Federal Realty Investment Trust. (FRT) — Q4 2017 Transcript

Good morning. I'd like to thank everyone for joining us today for Federal Realty's fourth quarter 2017 earnings conference call. Joining me on the call are Don Wood, Dan G., 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 on 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 that 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. Given the number of participants on the call, we kindly ask that you limit your questions to one or two per person during the Q&A portion of our call. If you have additional questions, please feel free to jump back in the queue. And with that, I will turn the call over to Don Wood to begin our discussion of our fourth quarter and year-end 2017 results.

Thanks, Leah. Good morning, everyone. A good quarter and, in fact, another good year for us, between meeting or beating estimates with fourth quarter FFO per share of $1.47 and $5.91 for the full year, 4.6% growth over 2016. There's strong residential leasing progress with the new phases of both Pike & Rose and Assembly Row, not to mention Santana Row and Bethesda Row, further validating the relevance of our mixed-use product nationwide and our broader real estate capabilities. We have strong comparable lease rollover rates throughout the portfolio of 15% for the quarter and 13% for the year; we further fortified one of the strongest balance sheets among any REIT; and we executed another timely and opportunistic debt refinancing along with a small but carefully executed equity issuance, which significantly derisked our development pipeline. This company continues to face the challenges of retail-based real estate head-on with more arrows in our quiver than most and a clear vision for the future. We're not playing defense; we're on offense and we're moving the ball aggressively. By reporting FFO per share this year of $5.91, or even $5.74 when including the opportunistic cost of retiring our 5.9% notes due in 2020, we remain the only publicly traded shopping center company to grow FFO, by NAREIT's definition, each and every year since the beginning of this retail cycle in 2010, the only one. In fact, we've grown NAREIT-defined FFO per share 48% over that period, even with last month's debt extinguishment charge. The consistency in which this company grows bottom line earnings truly sets us apart, no excuses, no exclusions, no reorganizations, no defensive dilutive asset repositionings, no recapitalizations, just consistent growth. And we don't expect that to change in 2018, as Dan G. will go over in a few minutes. Hard for me to believe that history and track record don't matter in predicting the future. Leasing in the fourth quarter was again strong at 15% rollover growth and remarkably consistent all year. Consider that on over 1.6 million square feet in comparable deals done in 2017, which was 10% more than we did in 2016. Rollover growth was 11% in the first quarter, 13% in the second quarter, 14% in the third quarter, and as I said, 15% in the fourth. Tenant improvement dollars stayed relatively stable and under control. Deals included TJX's HomeGoods concept at our Brick Plaza redevelopment, Marshalls' renewal at our newly redeveloped Northeast shopping center, and a new urban-format Target deal at Sam's Park & Shop in D.C. These deals at redeveloped or remerchandised shopping centers clearly more than pave themselves in densely populated areas, and our cost of capital advantage makes the underlying value creation even higher. Occupancy gains in the fourth quarter continued that trend that we've seen all year. Our overall portfolio lease rate of 95.3% was higher than both our 94.7% lease rate at September 30 and 94.4% last year at this time. Our total portfolio occupied rate at 93.9% suggests that there are 140 basis points of leasing that's been done, if not yet paying rent, certainly a positive for 2018. On the development side, noteworthy advances included a deal with Japanese apparel retailer, UNIQLO, whose first location in Maryland will be at Pike & Rose opening in the fall. This is significant because UNIQLO is international in scope and has largely selected productive malls for their real estate. Our mixed-use alternative was clearly more attractive to them and signals another hurdle that we've met in putting together an attractive and sustainable long-term neighborhood and place for shopping, living, working, and playing. We still have more to do on the retail leasing side, and we are 91% leased or under LOI, but getting deals over the finish line is arduous. The residential leasing momentum at Henri, our latest apartment building at Pike & Rose, along with a 97% occupancy stability at PerSei and Pallas, make it pretty