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

Move on to the 7:15 a.m. session at Citi's 2023 Global Property CEO Conference. I'm Craig Mailman with Citi Research. And we're pleased to have with us Federal Realty and CEO, Don Wood. This session is for Citi clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AV desk. For those in the room or the webcast, you can sign onto LiveQA.com and enter code citi2023 to submit any questions if you do not want to raise your hand. Don, we'll turn it over to you to introduce the company and any members of management that are with you today, then we'll turn it over to Q&A.

Well, thanks, Craig. Good morning, everybody. You know, I don't know what we did to Citi to piss them off to get the 7:15 slot here. But really can't thank you guys enough for being here. Anybody can listen on the webcast, but having to hear in person is helpful to us. To my left is our President and Chief Operating Officer, Jeff Berkes. We've been together over 20 years. To the right, the Chief Financial Officer of the company, Dan Guglielmone. Guglielmone. No one has it, no one gets it right, just Dan G, that works all day long. And Vice President, Head of Investor Relations, Leah Brady. That's it. Do I just go off, Craig, or do you ask me a question to get started? I don't…

Can you give a brief overview of the company? Or we could dive right into the questions. It's up to you.

Let me give you a preview of the company a bit. So I think a lot of you know something about Federal. But there's a couple of things that I think help put the whole company into perspective. We have been around a long time. This is one of the oldest REITs in the country, formed in 1962. We are basically a coastal company. So the perspectives you're gong to hear today include a lot of the perspectives of the first ring suburbs around Boston, New York, Jersey, Philadelphia, Washington, D.C., Miami, and South Florida, Northern Southern California. So that's the perspectives you're going to hear. To the extent you want to know something about what's happening in Oklahoma or what's happening in Texas, I have nothing to say to you. So just keep that in mind. We are real estate people. And what that means is, while we clearly are a retail real estate company, what we really do, if you think about a company that was formed on the East Coast in the 60s and 70s and 80s and 90s, what happened over that time is those first ring suburbs really densified, really got affluent. And as a result we, as real estate people looked at our retail and in a number of places said these places have become dense and affluent enough for us to go up. So about a third of our business is mixed use real estate. And it grew organically out of the business plan based on the markets that we're in. That gives us a perspective on residential and office in addition to retail. But the only time we have that perspective is when we built a ground floor base of what I think is some of the best retail product in the country. The overall portfolio is huge on hand selecting assets. And so this isn't a company that grew to $12 billion in total capitalization via acquisition of portfolios. It's been a one-off selective journey all the way through, really solid balance sheet. The whole idea of this place is we know this is a cyclical business. We know what cycle we're going into now. We knew what cycle we were going into in '08 and '09. How do you build a portfolio and run it for the long term for a consistently increasing stream of cash flow? And that, if you think about that as the genesis for every business decision that we make, you'll understand Federal a whole lot better. So real high quality retail and retail-related mixed use properties, coastal, that's who we are.

Great, Don, thanks for the intro. We're going to start with our opening question here. So what are the top reasons an investor should buy your stock today?

Look, the bottom line is we have found over a very long time people with money, lots of those people and high barriers to entry are critical to be able to keep that cash flow stream growing through cycles. We have the best demographics by far of anybody out in our space. In addition to that, if you look at what we do, because our business plan is so multifaceted, including a development component that is no more ever than 10% of our business, but an important component nonetheless and you look at our construction and process on the balance sheet, visible growth. So you've got high demographics, very visible growth, which not a lot of companies can show you visible growth in '23 and '24 like we can. And earnings multiple, which while trading at a premium, as it should to the rest of the industry, is the tightest premium that we've had in basically a decade. And so to me, you've got great demographics, you've got a way to look out and see the growth that we're going to get and we're relatively cheap. I don't know what more you want. That's shelter in a storm for a time like this.

Great. And Don, you've always had a lot of conviction in your view that demographics matter. Can you go through what makes you so certain and how that is kind of differentiating you as we're going into maybe some softer economic conditions?

Yes, I think that's a really important question, Craig, because over the last few years demographics haven't mattered nearly as much. They haven't mattered nearly as much because of what happened in COVID. This country put out over $5.5 trillion of stimulus. And the notion of that amount of money and that amount of dislocation among the consumer base was effectively a rising tide that lifted all boats. And so it obscures the difference in, well do demographics matter. I've heard people say to me, "I overplay that, Don, it doesn't matter nearly as much." Nothing could be further from the truth. Take a look at any previous recession. I've been at this company since '98, I've been running it since '02. Think about economic conditions over that period of time. It is crystal clear, people need to have money to spend in down cycles. They need to be able to choose where they're going to spend it. And lower demographic areas, of course much more to food and only essentials. In higher demographic areas, that's dependent upon that family. They've gotten much more flexibility to be able to determine where that money is being spent. It is critically important. And time shows it. It's not my opinion. It's what happens through cycles.

