Federal Realty Investment Trust (FRT) Earnings Call Transcript & Summary

Welcome to the 9:30 a.m. session at Citi's Global Property CEO Conference. I'm Michael Bilerman. I'm here with Christy McElroy. We're very pleased to have with us Don Wood from Federal. The session's for investing clients only. Disconnect. Disclosures are up here. You can sign in for live Q&A, and enter code citi2020 to submit any questions or you can raise your hand. Don, I'm going to turn it over to you to introduce your management team, provide the audience 3 reasons why investors should buy Federal stock today, and then we'll begin Q&A.

Well, good morning, everybody. Thanks, Michael.

Just move the microphone over a little bit, Don, make sure everyone can...

And with me today are Dan Guglielmone who is our Chief Financial Officer; Leah Brady who runs IR for us. And so thanks for giving us the time today. I think most of you know Federal. We've been around a long time, since 1962. We are known as a shopping center REIT, but I'd like to think of us as a mixed-use real estate company. We've been that for over 25 years. Basically, in the markets on the coasts, from Boston, Massachusetts down to Miami, Florida on the East Coast; and Northern California, San Jose in particular, down through LA. We are known, I think, as one of the highest-quality, if not the highest-quality retail companies in the country. We're very proud of that. What we do as a company is try to gather people, if you will, on the best pieces of land for retail purposes and then exploit them through residential, office, hotel, other uses on that piece of land. We're known for such places as Santana Row on the West Coast; Assembly Row, Bethesda Row on the East Coast; and most importantly, a big portfolio of great shopping centers that reduces our cost of capital to allow us to develop some of the harder stuff. And it's the biggest -- single biggest way that we derisk that stuff. In terms of why you should buy us, I don't know, Michael, when you ask that question, it's kind of funny because everybody is going to say, well, we're cheap, which is also true, by the way, although the markets are opening right now, so we'll see how cheap. But I'm not going to say that. At the end of the day, public companies need to have plans to sustainably grow their earnings. Not their same-store, not a particular metric here or a particular metric there, but at the end of the day, cash flow overall for the organization needs to improve. Ours has done that each and every year since 2010, and we will also grow earnings in 2020, we will grow earnings by more than that in 2021. And the reason is because we have a sustainable growth program. We're sitting with $761 million of construction in process on the balance sheet at the end of the year, with cash on the end of the balance sheet, by the way, with a $1 billion credit line that has no outstandings on it at all. And we have leases in place with companies like PUMA, with companies like Splunk, with residential development that will come online throughout -- late in 2020, into 2021 and 2022. So when you sit today and you say, well, okay, who's got a plan with sustainable growth and not just for those 2 years but continuing? There aren't a whole lot, I don't think. There is more uncertainty today, as what -- as you all know, for a variety of reasons. This is the time you look for the best-quality real estate. That's the reason that you should own Federal Realty. But that's the reason last year, the year before that and next year. It's not a how about now thing.

So we've started each of these sessions asking about ESG, which is obviously of increasing importance for all company stakeholders. What is the one thing, Don, that your company is doing to improve Federal's overall ESG score over the next 12 months?

It's interesting that you put it that way. I don't believe the objective should be to improve the score. I believe the objective should be to improve your environmental, social and governance practices. And that -- it's interesting, from Federal's perspective, maybe it's because of the urban areas in which we do business, maybe it's because of the densely populated way that we have to construct, the way that we have to -- the way we believe in place-making in terms of creating environment. It's part of our culture and always has been. What I don't think we've done very well is to communicate that. And then to your question, Mike, you will see in the next 30 to 45 days up on our website our sustainability report published. I think what you'll see in there are things that we've been doing not to be able to report and increase our score but rather show you how we operate our business. Whether that is $1 billion or more of LEED-certified buildings that we have in place today, whether it's millions of square feet of solar on our shopping center roofs or at least 1/4 of our shopping centers, whether it's the urban farming that we do at mixed-use projects like Pike & Rose or the honey from beehives that we have at Assembly Row, it's part of the culture. We didn't do that for score; we do that because those are the communities in which we serve and those communities demand it as do we because we live in the communities in which we serve. So -- and I will say I believe we are the only REIT in the country that has a LEED-certified neighborhood development gold certification, and that's for Pike & Rose development. That's pretty cool, the only REIT in the country that has something like that. So it's been part of our culture for as long as I've been there, and that's 22 years.