clear that the long-term growth prospects of neighborhoods like these are very much intact. More than two thirds of the market-rate units are already under lease at Henri at rents that meet expectations with a lease-up pace that exceeds expectations. Additionally, 54 of the 99 condominiums above the Canopy Hotel, which will open shortly, are under contract. Similarly, at Assembly Row, we've signed a very significant deal with Polo for a 10,000 square foot outlet store in the base of the hotel condo building in Phase 2. This deal was particularly significant because we couldn't get Polo to come into the project in the first phase due to the unproven nature of the urban outlet mixed-use model, product types that we pioneered. The success of the first phase at Assembly prompted them to sign. We still have more wood to chop on the retail leasing side, being 77% leased or under LOI, but we are getting there, and the environment and place are second to none. Residential lease-up of the 447-unit Montaje residential building is strong, with over 190 units already leased at rents which exceed expectations, and we expect to close on all 107 market-rate condominiums in just a few months, which will raise over $80 million. The dilutive impact during lease-up from these two residential projects totaled about $0.02 per share in the fourth quarter as expected. The value created above cost at those two buildings alone in the next two years is estimated at nearly $100 million. At both Pike & Rose and Assembly Row, we're evaluating and working through the next phases as we speak. Our mixed-use development capability, particularly when paired with our demonstrated cost of capital, is a true competitive advantage. On the West Coast, the fourth quarter marked the first full quarter in which we operated on an integrated basis with Primestor, a Los Angeles partner specializing in shopping destinations serving the Latino customer. It's an important additional arrow in our quiver going forward, and actual results in the fourth quarter exceeded our acquisition underwriting, which is a good start. This (continued positive results) carried into the first quarter this year with a signed lease for the only vacant box in the Primestor portfolio, months ahead of our expectation, where a vacant Walmart grocer was replaced by Bob's Furniture at over double the Walmart rent. Our underwriting anticipated a much smaller bump in rent. It's hard to see the Primestor joint venture as anything but a competitive advantage for us. The end of the street at Santana Row looks a lot different these days as our office development is fully out of the ground and remains on budget and on time for delivery in 2019. Now we've got to get it leased, and initial interest has been encouraging as we fully engage with the community and capitalize on the attractive amenity-rich environment that office users in Silicon Valley and nationally are demanding. The initial positive experiences that Splunk employees and management have been sharing in the community are particularly encouraging and helpful to our process. Finally, I'd like to hammer home the philosophy in which we're making real estate decisions these days because it puts our entire business plan in context. The retail real estate-based companies that will not only survive but thrive in the years to come are those who have positioned their assets to be the real estate of choice for the widest possible selection of tenants—not a narrow, limiting business plan, but a broader, wider funnel in select markets. To position ourselves for that outcome, there are three important considerations: First, location matters more today than it ever has; it seems obvious. Second, assets need to be in flexible formats that can be improved upon through profitable reinvestment; this is significant because on many retail-based properties in the United States, the revenue numbers generated after redevelopment are often not enough to justify the investment. Third, enhancing the experience is crucial. The placemaking, tenant lineup, and customer services at those places is both critical and harder than it sounds. Creating that environment goes beyond just checking a cool things to do checklist. Know that everything this company is doing today, even if it moderates growth in the short term, is meant to enable execution of this necessary long-term philosophy. The fact that we are doing it while still growing current earnings and cash flow, as we have throughout this entire cycle since 2010, is a testament to the quality of our real estate, our team's vision, and the execution competencies of that vision. Now let me turn it over to Dan to talk about the year before opening up the line to your questions.