And to that end, given your locations, your tenant base, the demographics, could you just talk a little about kind of the mark-to-market in your portfolio, the ability to continue to push rents even if things slow down a little bit. And just kind of give a broader sense of where you think the overall mark-to-market is today.

Yes. And this is a really important point. One of the criticisms against Federal that I've always heard, and I've been hearing it for, gosh, for 20 years, "Hey, man, your rents are high. There's nowhere to go. How do you how do you continue to increase rents? I mean, you know, what are you going to do?" The answer is really clear, in our markets, the ability to continue to increase rents is very, very clear. Just look at where we sign leases versus what's in place. And absolutely are in places $29 or $30 or some kind of number like that right there and $30 and look where we sign leases. We're regularly signing leases in the high 30s, the mid 30s, the 40s. And that when you think about an inflationary environment, look, if we don't get inflation under control, and you're talking about an economy that inflates at 8% and 9% and 10% annually, then that's a problem. And that's a problem for everybody. I don't believe that will happen. I believe the government is very powerful and we'll be able to get that inflation under control as we're starting to see a little bit. 3%, 4% inflation, really good for our business. And even if you look at and think about the type of negotiations that you've seen at Federal over the past couple of years, that increase in inflation gives us more leverage to push rents. And those tenants capitulate because they understand inflation. It's harder to push that early on. But here's the hidden thing that most, that companies don't disclose. Once you sign a contract, you sign a lease, okay? For 5 years, for 10 years, for 15 years, et cetera. Inside that contract, contractually, what are the bumps? And many, many companies don't have any significant bumps in those leases. In an inflationary time, that's killer. That means that your real estate will be worth less at the end of that lease than it is the beginning of that lease. And that's a problem. We have the highest, I believe, inherent contractual bumps inside a rent, inside a deal. On average 2.25% per year. That includes anchor deals which don't have a lot of bumps in them and includes a lot of small shops that grow at 3% a year or 4% a year in great shopping centers. That overall inherent contractual bump is a much more important fact than the rollover that is the common way people look at it. Rollover is important. It's a component, but it's only half the story. You have to know what the contractual bumps are. And we've been trying to disclose that and get that out more. It's not universally disclosed. I'm hopeful that it will be as a result of our pushing it, but it makes sense. If you got the best real estate, you've got the best chance to get a tenant on the other side who you can't just dictate to, you got to negotiate with, to increase throughout the life of that contract their rent by 3% a year or something like that, because they believe they're going to make money in that particular location with the cadre of other tenants that are around them.

And Don, you bring up the annual bump topic, which I think is important. The companies that do disclose that you guys are 25 to 50 basis points ahead of them generally, how much of that is the differentiation in your portfolio, maybe not having as much grocery, which is a little bit tougher to push versus your location, your just internal kind of leasing mentality to get the most out of tenants and being able to do that.

Craig, it's a really, really good question. The notion of the -- so today, groceries invoke big time. I mean 4 years ago I was worried about the industry not effectively being able to keep up with Walmart keep up with everything else that was going out there in the grocery business. Today it's one of the healthiest businesses around because of COVID and what has come from it. We've got a ton of groceries. I think 7 out of 10 of our properties have a grocery component, some kind of number like that, so it's important. But the leases as you would imagine, from any anchor, don't generally have bumps in them that are significant, maybe up 10% after 5 years et cetera, flat for periods of time like that. That's natural. But when you think about what you're trying to do with a piece of real estate, the notion is not just about that tenant. It's the collection of the 40 or 50 tenants within that entire retail destination and the correct balance, which there's no right or wrong, because real estate is local, but the balance between small shop, regional and anchor, whether it's a grocer or a TJX or whoever it is, is critically important. One of the biggest problems I have is with small grocery-anchored shopping centers that have a grocer without rent bumps of any significance. Maybe a drugstore, dry cleaner, pizza guy, but that grocer has complete control of that small shopping center. And so you get a nice cash flow stream, but it's flat man. And in a recessionary time, and over 10 years or 5 years or whatever else that shopping center will be less, worth less than it was before. And that's an asthma to what it is we're trying to do. So it is that merchandising mix. Obviously, if you create the right mousetrap, you're able to push small shop, which is a big part of what we do, small shop is an important part of the real estate business because that's where you have more leverage as a landlord over the tenant. And so that correct balance is one of the things we work on I think more than anybody.