Don, as you think about sort of bricks-and-mortar retail, clearly, there have been challenges over the last number of years. How do you think this coronavirus situation -- if it were to have a greater impact on people's lives and just going into public places, which obviously going into your destinations, experience-based retail, if that pulls back, what can it do to the retailer community that is already suffering, right, and this is like the last sickness that they need to come about, how do you protect your cash flows in that environment? And how do you sort of think about, a, the absolute impact to Federal but the relative impact to other retail owners? And maybe just talk a little bit about that aspect.

Yes. Well, listen, the uncertainty surrounding coronavirus, the uncertainty surrounding this election, the uncertainty surrounding the future of retail, you can pile a whole bunch of things on top of the uncertainty train. When you are a long term-thinking and a long term-acting company -- and we are. We don't just talk it; we act it. Investments we are making are for decades and not for the next quarter or the quarter after that of earnings. When you understand who we are and where we are, we are part of the fabric of every community. And sometimes that's necessity-based; sometimes that's lifestyle-based, but it's always part of the daily living of each community that we're in. So to the extent this virus expands to a level that we don't anticipate at this point, but should it and start impacting those communities, yes, there's no question that there will be softening demand. But if as is equally possible, the real issue that we'll be left with 6 months from now is supply chain disruption, which I think is the longer-term questionable piece of this, then that actually worries me a little bit more because it depends on the products that our retailers are selling, it depends on the construction and materials that are being delivered that have to -- that are necessary to construct and complete. And so there's -- it could be far-reaching. I don't think when you run a real estate company, there's all that much reactionary that you can do. I think basically, the most important thing companies can do are invest in the right places in the first place, be as strong as you can be to be able to handle whatever comes your way. It's really not much different than the virus itself in that the stronger folks will be able to blow through it. That's how I view Federal Realty. We have the best real estate in the best markets with the -- and are most tied into our communities in which we're in. And to me, that gives us the absolute best chance of being able to blow through it, if you will. That's how I see it.

Don, if we did see a supply chain disruption on a larger scale, I don't want to make this sound insensitive, but are there beneficiaries of that in terms of retailers or retail segments? And who -- to who is it the most detrimental?

I don't know specifically, Christy, the answer to your question in terms of exactly who. But sure, in terms of anytime there is a void in one place, that void is -- somebody else tries to fill that void. And whether that is a retailer that sources more domestically or whether that is a restaurant that is effectively serving healthier product, whatever that might be, someone will try to exploit the voids that are in the marketplace. Again, from a landlord's perspective, and that's how I always have to look at it -- because we're providing the canvas on which you're painting. And so if that canvas is the most flexible and the most valuable, then whatever the positives or negatives that happen through, on balance, we'll be better off. That's how we position the company.

And your -- as you mentioned in your remarks, I mean your development and redevelopment pipeline is very large today. You've got $760 million in CIP at the end of the year. You're adding another $400 million in 2020 and another $300 million in '21. What do you feel is the most appropriate level of development activity as you think about what's sort of outstanding as a percentage of gross asset value? Especially, and I know you don't invest for cycles, but you -- and as you think about maybe we're kind of near the end of one.

Well, yes. Well, it depends on the nature of that development because all dollars invested are not created equal. One of the best things that we have right now is the timing for which we built the first phases of Pike & Rose, the first phases of Assembly Row, the establishment of Santana Row, effectively the acquisition of CocoWalk, et cetera. The timing that we did that, we are now adding incremental phases. The places are already there. The places are already established. They're already part of the fabric of the communities in which we're doing business. So an incremental office building with retail under it, residential building with retail under it, like at Assembly Row, is far less risky than it would have been if we were starting a brand-new mixed-use development of the size and scope of Assembly Row today. Thank goodness we're not because of the strength of the balance sheet -- it wasn't an accident, because of the balance between core and development that we've always employed. We never stopped during the 2008-2009 recession in planning. So we're in a position today where, whether we're at the end of this cycle or whether it continues, we have derisked our development pipeline. Virtually all of that $760 million, including the $400 million of incremental development that you'll see this year, we've derisked it by doing it at places that are already established with the lowest cost of capital in the sector. There are no 2 better ways to derisk development than those things. And so I feel pretty good. Look, at the end of the day, I know that, that cost of capital is dependent upon a big core portfolio that produces a growing stream of cash flows. That portfolio is largely retail, and retail certainly is challenged. There are holes at the bottom of the bucket. And that is certainly the case; that will continue to be the case. But the stuff we have going in the top -- at the top of the bucket more than compensates for that, which is why we can continue to grow and not have a whole bunch of excuses as to why we have to sell a bunch and why next year, we'll be this or whatever. It's a continuation of a very long-term business plan, and I don't expect that to change.

