprised by an unexpected customer bankruptcy.

Growth

As the company has come closer to full occupancy, it has been able to improve its negotiating position. This is reflected in higher starting rents, about 11% higher on a cash basis, and 21% on a straight line basis.

Besides rent growth from renewals and new leases, the company should also be able to increase FFO from its development and redevelopment pipeline. Its in-process pipeline currently represents $750 million of active redevelopments and expansions, with about $180 million left to spend to complete them. This should not be an issue given the company's $1.3 billion of available liquidity. The pipeline should provide growth tailwinds over the next two to three years.

Dividends

One of the biggest attractions for investors in Federal Realty is its dividend track record. It is something that the company is clearly very proud of too, so they will try very hard to keep the increases going forward, even if they are relatively modest. For a dividend King, the current yield is relatively high at more than 4%, and meaningfully higher compared to the 10 year average of ~3.4%.

The company claims to have the longest record of dividend increases in the REIT industry, boasting 56 consecutive years of increased annual dividends and a compounded annual growth rate of 7%. The good news is that the payout ratio remains quite reasonable at ~66.3%, the bad news is that the company has slowed down the growth of the dividend significantly in recent years.

The five year dividend growth rate is about 1.5%, which is understandable to a certain degree as the company has had to invest significant amounts into its development and redevelopment pipeline, and the retail sector has faced numerous challenges in recent years, from Covid to large retail chains going bankrupt. Still, we think that once the company stabilizes occupancy and completes some of its major redevelopment projects, it will probably start making more sizeable increases to the dividend again.

Sustainability & Social Responsibility

Federal Realty appears to be an excellent employer, with a 4.2/5.0 rating on Glassdoor, with 100% saying they approve of the CEO, 90% saying they would recommend the company to a friend, and 95% seeing a positive business outlook. This is good, as we believe that companies that treat well all their stakeholders do better over the long term. The company is also making efforts to improve its sustainability, with 14 MW of solar power on its properties and efforts to reduce waste generation. Still, the company only earned a 'C' grade from CDP in 2022, so it can probably do more for the environment.

It also has programs to strengthen its relations and positive impact on the communities where it operates, motivate its employees, and have good governance practices.

These efforts have led to the company receiving a number of awards and positive ratings, as can be seen in the slide below.

Balance Sheet

Federal Realty has a strong balance sheet, ending the third quarter with $1.3 billion of total available liquidity, comprised of $1.2 billion under their revolver and about $100 million in cash. The company's leverage is above its target, with the net debt to EBITDA ratio at six times, but the company expects to be in the mid 5x over the next year. It has solid credit ratings, with BBB+ from S&P Global ( SPGI ) and Baa1 from Moody's ( MCO ).

Outlook

The company expects FFO per share for 2023 to be in the range of $6.50 to $6.58, with growth over 2022 of 3.5% at the midpoint. The company will give 2024 guidance when they host their earnings call in February. It will be interesting to hear management's commentary, as they sounded very optimistic during the most recent one.

For example, COO Jeffrey Berkes mentioned that landlords have regained significant negotiating leverage with retailers, as occupancy has moved up and some retailers are looking to expand once again. In particular, we found reassuring that he mentioned that they are making good deals right now with great tenants.

The leverage is definitely, as Wendy said, shifted to a lot of the landlords in many respects, given the shortage of space and given our proclivity to be tough on all terms in the lease, not just the financial terms. We're cutting good deals right now, and we're cutting them with great tenants. Really, really positive environment right now.

Risks

Not everything is rosy, however, as there are many signs that the US consumer could start spending less soon. For instance, the credit card delinquency rate has been increasing, and it is now at the highest level in almost ten years.

Should a recession occur in the US this year or next, this could disrupt the company's plans to continue improving occupancy and raising rents.

Valuation

Federal Realty is trading at a very compelling valuation, with EV/EBITDA more than five turns lower compared to its ten year average.

Similarly, it is trading well below its ten year average price/book multiple, and not much higher to the levels it traded at during the worst of the Covid crisis.

Federal Realty is not the only high-quality retail REIT trading at an attractive valuation. For example, its price to cash flow from operations per share multiple of around 15x is very close to the multiple at which Agree Realty is trading. Realty Income is about one turn lower, but we are more optimistic about Federal Realty's growth prospects compared to Realty Income's. In any case, it is clear that the rapid interest rate increases have significantly lowered valuations in the sector.

Analysts, on average, expect modest FFO growth for FY24, but a more meaningful increase in FY25. We believe that if the US economy can avoid a recession in the next few years, the company might achieve even higher growth than what analysts currently anticipate. This would be through a combination of contractual annual rent increases, deliveries from its development pipeline, rent increases on renewals and new leases, and modest operating leverage.

Based on our FFO estimates, we calculate a net present value of its future funds from operations of ~$124. This means the company is about 20% undervalued, and why we believe it deserves a 'Strong Buy' rating.

Conclusion

In general, the real estate sector looks attractive after the aggressive interest rate increases that have taken place the last couple of years. This motivated many investors to sell their REITs, and allocate towards fixed-income or cash investments. Perhaps this is why, when we look at the list of Dividend Kings or companies that have raised their dividends for more than fifty years, Federal Realty is the one we currently find most attractive. Management is doing a good job of restoring occupancy, completing its development and redevelopment pipeline, and sounded optimistic during the most recent earnings call. We believe shares are currently trading at a good margin of safety relative to their fair value.

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