That's helpful. And maybe shifting to the retail landscape generally, right. There's a couple crosscurrents here. You have inflation, but the consumer's kind of held up sentiments improved from the lows maybe over the last couple of months. Unemployment continues to be strong. And there's good demand, right, and we're kind of past the point for where people are taking space for '23, now they're looking out beyond '24, '25. I'm kind of curious your views on how maybe the economic weakness that could happen, is expected to happen back half of this year, is going to impact that leasing or is it just a timing kind of discrepancy where we might just be able to push through it?

Look, there's so many factors in that question, so many things that affect any business. But here's the point, right, if you truly are, and I know most investors don't think long-term and that's an issue for me, for us, because we have built this place to try to get through the inevitable cycles. We are clearly going, starting to go through and will go through a cycle over the next few years. I've said nothing like that the sky is blue with that common, no kidding. We just don't know how deep the trough will be. But if you build your portfolio with that long-term focus, which means with the right type of tenants, and today I will say this is commonly been said and I do believe it's true, COVID did kick out a lot of trouble tenants, those marginal tenants, 2018, 2019. They're gone in the middle of 2020 and 2021. So the basic tenant roster, if you will, is in better shape, I think, than it normally is going into a recession. And that bodes well, that's important. But certainly you're going to hear about -- I haven't seen this yet, I keep waiting, but I haven't seen a lot of tenants reducing their opens to buy. There is clearly a recognition of high quality real estate and there are just a limited number of high quality spaces available for tenants. An inflationary environment allows you to push the economics of those tenants more, that's a good thing. But certainly you would expect the open to buy of a number of stores, what we're going to do, bank financing, to be a headwind over the next couple of years. I simply ask you, when that happens, when the inevitable retailer says, man, I was going to open up 75 stores, we're going to do 25 a year. What 50 get cut? What 25 go forward? And the reality is very, very, very infrequently is it about what rent we're going to pay. It's much more about where's the long-term insulated shopping center where I can make money I believe on the tenant. I believe I can make money over the next 10 years. And inevitably, in times like this, that's the highest quality centers. That goes back to the demographic question that we started here with. That's what I think. Do I expect to see a softening of demand? Do I expect to see slower consumer spending? Yes. Anybody in here who says this week, no, everything's going to stay exactly the same, it's the way it's going to be, please don't listen to that, it just defies logic. So the notion of, yes, but what where and how. We forget often how local a business this is. And I don't envy any of you guys, because you have to make macro assumptions by definition. But I would implore you, in a time where that government subsidy has basically been burned through, in a time where I would bet you some more typical, not COVID related, but more typical cyclical activity is going to happen in a downturn, I would ask you to dig a little deeper and try to understand the importance of a particular location, a particular region, a particular tenant base. We're going to take some folks, I don't know where, how many are going through on Wednesdays to a shopping center that we have, I don't know 5, 7, 10 miles from here in Davie, Florida called tower shops, one that we bought in 2011. If I could show you because I'm going to show them, whoever is going to be there, what happens to the NOI, the property operating income of that shopping centers since we acquired it, how much money we put into it, what a redevelopment was, how much the expansion worked in who the tenant base is versus who the tenant base was, it would be so crystal clear to you that that's how you create value and cash flow both in a piece of retail real estate. And I'm going to try to ask you to ask for numbers like that of any other shopping center that's around there. So you can see the difference. It really is a local business. I don't even know what the question was, Craig. I went on.

You answered like 15 questions I may have in the future.

I get on a roll. I'm sorry. I apologize. I love what I do.

I am getting some questions coming in about tenant watch list, bad debt, in-guidance, you clearly layered in I think about 50 basis points generally, another 60 basis points for some specific tenants. Can you talk about any conversations you're having today or your guys on the ground about potential manifestations of this? Or is this still very much a kind of plug at this point for maybe the back half of the year outside of Bed Bath, which we can get into, but.

