Federal Realty Investment Trust. (FRT) — Q2 2015 Transcript

Good morning. I'd like to thank everyone for joining us today for Federal Realty's second quarter 2015 earnings conference call. Joining me on the call are Don Wood, Jim Taylor, Dawn Becker, Jeff Berkes, Chris Weilminster, and Melissa Solis. They will be available to take your questions at the conclusion of our prepared remarks. Certain matters discussed in this call may be deemed to be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include any annualized or projected information, as well as statements referring to expected or anticipated events or results. Although Federal Realty believes the expectations reflected in such forward-looking statements are based on reasonable assumptions, Federal Realty's future operations and its actual performance may differ materially from the information in our forward-looking statements, and we can give no assurance these expectations can be attained. The earnings release and supplemental reporting package that we issued yesterday, our Annual Report filed on Form 10-K, and our other financial disclosure documents provide a more in-depth discussion of risk factors that may affect our financial condition and results of operations. These documents are available on our website at www.federalrealty.com. And with that, I'd like to turn the call over to Don Wood to begin our discussion of our second quarter 2015 results. Don?

Well, thank you, Brittany Schmelz, and good morning, everyone. It’s a pleasure to be able to report today that we’ve had a very strong quarter for Federal in all areas of our business. Strong FFO growth, strong same-store growth, strong lease rollover, strong occupancy, strong development deliveries, and more acquisitions in Greater Miami. Additionally, we mentioned an 8% dividend increase, raising it by $0.07 a quarter to $0.94, marking the 48th consecutive year of increased dividends, which is fantastic. Now let’s start with earnings. FFO per share was at $1.33 excluding, of course, the prepayment premium from this year and the retirement of $200 million of senior notes. This was 8% higher than the $1.23 earned in last year’s quarter as the first phase of the development project began to contribute, and the core continues to perform excellently. I want to highlight higher-than-anticipated percentage rent at Assembly Row and nice residential rent growth at San Antonio Row, which is especially encouraging. This is good news because, as we’ve discussed previously, we are very consciously investing in our team with higher long-term incentives to ensure we are well prepared to execute and deliver on our business plan and double our NOI in the next decade. Hence, this is part of the reason for the general and administrative expenses increase seen in the quarter. This is a very balanced approach to growing our business, as it’s not a quarter-by-quarter business plan. On the leasing side, nearly 300,000 square feet of comparable deals were executed in the quarter at an average rent of $30.41, which is 15% above the $26.36 that the prior tenant was paying. Leasing strength was broad, with both new deals and renewals registering double-digit growth across all three operating platforms of our company: the West Coast, the core, and the mixed-use portfolios. As an example, we are thrilled to announce our first deal with Macy's in the form of their first Macy's Backstage retail stores, which is their value-based concept opening this month at our Melville shopping center. Additionally, we saw strong renewals at the newly acquired San Antonio Center in Mountain View, California, and at the Village of Shirlington in Arlington, Virginia, particularly in the health club and theater categories, both of which come with significant upgrades to their facilities—a clear trend we are seeing in the theater business as compensation from newer, more service-oriented companies gains traction. Same-store growth in the quarter was strong at 3%, with the impact of redevelopments, and 4.8% with lease termination fees compared in both periods. The impact of redevelopment really benefited from an excellent job at Mercer Mall in New Jersey. As for asset performance at Mercer Mall, it truly reflects our quarterly development competency. It’s a transformed asset and is undergoing similar transformation to become more relevant in retail. Occupancy jumped during the quarter to 94.9%, while the percentage of leased spaces is at 95.7%, both up a bit compared with last year and the first quarter due to strong leasing momentum. As you can see, this was a truly impressive operating quarter. Now let’s move on to report some development news. First in Somerville, Assembly Row continues to mature beautifully, with most restaurants and retailers meeting or exceeding their first-year projections. We’ve clearly struck a chord in the community and are providing a needed service that wasn’t being met. Percentage rent is above our expectations, and the office building is nearly fully leased, with virtually all available space either occupied or under lease or