And so as you think about derisking not just those projects but your entire portfolio and you think about trying to avoid the bottom of the bucket, can you talk about the health of different retailers today along the spectrum? On one hand, you have the legacy, more established retailers that are having their own issues. And then on the other hand, you have sort of newer emerging retailers that are investor subsidized without a clear path to profitability, right? So how has your view on tenant underwriting evolved?

Yes. Christy, very balanced because everything you just said is true, and there is no, at least in our point of view, kind of magic elixir of this is how it should work. Every retail decision -- retailer decision and every investment in a retailer is a specific decision based on the dynamics of that particular property. One of the things that seems pretty clear to me is that struggling retailers, because it is -- master of the obvious so I'll say it, but it's important to say: struggling retailers are cost-focused. You're struggling, the accountants have taken over. It's about the lowest amount of rent. It's about this kind of deal and that kind of deal. Strong retailers are top line-focused, makes sense. Those folks are much less rent-sensitive. Those are the folks who want to be in the better real estate. We happen to have the better real estate. And so interestingly, when you talk about tenant improvements, TI, when you talk about capital that's invested, I think it's really interesting to think this through a little bit because it's a big issue today. And every dollar of TI is not created equal, and let me give you a perfect example. If you have an investment in a tenant at a great piece of real estate with strong prospects for growth, is that investment, is that TI the same as a lesser-quality tenant who needs the money effectively to -- as part of their cost exercise to be able to reduce the rent to go in lesser-quality real estate because they're cost-focused? They're both TIs. Say it's $100,000, it's still $100,000. One is an expense, I would argue, and one is an investment. And that mentality has to be carried out on a deal-by-deal basis. And that's kind of what we see, Christy. The revenue-generating, the growth-oriented companies are far less rent-sensitive obviously than those that are really struggling. What we're trying to do continuously is to proactively get rid of those tenants that we don't believe have a future and replace them, in conjunction with the redevelopment because we always want more and better use for our real estate, with those tenants that have a great future.

And as you think about investing those TIs in those types of retailers that are private and you don't necessarily have, how much are they allowing you behind the curtain in looking at their revenue growth and their profitability so that you know what you're putting your money for?

Quite a bit, quite a bit, I can tell you. And here's the deal we just did with -- on a piece of land that didn't have another -- a lot of uses to it with Carvana. And so the notion of, okay, you're going to invest in Carvana? Who knows if that's going to make it, et cetera? Well, we were able to get behind the scenes pretty darn well there. We were able to make a specific decision about a piece of land for which we were looking at what our alternatives were. And on a risk-adjusted basis, we made a decision. That's -- that level of analysis, that level of thought to me is required with each and every property. One of the advantages of Federal is that we are not that big a company. We have 100 assets or 103 assets, 24 million square feet. I can tell you that I have been to and know inside now, in the 20 years I've been at the company or 22, every one of those assets a million times. So these decisions are not done by committee by saying how many deals we can do at once in order to keep our same-store growth up or any of that stuff. Our decisions are made individually based on capital allocation, which is what I think you really pay us for.

How about as you think about -- how do you think about your cost of capital today, right? You've got -- you talked about spend of another $400 million that you're putting into the pipeline, spend in the $450 million to $500 million range. But you've also had yields come down as construction costs have risen in sort of the environment. How do you think about the investment -- that level of investment relative to your cost of capital today especially given the disruption in the capital markets?

Go get them, brother.