Thank you, Don and Leah, and hello, everyone. We are really pleased with our results of FFO per share of $1.47 and $5.91 for the fourth quarter and full year, respectively, slightly ahead of our expectations on both measures and ahead of consensus for the quarter. The numbers in the fourth quarter were driven by higher NOI, primarily due to higher percentage rent and less impact from tailing tenants, offset by higher G&A due to year-end compensation adjustments and costs associated with our planned accounting and IT platform upgrade. Our same-store results came in at 2.6% for the same-store with re-development. Our new comparable POI metric came in at 1.7%. These results were impacted by a negative comp on term fees as well as the negative short-term impact of value-creating, proactive re-leasing initiatives, which produced a combined drag of 60 basis points. For the year, our same-store with redevelopment metric came in ahead of guidance at 3.4%. Calculating this using a simple average of all four quarters is a more representative measure for the year, and our same-store growth was 3.8%. Don touched upon our progress in leasing, but let me provide some additional color. Our lease percentage at year-end is 95.3%, up a full 90 basis points over year-end 2016. Our occupied rate increased to 93.9%, which is 60 basis points over year-end 2016. The gains throughout 2017 can largely be attributed to the significant progress we've made on the anchor leasing front, where our anchor lease percentage is back to a more normalized level of 98%. For 2018 FFO guidance, we formally provide a range estimate of $6.08 to $6.24 per share, affirming our preliminary guidance midpoint of $6.16. This 4%-plus FFO per share growth positions us at the upper end of our peer group again. This guidance assumes the following: capital spend on development and redevelopment of $250 million to $300 million for the year, which effectively has been prefunded; we anticipate selling up to $150 million in condos at Assembly and Pike & Rose; and the gains associated with this will not impact FFO. We forecast to refinance our $275 million term loan in fourth quarter 2018, although we have the flexibility to extend this loan to November of 2019. We will continue our proactive re-leasing activity in 2018, with leases already executed, such as Anthropologie replacing Barnes & Noble at Bethesda Row, Target replacing Petco at Sam's Park & Shop in D.C., and Muji on Third Street Promenade replacing Abercrombie, among others. This activity will weigh on results in 2018, creating $0.03 to $0.04 dilution on FFO and roughly 50 basis points of drag from a comparable POI perspective. However, it will also drive growth and value creation of $50 million to $60 million once stabilized. Please note, this activity will put some pressure on occupancy during the year due to downtime, although not leased percentages as the leases are already executed. As is our custom, this guidance assumes no acquisitions. In regards to G&A, we forecast roughly $36 million in 2018, or about $9 million per quarter. This reflects the additional costs associated with the upgrade of our accounting and IT platform. And regarding same-store, our estimate of comparable POI growth, our new metric introduced in the third quarter, is affirmed at 2% to 3%. As a result, we project total property operating income will grow in the 5% to 7% range in 2018 relative to 2017. On the balance sheet, we continued to be opportunistic during the fourth quarter, further derisking our best-in-class balance sheet. First, with a $175 million reopening of our benchmark 10-year notes due 2027. This decision came in advance of the expected mid-December Fed rate hike and the anticipated passage of tax reform, where we managed to lock in a 3.32% rate at a record 10-year spread for Federal, at 97 basis points. We used these proceeds to redeem our 5.9% notes due in early 2020. Note, we did take a $12.3 million charge due to the early redemption, which was recognized in the fourth quarter. With the 10-year treasury up roughly 50 basis points in the last 60 days, this decision looks like a prudent one, at least so far. Second, we were also able to tap our ATM program during the quarter to efficiently issue $66 million of common equity at a weighted average price of $132 per share. This opportunistic activity positions our A minus rated balance sheet extremely well heading into 2018. We have prefunded our capital plan over the course of 2016 and 2017 at an attractive cost, so we effectively have no need to raise incremental capital in 2018. Our net debt-to-EBITDA ratio stands at a modestly elevated 5.8 times and is poised to decrease into the 5 to 5.5 times range over the course of the year as executed leases commence and as we reduce leverage through condo sales, 75% of which are under contract. Our fixed-charge coverage ratio had a four times run rate for 2017, and we expect that four times coverage to remain for 2018. Our weighted average debt maturity has been extended to over 11 years, and we reduced our weighted average interest rate to 3.8%, with 99% of that balance sheet fixed. Despite disruptions in the equity markets and the rising interest rates, the strength of our best-in-class capital structure positions us to continue differentiating Federal as we move forward in a challenging retail and capital market landscape. And with that, operator, you can turn the line over for questions.

