Every once in awhile, new stocks get added to the Dividend Aristocrats Index and old ones get taken out. This year, General Dynamics and Federal Realty Investment Trust were added to the prestigious index, while HCP Inc. was cut out. We’ve already discussed General Dynamics last week, so this week we’ll be taking a close look at the other new entrant on the list.
As the name suggests, Federal Realty Investment Trust is a Real Estate Investment Trust or REIT. It’s a company that owns, develops, and operates real estate throughout the country. Specifically, retail properties. REITs are designed to create stable income from properties. They own land, spend money on creating new properties or renovating old ones, then manage tenants and create long-term lease agreements. If everything works out as planned, there’s a stream of cash flow created every month for the company. 90% of the net income is passed through to the investors without being taxed at the corporate level.
In other words, this is most liquid and diversified form of property-ownership for retail investors.
Valuing a REIT isn’t the same as valuing other public companies. Because of the way taxes and the business model is structured, valuing a share of an REIT is similar to valuing a large portfolio of properties.
Today, we’ll be taking a deep dive into Federal Realty Investment Trust’s strategy, portfolio, and financial situation. Understanding how the properties are developed, where they’re located, how much income they can possibly produce and how risky the strategy is will help us estimate the stock’s intrinsic value.
Here’s what you need to know before you consider buying FRT:
About Federal Realty
Federal Realty was established in 1962. Right off the bat, the trust focused on generating income from retail properties and paying investors an escalating rate of dividends. The properties are usually mix-use and in heavily commercial areas. Altogether, the trust owns and operates 96 properties which are occupied by more than 2,800 tenants.
Properties are currently located in 13 different states in America:
- District of Columbia
- New Jersey
- New York
- North Carolina
The company was listed on the New York Stock exchange under the ticker FRT. It has paid an annual dividend every year since it started trading, which means this year’s dividend will be its 55th. The company has also managed to increase the dividend consecutively for the past 49 years.
It’s fair to say Federal Realty has a vast and well-managed portfolio of retail properties across the country. The fact that it has managed to become part of the Dividend Aristocrats Index this year goes to show why it’s a dividend appreciation stock worth considering for income-seeking investors.
When it comes to property, it’s all about three things – location, location, and location. REIT managers know this well, so to understand the strategy behind Federal Realty it’s important to understand where the properties are located and why.
If you read through the property portfolio, you’ll realize that the retail centers are based in the biggest cities in the biggest states. The strategy is to get large plots with potential for heavy retail traffic in popular coastal cities. This is why the main properties are in tourist hotspots like Los Angeles, Boston, San Francisco, and Washington D.C. Heavily populated areas with significant limits on real estate markets.
San Francisco and Los Angeles are already the most expensive property markets in the country. Nearly 16% of all properties are located in California.
Meanwhile, the mixed-use properties are in neighborhoods like Santana Row in San Jose, California, Pike & Rose in North Bethesda, Maryland and Assembly Row in Somerville, Massachusetts. These urban hotspots have potential for being attractive living and shopping districts for their particular community.
Altogether, the company owns 1,867 residential units spread across California, Maryland, and Massachusetts.
Properties are selected on two factors: income and number of households. The strategy is to aim for the highest income and the most densely populated areas in the country. Here’s a chart that explains how Federal Realty’s properties stack up against the national average:
Federal Realty aims to get properties that are located within 3 miles of more than 2,000 households where the median income is above $80,000. In other words – more rich people.
Key factors behind the strategy are:
- A focus on east and west coast properties
- Affluent neighbourhoods for both shopping and residential
- Highly populated parts of the country
- 94.6% occupancy rate
- Growth through property acquisitions and rent increases
Half a century of dividend growth doesn’t come from a weak balance sheet. That’s true for Federal Realty, which has managed to create a pretty air-tight income generating model for its business.
All the financial information we have here comes from the company’s first quarter reports in 2017. Here are some quick facts about the financials:
As you can see, there’s more of an exposure to the Top 20 US Markets than the peer average.
The company doesn’t just focus on getting the most valuable properties, it also tries to squeeze income from these properties as much as it can. The locations cover one-third of America’s retail expenditure. The cash rents are 67% higher than average REITs and the leasing spread has been double the national average since 1998 (16% vs. 8%).
Last year the company paid $3.92 per share in dividends. It earned $548 million in operating profit, $787 million in rental income, and has real estate assets worth $7 billion.
FFO has grown 5% on average every year. In 2017, the company estimates funds from operations will be somewhere between $5.85 and $5.93. Dividends, meanwhile, have grown 7% on average every year.
The market value of the whole trust is $9.1 billion.
Although the dividend yield is pretty reasonable here, so we will apply the dividend discount model. However, REITs can be valued in one of three ways: the net asset value approach, price multiples, or the dividend discount approach.
We’re going to try all three variations on Federal Realty and figure out the intrinsic value by taking the average:
Net Asset Value
Net asset value is simply the value of the equity in the trust.Estimated liabilities are subtracted from assets to get the value of each share. This includes the value of all the operating properties, the value of land, the cash on the books, and the receivables on the book.
You can also simplify the valuation by simply taking the book value.
For Federal Realty, the book value per share is $27.44, while the market price per share is $125.
There’s two multiples that need to be compared to the firm’s peers: Price to FFO and Price/AFFO. P/AFFO is more subjective since there’s no clear definition on what adjustments to FFO are necessary, so let’s just compare the P/FFO to the industry average:
- Price/FFO: $125.43/$5.65 = 22.20
- Industry Average: 18
This means the P/FFO multiple is 23% higher than the REIT average in the country.
Dividend Discount Model
Value = next dividend / cap rate*
= $3.92 x 1.07 / 4.5%
For this calculation I’ve assumed that the discount rate appropriate for the REIT is the cap rate it has used for almost all its properties. By this measure, the stock is nearly 34% overvalued.
REITs are a great way to get exposure to that other asset class that acts like a great dividend appreciation stock – real estate. Real estate often combines the stable returns of bond with the capital appreciation of stocks, which is a great combination for income seeking investors.
Federal Realty is one of the oldest REITs in the country. Over the years they have proven their ability to find and develop high quality properties across the coasts of America. Shopping malls, entertainment hubs and residential compounds are all picked in high density, high income parts of the country. This ensures they have more than enough of cash flow to satisfy investors for years to come. The fact that it is part of the Dividend Aristocrats Index is another plus.
However, the valuation indicates the REIT is overbought right now. Despite the potential for growth and stable inflows of cash and increasing dividends for the foreseeable future, FRT may not be the best buy. The price is too high at the moment. Wait and watch might be the best strategy.
Next week, we’ll bring you another great dividend aristocrat and dividend appreciation stock. Stay tuned.