Federal Realty Vocalizes Strong Commitment to Dividend Despite Disappointing April Rent

Federal Realty (FRT), owner of grocery-anchored shopping centers, reported earnings on Wednesday and revealed that only 53% of April rent was collected.

The REIT's properties have long been a stable source of rental income due to their location in large, affluent markets like Silicon Valley and New York.

Investments over the past twenty years in nearby office and residential complexes have made Federal Realty's shopping centers even more attractive to tenants.

Indeed, Federal Realty's 52-year streak of annual dividend increases is a testament to the robust performance of the company's portfolio of properties.

But the coronavirus pandemic is test like none other on the resilience of the firm's portfolio and, subsequently, the dividend.

It's no surprise which tenants aren't paying rent: apparel retailers (16% of rent), restaurants (15%), fitness centers (4%), and more are either closed or operating on a limited basis. Just 47% of tenants are open for business.

11% of rent is from small, local businesses that don't generally fare well during downturns due to limited cash reserves and poor access to capital. Many of these tenants may be forced to shutter, creating vacancies that will be hard to fill.

Furthermore, Federal Realty's shopping centers are concentrated in coastal metropolitan areas under relatively strict lockdowns. Management acknowledged that these regions will likely be some of the last in the country to fully reopen.

Federal Realty is in discussions with certain tenants to defer rent payments while their stores are closed. However, many of these businesses operate on thin margins and may never have the capacity to pay back rent in full.

This is uncharted territory for Federal Realty, who in 2009, in the depths of the last recession, saw same-center rent actually increase and occupancy drop just 1.1%.

Based on Federal Realty's pre-pandemic rental income and expenses (almost all of which are fixed costs), we estimate rent revenue could decline around 15% to 20% before cash flow would fall short of covering the dividend.

No one knows where rent collection will trend from here, but given April's numbers and the growing likelihood of a prolonged recession, it's very possible that Federal Realty's payout ratio will exceed 100% for the foreseeable future.

Moreover, Federal Realty's shopping centers have required higher investment in recent years to stay competitive in the era of e-commerce.

For the balance of 2020, Federal Realty's capital expenditures are expected to consume around $250 million, presumably some of which management had planned to pay with excess cash flow (as opposed to debt).

If Federal Realty doesn't foresee the business generating excess cash flow for the next year or two, the dividend, which costs $315 million annually, is a lever that can be pulled to free up cash to invest in important property improvements.

The bottom line is that the dividend's margin of safety has substantially decreased following Federal Realty's earnings report, and we are downgrading the firm's Dividend Safety Score to Borderline Safe as a result.

That said, Federal Realty's management team has vocalized one of the strongest commitments to the dividend of any retail REIT we've studied recently.

Despite April's figures and the unprecedented uncertainty facing the firm, Federal Realty declared its regular quarterly dividend payable in July.

In a call with analysts on Thursday, management said that "our goal is to maintain a cash dividend and push our 52-year record of increasing dividends to 53."

The case for protecting the dividend isn't pride so much as a recognition that equity will need to be issued in the future at attractive prices to fund growth plans, and a long dividend track record is important to many investors:

CEO Don Wood's strong words during this rough stretch are backed by the firm's solid liquidity and credit rating, as well as management's confidence in the long-term trajectory of the REIT's portfolio of shopping centers.

After drawing on the firm's $1 billion revolving credit facility and issuing a $400 term loan, Federal Realty now has $1.4 billion in cash on hand.

We estimate this $1.4 billion cash reserve is enough to cover the dividend and all capital expenditures for the next 3 years even if rental income were to remain depressed at 50% of pre-pandemic levels the entire time.

The point isn't that Federal Realty would burn through cash to maintain the dividend in such a catastrophic scenario. The point is the firm's liquidity provides management with some flexibility to be patient and take a wait-and-see approach.

An investment grade A- credit rating from Standard & Poor's also gives management confidence that debt markets will continue to be accessible and that upcoming maturities ($340 million in 2021) can be refinanced at reasonable rates.

Lastly, management believes that the firm's shopping centers will bounce back quickly once fully reopened and continue to perform well in the long run due to their convenience and presence in markets with high-paying jobs. Without this confidence, management might be quicker to reset the dividend lower.

All said, a dividend cut doesn't appear imminent unless conditions materially worsen and many more tenants fail to pony up rent. Federal Realty has the financial capacity to fund its business and the dividend for a while, which appears to be management's intent while waiting to see how things play out.

However, barring a quick resurgence in the economy, it's hard to imagine cash flow covering the dividend anytime soon. If stores remain closed longer than expected or the downturn is drawn out by consumers avoiding non-essential store visits, a downgrade to Unsafe would be considered.

On the other hand, if the retail environment improves substantially this summer, an upgrade to Safe could be warranted given management's priorities.

We will continue to monitor this rapidly-evolving situation and provide updates as new information arrives. For now, investors should consider how comfortable they are with the increased level of uncertainty facing Federal Realty's dividend.