LOI. The construction of the partners is on or ahead of schedule, and occupancy by partners’ employees is expected to begin next summer. That building is substantial and brings wonderful scale and perspective to the entire site. Check it out during any trip to Boston; it’s impressive. Our own construction on Phase II is just now getting underway and will start to deliver in 2017. The future of the Assembly Row section of Somerville is extremely bright, and there will be incremental investment opportunities here for at least the next six or seven years as we fully build out. Four hundred miles south is Pike & Rose in North Bethesda, Maryland, and there, too, we have lots of construction and exciting progress to report. Let’s start with the residential lease commencement at the Pallas high-rise building; we've signed 36 leases, which is about 11% of the building, in the first couple of months at rents at or above our pro forma, with the initial step of movement underway. The new parking garage will open next month as scheduled, providing over 550 additional needed spaces. Virtually all available office space in the first phase is now either occupied or under lease/LOI. As the second phase gets underway, we have signed leases or LOIs with some great anchors very early in the process, which should give you a sense of the direction we’re heading. Pinstripes, a 30,000-square-foot bowling and entertainment concept, will anchor the development. REI will relocate from a mile away to anchor Rockville Pike with 38,000 square feet. We are also nearing a deal with H&M for 25,000 square feet on one of the best corners in the project. We are continuously working on more leasing and have partnered with incredible names as we begin construction on the second phase, which is vital for creating the critical mass this site requires. Deliveries and store openings in this phase are expected to begin in 2017. Honestly, I can’t wait to showcase the project at our planned Investor Day there on September 30. I hope most of you are planning to attend. While there will still be plenty of construction on the interior upper floors of Pallas, along with some exterior trim finishing up, and with the second phase well underway at that point, it won’t be hard to see why we are so optimistic about the substantial value being created now and into the future. Meanwhile, on the West Coast, our first dozen tenants opened last week at The Point, which is our 150,000-square-foot addition to the Plaza El Segundo shopping complex in El Segundo, California. Thank you to the West Coast team for your insight and kindness over the weekend as they visited The Point; it truly means a lot to us. Eighty percent of that space is leased, fully executed, and we expect to open more tenants throughout the summer and fall. We know this will soon be a favorite gathering and shopping destination for the underserved communities in Manhattan, Hermosa, and Redondo Beach. Tenants like True Food Kitchen, Lucky Jeans, Madewell, Athleta, Mendocino Farms, and SoulCycle surround a large, attractive park-like public space that encapsulates what we are creating here. Significant value is being created from day one and will continue to improve for years to come. Perhaps the newest news to discuss is our well-studied commitment to South Miami. We previously reported on the CocoWalk acquisition with our local partner, Grass River, in last quarter’s call. Since that time, we have closed on several Coconut Grove street retail buildings in close proximity to CocoWalk to establish a more significant presence. We have also secured a larger retail mixed-use project just a few miles away with the same local partner, Grass River, and the due diligence process is largely complete, with a closing date expected in the next few weeks. Jim will provide more information on that to the extent we can during his remarks. My point in discussing this is that we have gone from a non-player in South Miami a few months ago to a very significant landlord controlling hundreds of thousands of square feet in just six months. The initial acquisition capital was roughly $200 million at a reasonable yield of about 5%, while we worked hard to create a significant repositioning and redevelopment plan. This could potentially allow us to deploy an additional $150 million to $250 million into these assets over the next five years. I am hopeful and confident that our experience from Bethesda Row, Assembly Row, Pike & Rose, Santana Row, and The Point, along with countless smaller examples from the last 20 years, places us in a unique position to achieve this. Even if we encounter setbacks, we still have excellent real estate and a very solid downtime buffer. As you can see, there's a lot happening across various segments of our business plan. We remain on track to double our income in the next decade as we have discussed multiple times over the past couple of years, and so far, everything is going well. Let me now turn it over to Jim Taylor for further guidance and explanations, and then we will open up the lines for your questions.

