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Federal Realty: Abnormally High Yield Likely Means High Returns

GuruFocus.com
·8 mins read

- By Nathan Parsh

Stocks that trade in excess of their long-term average dividend yields are among my favorite. A higher-than-usual yield could mean that the underlying company could be facing extreme difficulty that is sending investors running from the stock. Or it could mean that the market is overreacting to some headwind and has priced the stock too low. This has allowed the yield to move to a level rarely seen.


Investors purchasing stocks that are down due to market overreaction can reap the rewards when the market corrects and the yield is closer to its average.

One name that I feel has been unduly hampered is Federal Realty Trust Investment Trust (NYSE:FRT). The stock has a yield that is currently above 5%. The stock hasn't averaged a yield above 3.5% for an entire year since 2010.

Shares of the company are also undervalued using the more traditional method of price-funds-from-operation to value real estate investment trusts.

Let's dig deeper into the trust to see why the stock has a strong prospect for high returns.

Quarterly highlights

Federal Realty reported second-quarter results on Aug. 5. Revenue fell almost 24% to $176.2 million, which was $34 million lower than expected. Funds from operation fell 83 cents, or 52%, to 77 cents. This was 41 cents below expectations.

Covid-19 was a significant headwind to results as the trust wasn't able to collect rent as usual due to the number of tenants that were closed due to state and local directives. Federal Realty estimates that Covid-19 reduced FFO by $55.2 million, or 73 cents per share.

Results were also impacted by bankruptcies, including J. Crew, 24 Hour Fitness, GMC, Brooks Brothers and others. All told, these bankruptcies represented almost 650,000 square feet, or nearly 28% of total square footage under management, and 110 locations.

Federal Realty collected 68% of total rent due for the second quarter. While this is a low figure, rent collection actually improved as the quarter progressed and beyond. For example, rent collection for July was 76%. The trust also entered into deferral agreements with tenants for $21 million, or approximately 10% of second-quarter rents. The average weighted repayment period is nine months.

The trust's portfolio was 93% leased at the end of the quarter, with the comparable portfolio being 93.7% leased. During the quarter, Federal Realty signed 50 leases totaling nearly 315,000 square feet of retail space and 15 leases for 95,000 square feet of office space.

For spaces for which there was a former tenant, Federal Realty's average rent per square foot increased to $28.55 from $25.64. The trust's cash basis rollover growth of more than 11% despite the weak environment for retail. That is arguably an impressive performance.

As of the end of July, 87% of commercial tenants were open for business compared to just 47% on May 1. The improvement in the number of businesses opened should go a long way in Federal Realty's ability to collect on past and future rents.

Federal Realty ended the quarter with cash and cash equivalents of $980 million. In addition, the trust has an additional $1 billion in an undrawn revolving credit facility. Federal Realty has no debt due within a year and just $340 million due by the end of 2021. The trust is well positioned financially for any additional hardships related to the pandemic in the near future.

According to Seeking Alpha, Wall Street analysts expect Federal Realty to produce FFO of $4.77 per share in 2020. This would be a 25% decrease from the prior year. The trust has compounded FFO per share at an annual rate of 5% over the last decade. At the same time, the share count has increased by 21% over the last decade so actual FFO has more than doubled over the last decade.

Dividend and valuation analysis

Following a 1% dividend increase for the upcoming Oct. 15 distribution, Federal Realty has increased its dividend for 53 years. This is the longest dividend growth streak among REITs and one of the longest in the entire market place.

The trust has increased its dividend by an average of:

  • 3.6% per year over the past three years.

  • 5.1% per year over the past five years.

  • 4.6% per year over the past 10 years.



The most recent raise was below the averages listed, but this was likely due to the uncertainty regarding how the current environment would impact results.

With an annualized dividend of $4.24, the expected FFO payout ratio is 89%.

While REITs often have a high FFO payout ratio, Federal Realty's payout ratio is usually lower. The average payout ratio since 2010 is 68% and hasn't been higher than 72% over this period of time. This is due to the trust conservatively managing its business and dividend. This likely also explains the lower than usual dividend increase. With a more normalized operating environment, the dividend raise probably would've been higher.

I don't expect that the dividend is likely to be cut. Federal Realty estimates that it will have $1.3 billion of cash on hand on Feb. 1 of next year. The company has no debt maturing before then and dividend payments for the last four quarters was less than $321 million.

Using the current share price of $82 and the annualized dividend, the yield on the stock is 5.2%. The 10-year average yield is just below 3%. This means that the current yield is more than 220 basis points above the long-term average. As stated previously, Federal Realty hasn't had an average yield of more than 3.5% in at least 10 years.

Reverting to the average yield would require the stock to trade at $145, which would be a 77% increase from today's share price. This would be an incredible gain, one even the most optimistic of investors isn't expecting. This just shows how much higher the dividend is compared to its historical average.

Using the price-FFO ratio also reveals that the stock is undervalued. The stock has a forward price-FFO ratio of 17.2. Since 2010, shares of Federal Realty have traded with an average price-FFO ratio of 23.4 according to Value Line.

An argument could be made that using the 10-year average price-FFO ratio to determine how undervalued shares of Federal Realty are is too bullish due to current circumstances for trust.

I have a target price-FFO ratio of 19 to 21 from Federal Realty. I feel that this takes into account the short-term headwinds as well as the trust's long-term performance and dividend growth track record. Using estimates for 2020 and this valuation range gives us a price target range of $91 to $100. This would result in a gain of 11% to 22% from today's share price.

The dividend yield would be 4.7% at the low end of this range and 4.2% at the high end. Even this yield range would be superior to the trust's decade-long average.

Between gains in share price and the dividend yield, investors could be looking at 15.7% to 26.2% in total returns for shares of Federal Realty.

Final thoughts

The second quarter was difficult for Federal Realty as more than half of tenants were closed at some point due to restrictions related to the ongoing pandemic. This severely limited the trust's ability to collect rent. However, recent collection did improve by the end of the quarter and was higher still in July. Agreements to collect past due rent were also reached with a sizeable portion of tenants.

Federal Realty was also busy signing new lease agreements and at a higher price per square foot then what the previous tenant had paid. This plus the improvement in rent collection helps to reassure me that the trust's business is returning to a more solid state.

In the meantime, shareholders of Federal Realty are being paid a yield that hasn't been seen in a very long time, if ever. The current FFO payout ratio is high, but this is due to unusually high circumstances. Traditionally, Federal Realty has one of the lowest payout ratios among those in the real estate sector.

Even a modest reversion towards the stock's average yield or price-FFO ratio would result in at least double-digit total returns with the possibility of more than 26% in total returns were the stock to trade at the high end of my valuation range. This is an excellent prospect for what is one of the better managed REITs in the market.

Disclosure: The author doesn't have a position in any stocks mentioned in this article.

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This article first appeared on GuruFocus.