Look, I think we've set up the company and the balance sheet in a way that kind of gives us multiple sources of capital to attack. And obviously, with rising construction costs, mitigating yields and so forth, I mean that goes into every single capital allocation decision we have. We try and source as best we can from utilizing internally generated cash, of which it's $75 million to $100 million a year on average and where we can see that projected over time. Selling assets at very, very attractive yields, significantly attractive yields relative to kind of where we're buying assets. In 2020, we're actually going to have accretion from our asset recycling program and the fact that we're selling assets at lower yields than we're actually reinvesting it into new developments or whether it be new assets. And those are 2 very, very attractive components. If we can sell assets at IRRs -- unlevered IRRs in the 5s because we understand kind of what the growth trajectory of those assets are and redeploy it into our development, we think that's a very good capital allocation decision. Leverage-neutral debt capacity is another source. Because we're growing EBITDA, because we do grow every year, we create leverage-neutral debt capacity. And so all of those components kind of give us a -- we're not relying upon equity this year if we don't have to, which kind of given where we are, we feel very, very fortunate to be in that position where it's not critical for us. We will if it avails itself, but that's not a critical element of our business plan this year from a capital perspective.

It's just as you increase the level of activity that you're doing, there's an offset there because you have the $75 million to $100 million of free cash flow, but then your -- the more you do, the more you have to supplement with equity raise or dispositions. And that's a higher cost of capital obviously.

No. Christy, I mean you're 100% right. And the point on construction costs is to remain to that. There is no question that having a use of capital on a risk-adjusted basis that incrementally on development provides 150 at a minimum basis points over the cost of a stabilized asset that way, in a risk-mitigated project, seems to us to be a very good use of that capital even given where we are in terms of cost of capital. The construction cost increases clearly are stopping a lot of development in this country right now. No question about it. You can only make those numbers work to the extent you're in places where that -- obviously, the rent will be able to support that. We're finding, and I'm really kind of proud of this, the office users in particular are demanding the amenity-based communities that we are delivering and, as a result, are willing to pay up for that. Similarly, human beings who want to rent an apartment are paying up to have that level of amenity-based efficiency, if you will, with them. I don't think that ever changes. Once you get used to all of that efficiency, those services, that quality, it's really hard to let that go. And so we do think about this very much for the long term. And we also know that where we're putting that capital has historically -- and I see that -- this only getting better, not worse, has historically grown better than assets which are kind of one and done. This is what they are. The places we're talking about mature over decades. We can show you that at Santana Row. We're starting to see that at Assembly Row. It's pretty clear to us from Bethesda, Maryland. So investing with today's cost of capital and today's construction cost is tighter than it's been, no question about that, but still sufficiently accretive on a risk-adjusted basis.

Is there questions in the room? Okay. There's one that came in through live QA. Don, have your long-term growth rate expectations changed over the past 5 years? And if so, how have they changed relative to going up, down or being the same?

Sure, sure. Let's -- so as you sit here and you ask me that on March 2, 2020, absolutely. The whole status of the macro market and oversupply of retail suggests that, that will be lower. That rate will be lower than it was in 2000 -- then I was thinking if on January and March 2, 2016. Having said that, we know this is a cyclical business, and cycles not just because of recessions and things like that but cycles because of things that change in consumer preferences, et cetera. Everything that we're doing, Michael, is about Federal 2025. It's why I'm very comfortable that '20 is better than '19 on a cash flow basis, '21 will be better than '20 and '22 will be better than '21. And so to -- whether that can get back to levels of 6% and 7% growth, I don't know as I sit here today. I think there's just too much uncertainty, and we clearly have an overretailed country that takes a long time to work its way through. Having said that, I can't think of an organization that is better positioned to continue to grow and potentially get back to levels like that than us.

Any questions? In regard to California, so the city of Santa Monica is looking at potentially redeveloping Third Street Promenade. You're getting back a space there. Banana you've talked about, been very vocal about you're not really sure what you're going to do, what sort of the plan there is.

We're pretty sure now.

You're pretty sure now? Okay. Good. Well, then maybe...

We're not sure enough for me to tell you now, but we're pretty sure now.

Oh, I mean you can't say...

All right. Finish your question, I'm sorry.

And so my question is, do you have any insight into what the city is planning? And how does that impact your plans with regard to that space?