Thank you, Don, and good morning, everyone. As Don highlighted in his remarks, our results this quarter not only set a new record for the Trust in terms of FFO per share, but they also demonstrate the continued successful execution of our long-term plan—a plan that has driven the 48th consecutive annual increase in our dividend of 8%. I will provide some additional color on our quarterly results, our balance sheet activity, acquisitions, and our outlook for the remainder of the year. Overall property operating income grew by 9.2% year-over-year. As usual, the largest single driver of that growth is our operating portfolio, which grew at 4.8% on a same-store basis, including redevelopment, and 3% excluding it. Cash flows really escalated this quarter by 15% on deals expecting occupancy in the future, and we believe we remain on track to continue delivering sustainable growth. Importantly, as highlighted in our supplement, we continue to successfully deliver on our redevelopment pipeline. As Don noted, most notably this quarter was the stabilizing redevelopment at Melville and Mercer Mall. In addition, the initial phases of Pike & Rose and Assembly contributed approximately $3.5 million of NOI during the quarter. Finally, this quarter we benefited from the successful integration of our acquisition of San Antonio Center in Mountain View, California, as well as CocoWalk in Coconut Grove, Florida. As previously discussed, these assets are not only accretive in the near term but also present compelling redevelopment opportunities given their infill locations. Our general and administrative expenses increased by approximately $1.2 million year-over-year, primarily due to transaction costs connected to the closing of CocoWalk, as well as higher personnel costs, as Don mentioned, as we continue to invest in our growth platform. As was discussed last quarter, despite this incremental investment in our growth platform, we expect our G&A to remain at about 5% of revenue. Interest expenses grew slightly during the quarter due to lower capitalization interest as we deliver parts of the first phases of Assembly and Pike & Rose, but this was offset by lower rates as we continue to reduce our weighted average interest rates, which currently stands at about 4.3%. Bottom line, FFO per share grew by 8.1%, in line with our long-term growth plan of 7% to 9% even as we continue to invest for the future. As many of you have heard us say at conferences and during one-on-one meetings, we could generate higher absolute FFO where we would scale back on that investment and consider leveraging up. However, that is a cyclical plan only. A track record that extends back further than many of us on this call guides our relentless focus on predictable, sustainable growth. Turning to the balance sheet, early in the quarter, we redeemed $200 million of our 2017 6.2% notes using proceeds from our third-year debt issuance at 4.18%. Importantly, we extended our weighted average tenure to 10 years, which provides us maximum flexibility to access the most opportunistic parts of the yield curve as we look forward. We’ve maintained the longest weighted average tenure among shopping center REITs. At quarter-end, we had approximately $100 million drawn under our revolver, giving us ample liquidity to fund our ongoing growth. On the acquisition front, we successfully integrated the CocoWalk asset during the quarter, identifying near-term upsides as we execute on our longer-term plan for the asset. Additionally, we closed on the acquisition of interests in seven retail assets located along the primary shopping streets within the Grove District, providing us further opportunity to capitalize on the positive rental trends in the area. We placed approximately $110 million worth of assets under contract within the broader trade area, which, like CocoWalk, benefits from a fantastic infill location and presents an opportunity to create significant value through developments that cater to the flourishing population in the vicinity. More details will be forthcoming on that asset soon. With our strategic focus on the Miami-Dade market and our partnership with local experts at Grass River and Comras, as Don mentioned, we have rapidly built a substantial market presence. We couldn’t be more excited about this market and how it will benefit our overall portfolio through inevitable cycles. Now turning to guidance for 2015, we have tightened and increased the mid-point of our previously provided range to $5.29 to $5.33 per share, representing a 7.5% growth year-over-year at the mid-point. This updated guidance reflects the strength of our opening at Assembly Row, where, as Don mentioned, many of our tenants are now paying additional percentage rent. Importantly, we continue to strengthen our core, and our team has done an excellent job managing rollover and leasing additional space. We expect to see robust capital growth for the remainder of the year, well above the historical average. However, we will also see some lag in same-store NOI in the second half of 2015 due to tenant rollovers and higher termination fees that we realized last year. Even with these timing issues, we expect same-store NOI to average 3.5% to 4%, inclusive of redevelopment, for the entire year. Some of the larger timing assumptions that have been factored into our guidance—and will impact the balance for this year and 2016—include approximately $80 million of office space at Pike & Rose and Assembly that is being delivered this year. We already have leases in place for over 95% of that space. Based on the deals being finalized, we expect these tenants to take occupancy through mid-2016 and, accounting for free rent periods, be fully paying rent in 2017. The retail component at Assembly Row is currently 97% leased with 95% occupied as of the end of the second quarter, with the final tenants set to take occupancy later this year. The retail component at Pike & Rose is over 90% open as well, including tenants like iPic, Del Frisco's, Summer House, City Sport, and Sport & Health. The remaining retail space will continue to open over the next six months. Pallas, the 319-unit high-rise, which represents approximately $110 million of investment, has opened and is expected to lease up over the next 18 months. Given that timing, we anticipate it will weigh down NOI this year and into early next year until it reaches stabilization by the end of 2016. Finally, from a timing perspective, the point redevelopment at Pallas House, which represents approximately $85 million of investment, opened last week and is performing extremely well. We expect that project to stabilize by mid-2016. As we look forward, we remain confident in our plan to generate 7% to 9% growth, even as we invest for the long term on both sides of our balance sheet. While we have not provided guidance for 2016, which we will do next quarter, we expect to remain within that range nonetheless. Finally, we look forward to seeing you at our Investor Day on September 3. We expect to showcase our first phase at Pike & Rose, and to also highlight new developments at Assembly Row and demonstrate opportunities for added investments among our first mixed-use properties. You’ll have a chance to meet our broader management team responsible for executing our plan and to engage with members of our Board of Directors. With that, operator, I would like to turn the call over to questions.

