Federal Realty: A dividend king with a preferred option (NYSE: FRT)
Federal Real Estate Investment Trust (New York stock market :TRF) is a fully integrated retail REIT that has been around for decades, since 1962. During that time the company has consistently increased the dividend for 55 consecutive years, making it part of an elite group of only 37 companies who did this, known as the Dividend Kings. These are companies that have weathered the storm time and time again, decade after decade, while maintaining a growing dividend.
It is also apparently the longest record of annual dividend increases in the REIT industry.
So it’s good. Yet, we all know that past success is no guarantee of future success, so we should take a closer look at their portfolio.
At a high level, the company manages 105 properties with ~3100 commercial tenants, 25 million square feet, and ~3400 residential units. These properties are in what management identifies as “strategically selected first-ring suburbs of nine major metropolitan markets with high barriers.“Here’s what that translates to on a map.
These strategically selected areas have created a remarkable characteristic for FRT: their demographics. With the current inflationary environment, one challenge retail may see is lower median income households cutting back on spending. We can see that with FRT, the median household income within 3 miles of FRT properties is over $105,000 and well above its peers. Not only that, but the population density for FRT is also higher.
Given these demographic characteristics, the company may be better insulated from a decline in consumer spending. They certainly seem better positioned to overcome this scenario than any of the benchmarked peers.
We can observe that the company recorded a record quarterly FFO in the second quarter of $1.65 and an overall increase in FFO guidance suggesting 9.5% to 12.2% growth in FFO per share over 2021. From the point From a balance sheet perspective, they maintain a credit rating of BBB+ from S&P and a Baa1 rating from Moody’s. Leverage is high at 5.8x net debt to EBITDA. Based on their Q2 deposit the leverage ratio is 1.64x, which seems manageable given the growth in FFOs.
Another way to assess leverage is to compare the value of their real estate to their debt. Senior notes and debentures were $3.407 billion in the second quarter, with impaired real estate accounting for $7.058 billion. If we look at this from the perspective of loans secured by real estate, then the loans have a loan to value ratio of just 48% – this is very conservative and suggests that the value of the real estate should help support the debt .
Ninety-three percent of the debt is at fixed rates, which will also help given rising rates.
Finally, we note that their portfolio is well diversified both by category of activity and by tenant. It will also help the company weather any lingering recession.
FRT valuation and preferred option
This is where I hit a snag with the company. The Trust is currently priced at 2.85x P/B, which is technically below its five-year average of 3.84x. Anyway, it’s a bit rich for my taste even though FFO is growing. The forecast for 2022 FFO is $6.10-$6.25, which means that even taking the high end, the stock is trading at a P/FFO of 15.48x. I like to buy companies that are trading below their valuation; The FRT does not seem to be.
Yet there is another way to invest in this company that seems to represent a mispricing: Series C Cumulative Preferred Shares (New York stock market :FRT.PC). This is a small set of $150 million shares that are backed by equity of $2.876 billion more than nineteen times. Revenue for the first six months of this year totaled $109.642 million with net income over the past five years equaling $1.279 billion.
Despite the clear support for a full valuation of the preferred shares at face value ($25.00), the preferred shares are currently trading just off their 52-week low at $19.33. As recently as August, these stocks traded above par and generally have done so throughout the past year.
The downward trend is probably somewhat yield related. Even at current depressed prices, the annual dividend of $1.25 represents a yield of 6.46%. With rising interest rates, the value of that return is no longer as high as it once was. Yet, given the nature of the business, it appears to be a guaranteed return of 6.46%.
Consider that if the company does not pay a dividend on its preferred stock, it means that it is also unable to pay a dividend on its common stock. This feature ruins an established 55 year history and their base as a Dividend King stock which they clearly enjoy. I think with this reality in place, it is very likely that buying today will lock in a 6.46% return. And even if a disaster occurs and the company does not pay dividends on the preferred stock, it is a cumulative structure, which means that a dividend would still accrue to which the preferred stockholders would be entitled.
When we consider that the company has an open ATM equity program, we can also see how the company issues common stock to preferred stockholders. In the six months ended June 30, 2022, they generated $259.4 million from this program. This alone covers the total preferred stock value of 173%.
The preferred shares very recently became due and payable from 9/29/2022, so in theory the company could redeem them at any time. Historically speaking, the company has two other series of preferred shares that have been redeemed – even though they were over a decade ago. If we examine their debt financing agreements, we might find clues as to the likelihood of them being called.
The cost of financing the preferred shares is a fixed rate of 5.00%. There are only four debt agreements that are more expensive than this in the table above. This means that if the company was able to repay its debts based solely on the cost of financing, it would be in fifth place to repay.
Investors may be attracted by the Dividend King status and the current yield of 4.46% for FRT. With stocks trading at what I consider high valuations, I would say that even if the yield is hedged, the potential for capital appreciation seems minimal to me. Even if they execute and meet their 2022 FFO guidance, the stock would trade at a P/FFO of 15.48x.
Management is currently diluting common shareholders through an ATM equity program that is fueling growth, but will once again put sustained pressure on common stock over the next year.
My thinking here is that FRT’s move to their preferred stock may be a better opportunity over the next year. FRT.PC is outperforming 6.46%, pays quarterly the same as common and is currently well supported by balance sheet, business growth and equity issuance. And it’s trading at around 23% off face value, meaning there’s potential for capital appreciation.
If the preferred stock is redeemed within the next two years, we could estimate the returns. Two years of a return of 6.46% (12.92%) plus capital appreciation at face value from current prices of $19.33 (29.33%) would imply a two-year total return of 42.25%. And regardless, that 6.46% yield is tied to the company’s reputation as the king of dividends. They can’t afford not to pay this and maintain their 55 year tradition – so I think it’s highly likely that this preference will continue to pay dividends as usual and will eventually be redeemed at par.
The relevant question is when. But given the current momentum in common stocks, I think preferred stocks are poised to outperform over the next two years. So a switch can be worth it.