I'm going to do macro and then get a more specific on this. So over 20 years, on average, bad debt in a particular year, about 1% of revenues, about 1%. During good years, 0.5%, 0.75%. During the Great Financial Crisis, hit 3% in '08 or '09, whatever, whatever, it was here. I very much would expect '23, don't know about '24 yet. You guys may have a better idea to fall right in that average, which is more, 1%, which is more than it was over the past, past, well last year and certainly '19, '18, '17, '16. So that's kind of the, just to get your arms around the whole thing and then feel free to go into tenant diversity or whatever else you want to talk about.

Yes. And let's back up maybe a bit and pick up what you just mentioned, Don. You know, we have an extremely diverse portfolio. The largest tenant in our portfolio only accounts for 2.8% of our revenue. And when you get down below that, only 7 tenants account for more than 1% of our revenue. So the portfolio is extremely diverse not only by name, but also by category. We're not all in on any one category and we have some great disclosure in our investor presentation about that. And so far this year, which we think is important, we, you know, obviously if you're heading into some time on there, some headwinds, having a highly diversified portfolio is significantly important and doesn't expose you to any single tenant failure risk. We haven't seen so far this year anything that would indicate that we're not going to be close to the range that Don is talking about. Tenants are paying the rent, tenants are making money in our portfolio. That's why our leasing has been so strong, driven by the strong income around our properties. We talked a little bit about the population density around our properties, but the incomes are just on average off the charts, over 10 billion of spendable income within 3 miles of our properties. So far so good. And Dan, I don't know if you want to add anything to that, but we're on pace.

Yes, sure. Yes, I'll just clarify. I mean we talked about, in our guidance range for 2023, we had a base level of 75 basis points and then an additional incremental separate from our largest exposure watch list tenant, which would be Bed Bath & Beyond of 25 to 60 basis points. So a little bit above the 1% kind of historical average kind of 1% to 1.3%-ish.

In guidance.

In guidance, right. Okay.

You're going to use it.

We are on the low end of the Bed Bath & Beyond exposure, less than 70 basis points. We're out in front of this where when I joined in 2016, we almost 2.5% exposure to Bed Bath, down to less than 70 basis points in our 2023 expectations. We have a lot less exposure to other watch list tenants, all single digit, 4 basis points, 6 basis points, for folks like Party City and Tuesday Morning. So really, I think we're in a very, very good position with exposure. So the tenants that I think all of the open-air sector is worried about. And so I think we're very well positioned there as well.

So in aggregate, what do you think the watch list comprises of ABR and why -- how you guys measure it?

I think the near-term concern, we have less than 1%. Well, I'll take, just to make the point clear, take the all 100% of the income from Bed Bath, 100% of the rent that we get from Party City, 100% of the rent that we get from Tuesday Morning, let's throw Regal Cinemas in there. I don't think we have any Regals.

No, we have no Regals.

Throw Regal in there.

Right 8.

Throw Right 8 in there, take that whole pile, less than 1% of revenues in the company. If it all just went to 0, which it won't. It's a really diversified, high-quality portfolio. Important to understand in '23 and '24.

Maybe shifting a little bit to external growth because we've hit on a lot of the organic. Could you just go through some of the external levers, perhaps touch on development acquisition dispositions? And maybe some thoughts around the moving target of where cap rates are now, maybe going to, how you think about return hurdles internally vis-a-vis your cost of capital?

Yes. You want to do that?

Sure. I mean obviously not a lot of transaction volume. So it's hard to say where cap rates are, as you point out, Craig. We've, for a long period of time, always looked at our cost to capital on a long-term weighted average basis. So when interest rates are low and multiples were high, we weren't chasing deals down into the low 4 cap rate territory. And similarly, as cost of capital rises and cap rates rise, we feel we're thinking long-term about those opportunities. And to the extent we can find them, and we're always in the market, acquisitions for us is not an on-off switch, it's a volume knob. To the extent we can find them, we're going to execute on them. The center that Don mentioned a few minutes ago in Davie, we got that coming out of the Great Recession, financial crisis in 2010. So we've got our eyes peeled for those opportunities. Right now market is very slow, few things kicking around out there. But we'll be well-positioned to take advantage of that. And I think, Dan, you probably have the numbers a little tighter than I do. Since the pandemic started, we've invested a significant amount of money in assets that we think have great go-forward growth potential, largely funded by dispositions of assets that we think are slower growth. So when…

I mean, how much, '21 and '22, roughly $1 billion of acquisitions that I think we've done a really, really good job shaking free generational kind of opportunities during that time period, taking advantage of some of the fear and owners during the period of COVID. And what we're finding is that we're actually outperforming significantly, 50, 75, 100 basis points, depending upon the asset, what our original underwriting was, which has been another source of better leasing, better operations, seeing opportunities to push rents where we didn't underwrite it that way. I think we see that as an additional source of upside in terms of the $1 billion that we put to work in the last 2 years in terms of outperforming what our expectations were.