Hey, good morning, guys. Just with regard to The Point, can you discuss your objectives in merchandising the retail and restaurant mix, and how the supply in the area is impacting that? Have you figured out a way to make the two assets join more seamlessly to encourage that cross-shopping? I know there was an issue with the train tracks between them.

Hey, Jeff, you are on the line; do you want to take it?

Yes, sure. Hey, Christy, how are you? As you know from being out there, we have a sectional pass-out area known as The Collection, which consists of about 50,000 square feet of lifestyle retail that performs exceptionally well. Therefore, for The Point's merchandising strategy, our aim was to build on that success and fill the unmet need for additional lifestyle retail in that trade area, which we’ve successfully done. We have 25,000 square feet of restaurant space at The Point, as this market is significantly underserved in terms of good dining options, and we aim to create a gathering space, similar to Santana Row, where people can park, meet friends, and decide where to go once they arrive. Every other restaurant opportunity in that market tends to involve driving there and back to the car, which creates a real unmet need. Regarding connectivity, yes, the railroad tracks are a permanent challenge, but we are currently working on a couple of ideas with the city of El Segundo to improve connectivity and expect to have those finalized within the next few months. The connection between The Collection and The Point is not super pedestrian-friendly right now, but it is only a two- or three-minute walk from the front of The Collection to the main entrance point at The Point. So it's manageable, but we can make it better.

I mean, having said that, Christy, one thing I want to emphasize is that we continue to debate whether connectivity is necessary. With any new project, we will learn over the next few months. Personally, I’m not entirely convinced that it is necessary to connect them at all, but we’ll see as we evaluate it. We do have some alternatives in mind if we determine that connection is must-have.

Okay, and then just secondly, Don, you mentioned the $110 million opportunity acquisition you currently have under contract. Can you provide a bit more information about it? What kind of value-add opportunities are related to it? Was it widely marketed, and is that acquisition currently included in your 2015 guidance range?

It’s not in our guidance at all, and I’m not going to get into specifics about the asset. However, I will tell you this: we made a strategic decision to invest in South Miami because we anticipate growth there. We recognize that South American capital is coming into play and with all the developments downtown, many players are vying for attention and we believe we will be successful. We did not compete directly in those activities. Our strategy was to acknowledge that Miami has clearly matured into an essential city, increasingly significant on the global stage, and it has many successful residents who reside there and require housing and services. This is our approach, and we're committed to expanding our footprint in that region, which is why we're making these incremental investments overall. So, looking at CocoWalk, the street retail, and this other asset which I will discuss in detail on an upcoming earnings call, we're crafting a comprehensive plan for the future of our business. We strive to make accretive acquisitions, providing foundational material for our growth.

Thanks so much.

Good morning, just a quick question regarding your recent acquisitions over the last two to three years. It seems like you have worked with minority partners a lot recently, which likely means handling responsibilities for shaking the properties' leases. Can you walk us through the pros and cons of having minority partners, and do those extra voices complicate your ability to achieve your objectives with some of these properties?