Yeah, thank you. I was wondering how much reserve is being attributed to Ascena. I know you have 33 stores, and I guess we're expecting them to not spook the restructured and the store closings to spring. So if you could comment on what you see the bad debt might be from Ascena.

With regards to Ascena, we factored in that we have 33 locations. In our conversations with them, we expect to rationally shrink our store footprint over the next 12 to 24 months. I don't think we can specify a exact number regarding bad debt or cushion we have. We've looked at space-by-space, but I don't have that number for you.

The only thing I would add to that, Craig, is we got comfortable when we laid out the guidance we provided, ensuring we weren't overly conservative and looking at tenants like Ascena, making sure that unless something much more catastrophic occurs than we anticipate, we're covered.

Okay. Great. And then I just wondered if same-store NOI and FFO growth by quarter will be back-end loaded as you start to bring on some of the Assembly and Pike & Rose stuff.

Yes, certainly, with FFO in 2018, it should be back-end loaded towards the third and fourth quarter as we accelerate FFO in bringing online the benefits of Assembly and Pike & Rose. It's tougher to say about the cadence in regard to same-store. Obviously, Assembly and Pike & Rose Phase 2s are not included in the same-store portfolio, making it a bit difficult to describe the cadence over the year.

Don't get carried away with the back-loaded stuff, though. There are a lot of things we're doing for the future that can impact those quarters, so while it may be a little back-loaded, don't put too much weight on that.

Okay, thank you.

Good morning. Just two questions here. First, Dan, you said that the G&A guidance for this year is $36 million, which is flat with this past year. Regarding other REITs, we’ve heard about payroll pressure and increased wages. I'm curious how you guys are maintaining flat G&A. It seems to be a growing issue across different REITs this season.

Alex, it's a great question. There's no question that we're in a less predictable period. We're certainly more conservative on G&A, and you'll see it within the officers. There were basically no raises for Vice Presidents and above, with only a couple of exceptions. This year, we're very conscious of it. We run tight like we did in 2008 and 2009. If we're not seeing the growth we want, we'll tighten that up. The average executive at this company has been here about 15 to 17 years, and we understand the cycles. Sometimes we need to be tighter, sometimes less tight, and that's part of our company's DNA. The real estate business is straightforward in that regard.

And then the second question, Don, you guys have sold off basically in line with peers despite your track record. At what point would depressed stock prices affect your planning on new projects or cause you to reconsider how you create value at Federal?

There's no question, I'd be lying if I said a dip down to our current trading values isn't impactful. If they are sustainable, it absolutely impacts our capital allocation. You’d want us to be more disciplined and raise the bar on capital allocation decisions. The good news is, as we finish Phases 2 of both Pike & Rose and Assembly and are currently underground with the construction of 700 Santana Row, we've funded those capital needs beforehand, leading to very little requirement for capital in 2018 and 2019. We are looking at incremental phases with a diligent approach, evaluating them against the current capital environment. We're creating significant value with the mixed-use portfolio, particularly the redevelopment portfolio. You can see our stellar leasing and occupancy performance. Those levels of value creation will remain unaffected by current trading conditions, but will be scrutinized under cost-of-capital metrics.

Okay, thank you, Don.

Hey, good morning. Just a follow-up on Alex's question. Beyond the current capital plan, you’ve previously used your balance sheet for opportunistic acquisitions. I'm thinking about the Primestor deal last year. In this higher cost of equity environment, how do you approach potential acquisition opportunities?

With a sharper eye. I don’t know if we will see much difference in cap rates across the board. Historically, there have been some excellent buying opportunities, but we didn't find a lot because the good stuff just doesn't back up in terms of cap rates. So I don't know if we will see much opportunity. We’re actively monitoring the market. The Primestor venture has exceeded expectations, as I mentioned, and we’re optimistic about potential growth in the coming decade due to a smaller development opportunity that is still in the works.

Okay. And then just at Bethesda Row, I saw in the K that you sold a small land parcel in late December. Can you explain the reasoning behind that? Also, with Anthropologie replacing Barnes & Noble, how do you feel about this new larger concept?

The small parcel was what we refer to as the indiscernible parcel. It's located across the street and is very small. We couldn't find a value-accretive deal for it, so we sold it back to the county at what we believed was a fair price. Regarding Anthropologie, they are launching a new, larger concept that brings together their various brands and products in one location. This creates a type of department store for the future, a new model that aligns well with the business and tenants.

With Anthropologie, what excites us is that they are uniting several of their brands in a larger format, which embraces fashion, home furnishings, cosmetics, and shoes—all under one roof. This merging illustrates a new retail future that aligns with the overall tenant mix and enhances customer experience.

This proactive approach is why we felt it was essential to replace Barnes & Noble with Anthropologie. While it may result in downtime and loss of rent in 2018, the long-term value created by the new lease will be worthwhile.