Yes. I'm going to see if I not get kicked under the table because I want to make this point, it's really, really important. Acquisitions in and of themselves don't create value. You buy something, yes, maybe you buy it a little better than you thought, so there's maybe some incremental value on day 1 but it's what you do with the asset over the next period of time that creates the value. There is a very long period of time in this industry, in the early 2000s when acquisitions were all about being accretive in year 1 to earnings. And that's not unimportant. It's something, but it's not everything. Because if you buy the wrong asset at a nice high cap rate that's accretive to your earnings initially, but it is not bulletproof for changes in the economy, what you'll wind up doing is spending the next decade, selling off all the assets that this is really -- we're a much better company because we're going to sell off all the stuff that we shouldn't have bought in the first place. And so the notion during periods like this of buying assets, if you're going to be acquisitive, buying assets that are generally on larger pieces of land because that gives you more opportunity to do things down the road and the ability not only to push rents, but potentially to redevelop. And redevelop does not mean splitting a box into 2, redeveloped means having GLA, creating a different environment for consumers, significant different environment, et cetera. When you do those things, that's where value and cash flow get created over the ensuing period of time, not just accretive for the year you bought it. Sorry, I had to say that.

And maybe away from acquisitions though because you guys have created a lot of value through development, you have a pipeline, right? How do you think today about where we are in the cycle, the balance sheet is in good shape. But again, return hurdles are moving because your cost of capital is moving. How do you get comfort underwriting that today? Maybe what kind of buffer do you need in the pro formas today versus 24 months ago that make you feel comfortable?

Really good question. If you think about us as having a dashboard out in front of us of -- with dials on them. And one of those dials, the acquisitions that Jeff talked about, one of those dials is development opportunity. And certainly over 2 decades for us, that development opportunity, we've become very proficient at what we do. Certainly that doesn't mean that in any period of time, we don't turn that dial down. Turn up the acquisition dial, et cetera. The economy and the marketplace determines when you turn dials up and down. You don't turn them on and off. You turn them on and off and you can't rebuild them again, which is why I think lots of companies don't have sustainable development operations. Right now it's a difficult time for us to turn up that dial in development. Development, you need to know 3 things. What's it going to cost to build it, what the rent is going to be when you do build it, and what's the timing of that to all happen. And certainly, over the last year or 2, what it's going to cost, big issue. I will say that's ameliorating now. That's starting to get far more predictable. I'm liking what I'm seeing in terms of about the ability to predict cost. I also like the ability to predict rent and where that rent is going to be at the culmination of that. What I'm not comfortable with yet is the timing of that. And so from my perspective today and probably for the next 6 months, we'll see as things change, but we have over the last year and will continue again for at least 6 more months, turned down that development spicket. But we do have, heck, 1 million square feet of truly shovel-ready projects. So that having that arrow in the quiver to be able to go back like that, critically important, again, to a long-term stream of cash flows that is not just dependent on one thing because the simpler the business plan, which is great when in a risk-off environment like now, I get that, right, but a simple business plan will make that company perform like a commodity. It goes up when times are good, down when times are bad, all that. What we try to do is to minimize that so that up is higher and down is not as low. That's what we try to do through cycles. And by having a multifaceted business plan, we've got a better chance of getting that done. And that's what's happened throughout a very long history, the exception of COVID where our markets were closed. They were shut off. You can't open your store in Maryland, in California, in New York. That was different than Texas and Georgia and Florida. A more normalized typical recession like we're about to go through, now I very much believe we will outperform.

Can I add one thing to the development.

Jeff, I got to cut you off because I got to do rapid fires real quick. Apologies. Same-store NOI for your property sector, not your company in '24.

I'm sorry, it's being a wise-ass. Can you start that again?

Same-store NOI in '24 for the retail group.

So caveat, I hate the rapid fires, I think it's nonsense, and I will answer everything, but take it for what it's worth. 2%.

Okay. Buy, sell, build, redevelop or hold in today's environment?

The real answer, you only want one. The answer is all. It really is. If you want to say buy, say buy.

Okay. And fewer or the same amount of companies a year from now?

Fewer.

Fewer. Okay. Thank you guys very much.

Thank you guys for being here. Appreciate that.