Well, look, the -- when you look at the city of Santa Monica, it's obviously -- it's a great place. And the citizenry of Santa Monica is very proud and very specific in terms of what they would love to have happened there. They have a mall at the end of the street that has its issues. They have a street that has its issues. There's a lot of nervousness associated with that. When we look at each individual building that we own and think about how we can play a part in Santa Monica 2025, we know that our corner property right on the corner of Wilshire Boulevard and Third Street, the third block, if you will, up from the mall, is a building where we're very close with a user for -- it's 3 storeys. It's a Banana -- 3-storey Banana Republic: basement, ground level and second floor. Therefore, the basement and first floor, we're very close on the deal. That would be terrific for everybody. The second floor, we're going to do office. And again, it's the same thing that we're seeing. It's really kind of cool. In almost every urban market that we do business, we want some kind of small piece of office. And what people will do with businesses who -- whether it's high net worth, whether it's architecture -- architect's offices, whether it's real estate offices, et cetera, to not have to go on major roads and commute is -- knows no bounds. When you think about the coworking space and does that have a place in the future, I very much think it does. I'm in a conversation today with Industrious, and again, I think those guys are the grownups of the space, frankly, in terms of what's happening there. There's clearly a coworking model that can go somewhere. That's not what we're talking about for Third Street, just to be clear. Okay. So I didn't say that, all right? But the notion of densely populated places where you can have 15,000 or 20,000 or 25,000 square feet of a place for locals to work is a real positive and, to me, a real trend.

How has your views on coworking evolved? I mean just as a follow-up to that, Industrious has a good model. Does it make you more risk-averse in regard -- what happened with WeWork, does it make you more risk-averse in thinking about future dealings with coworking operators?

Well, no. So because we come from a retail background, the notion of merchandising, the notion of a space, if you will, that -- which tenant goes next to each other is inbred in how we think. It's not been part of the office model. Whatever accounting firm and legal farm or whatever else is in the building, whatever, as long as they can pay the rent and the credit is good. I think that's changing. And so I do think the notion of having a product -- because coworking is a different product, having a product as part of the merchandising, if you will, of an office building has a place. That depends on each particular place. It depends on the deal that you cut. It depends on the economics, all of that. But I see it has a place. And we'll see if WeWork finds its way back. It's -- I think they got a great man in Sandeep, as you know. I feel that way about him, to see what that can turn into. But there is a product there that when managed correctly should have a place in a mixed-use community.

And on the call, you mentioned potentially looking to invest more in the New York area. Would you look to buy more in Hoboken? And how do you feel about New York City street retail today as a -- given the dislocation that's occurred there?

So many people ask us, are your rents too high? And one of the things that I love is that for a lot of the places that we have chosen to be, our rents are too low. So when -- and I'll get to Hoboken in one second. But when you go and look at Assembly and if you were to talk to the PUMA CEO who signed a 150,000 square foot lease, and you say, why are you here? And he'll talk about the amenity-based and all that. He'll also say because it was cheap, because the comparison is not with suburban office somewhere else. The comparison is what South Street Seaport. It's with expensive -- more expensive areas downtown by just being on that first ring outside. That's how we view Hoboken. And when you look at everything that's happening on the west side of Manhattan, all the space that used to support Midtown has effectively been gobbled up by an amazingly ambitious project in Hudson Yards and all that surrounds that and everything else. But the rents in Hoboken, our average retail rents are $50 a foot. They're not $200 a foot. It's $50 a foot. A lot for a shopping center company? Sure compared to some shopping center in Indianapolis, right? It's $50 a foot, expensive. For that proximity from Manhattan? It's cheap. And so it's all about making sure you're comparing to the things that you should be that are comparable obviously in terms of decision-making that's happening. We do like Hoboken. Now everybody knows we're interested in Hoboken up until the prices and it's harder to get more product in Hoboken. But the idea of that side of the river being a beneficiary to what's happening on the west side of Manhattan is -- to me, it's hard to argue with.

All right, Don, we got rapid fire. Will the shopping center sector have more or fewer public companies a year from now?

Fewer.

Same-store NOI growth for the shopping center sector, not Federal, in 2021, and for reference, 2020 guidance is?

1.8%.

1.8%?

2%.

What will the 10-year Treasury be a year from now? It's $1.07 currently.

I don't know, man. $1.07.

Oh, you say flat?

That's what I'm saying.

Okay. And in what year will the U.S. enter a recession?

2024.

2024. Great. Thank you so much.

I don't know. Mike, I don't know.

Thank you.

All right.

Thanks so much.