Yes, Jason, there's no doubt about it. Let me start by saying that every deal we make is not a part of a formula—it is based on specific real estate transactions that we believe can create the most value. Regarding South Miami, a local partner who knows the specific ins and outs of the marketplace helps us produce better results. We gain additional expertise through that partnership. Therefore, while a partnership adds another seat at the table and introduces complexity, we believe the balance of benefits outweighs the downsides in this case. In some past transactions like Plaza El Segundo, it was about how to gain control of an underperforming asset and transform it into something better.

Additionally, Jason, we tend to bring in minority interests throughout our transactions, as we did with The Grove and Shrewsbury, where we effectively own and control the asset but the minority owners’ interest is reflected in the asset model. The key point is we will never compromise on the locations we seek or on value creation. To maximize the best real estate possible, we remain open to whatever structure is necessary to execute.

The only thing I’d add to what Don and Jim have mentioned is that when we engage in partnership deals, whether for tax reasons or otherwise, the partnering individuals usually do not have a say in day-to-day operations concerning what happens. So while there might be a bit more reporting and communication, it's not that we require their approval to implement necessary actions around the property.

Thanks, and then another question regarding your restructuring of your team. Does this increase your capacity to pursue other mixed-use redevelopment projects? It sounds like it will require extra time. How much broader do you envision your capacity to tackle these projects?

Yes, I am hopeful that it boosts our capacity to execute various steps. In South Miami, our partners possess solid local developmental know-how which is crucial. That said, how much more capacity we gain from this restructuring—I'm not sure. What we are discussing is quite ambitious. As you evaluate the progress and changes we’ve made, it’s clear that we are moving towards professionalizing our team and scaling up. Overall, I am cautiously optimistic that by bringing in top-tier talent, we can increase capacity to achieve our broader goals.

Okay, and then lastly, as you look at your releasing spread, do you see any specific strengths or weaknesses in terms of geography or property types? Are small shop centers performing well, or is there anything weighing on your releasing efforts?

Yes, it really depends on the market dynamics. The West Coast is performing exceptionally well, we are also seeing strength in Boston. However, D.C. is slightly softer right now. Overall, though, it’s a mix of various elements that influences our overall results and we continue finding opportunities to secure better leases. I don't expect the situation to change.

Thank you. Regarding the partial interest in the Seventh Street retail buildings in the Coconut Grove District, can you clarify what percentage of the investment is?

Craig, it ranges anywhere from 20% to 80% on an asset-by-asset basis, and I think it’s important to note that we have established a strong position in these assets, which we believe will appreciate over time. These seven separate buildings are situated on the primary shopping streets within the Grove. Along with the dominant position established with Coco, these buildings will allow us to leverage additional growth over time.

Okay, I was just—your answer was good. I’m just curious if this aims to facilitate the restructuring, while also taking advantage of market improvements in the neighborhood?

Correct.

Okay, and the $150 million to $250 million—would that include expansions? It sounds like it would necessitate significant physical restructuring.

Yes, and that's not just a figure we pulled out of thin air; it will depend on how we underwrite these assets while exploring what can be done with them—which may require some major physical alterations.

Thanks, good morning, everyone. As the leasing gets ramped up at the second multi-family at Pike & Rose, I was curious how progress aligns with your initial expectations.

I covered that in my remarks earlier, Craig. The building—called Pallas—opened for leasing at the end of June. We signed 36 deals, at or above our pro forma expectations, which is a solid start. It’s a great product and complements the initial building, as it’s more upscale and is a high-rise compared to the stick-built properties—we are off to a great beginning.

Are you needing to do any additional marketing to meet expectations compared to the first building?

Not so far. We are continuously exploring innovative marketing strategies. While we are seeing some market concessions develop, we hope it stays on target. This project will take time and investment until we can fully optimize it. However, we are indeed seeing strong start performance.

Thanks. Just one more question concerning your CocoWalk asset: you cited a $6 million investment in the buildings. Was this meant to convey the estimated square footage assemblies currently or just half of what that area represents? Given the opportunities around that neighborhood, I was just curious.

If I can clarify, it is not as if this investment alone would impact the market significantly; it’s more of a foundational step for further developments. We have to carefully analyze whether we can gain critical mass that could genuinely influence the market, which is challenging. We've done a good job of establishing a right foundation, so significant future development opportunities remain viable.

It is a magnitude with respect to the areas where we want our assets to be grounded.

Thank you all for joining us. As we’ve mentioned, we will start to see further details in the coming week.