Good morning. Don, you mentioned challenges getting some leases finalized. Can you talk about how tenants are evolving in profitability thinking and what sort of rents they can pay versus the old occupancy cost model?

It's a good question, Jeremy. Clearly, we’ve seen a lot of anchor leasing progress over the past 18 to 27 months, some of which is already paying off and some will be rolling in 2018 and more in 2019. If you compare February 2018 to February 2017, it seems like retailers have a better grasp of their business plans today than last year. We're finding we can negotiate strong economic deals that add value to both the property and the overall tenant mix. However, some second-floor spaces that once made sense are now challenging. We may face obstacles in effectively adding value to some of those spaces, but, overall, we can still secure good deals.

Great. And for Dan, you mentioned Q4 came in slightly above expectations. Regarding guidance, was it just the additional re-leasing activity that affected expectations, leading to the new range provided?

Yes, we did feel good about Q4's performance exceeding expectations, and overall, our 4.4% results surpassed our projections. That was primarily driven by the 2.6% performance that was better than we anticipated in the prior quarter. For 2018 guidance, while we provided precision, there isn’t much more to read into tightening the range.

Thanks.

Hi. With the 10-year backing up and changes in the REIT environment, can you talk about market pricing for different asset types?

On the acquisition side, Mike, the best assets that we are looking to acquire have not shown a backup in cap rates yet, despite the recent trends. Although we may eventually see movement, it hasn’t permeated the market among the types of properties we're eyeing.

Yes, on the West Coast, high-quality deals closing late last year and early this year were in line with our foreseen pricing, showing aggressive pricing for those types of assets. Many buyers remain interested in pursuing high-quality assets, so we may not see a substantial shift in pricing yet. We haven’t witnessed much change in cap rates for Class A institutional quality assets following the treasury rates movement.

Okay, thank you.

Good morning, guys. Don, there's an increasing burden on landlords to understand the value of their space to retailers, and communicate it effectively. Do you see retail landlords investing more in data analytics for operational excellence in merchandising and tenant selection?

I think it’s essential. There's a need for landlords to invest in data, but we need to navigate this ecosystem to avoid unnecessary costs. The transformation regarding data and its importance to retailers and the study of consumer behavior is critical for a viable retail future. We need a strategy to capture and leverage the right data effectively, as what's pertinent shifts quickly. Federal Realty's focus remains on facilitating a solid position in this changing landscape.

Just as a follow-up, do you see this data investment leaning towards tenant identification or helping existing tenants enhance sales?

Both aspects will be important. As more retailers refine their strategies, many are looking to leverage data for decision-making. This ongoing dual need for tenant identification and aiding existing tenants' profitability represents a critical evolution within the retail space.

And one more question—there's been a lot of attention on Amazon's second headquarters. Can you speak to Federal's involvement in any remaining bids or if you're positioned nearby?

It's an honor to be in the conversation surrounding Amazon's second headquarters. We are certainly in the vicinity—particularly at both Assembly and Pike & Rose, which are among the finalists. I can't provide details on our direct involvement but it's reasonable to anticipate an indirect benefit if selected, especially from those two locations.

Thanks. Going back to the same-store NOI guidance for this year, can you provide your rent spread assumptions? In addition, how do you anticipate occupancy performing, especially with the downtime from lease transitions?

Regarding rent spreads, the last eight quarters have shown remarkably consistent low double digits to mid-teens. I would expect those to remain comparable in 2018. There may be some volatility, but on average, it aligns with our 2% to 3% comparable POI growth. However, the proactive re-leasing, which introduces some pressure on occupancy, will likely be reflected in that number with about a 50 basis point impact.

Okay, that’s helpful. Also, can you elaborate on your exposure to larger box sizes, like 30,000 to 40,000 square foot spaces, which seem harder to fill?

Size matters, but context is crucial. The challenge arises in understanding the viability of specific uses for such spaces. For instance, we have a couple of second-floor-only boxes that pose a challenge today. Our ability to find suitable tenants in those spaces depends significantly on the location and the alternatives available. We need to assess each property on its merits rather than general size classifications. While it can vary, we have alternatives and other uses available to us to potentially transform these challenges into opportunities.

Thanks for the color. Operator, I have one more housekeeping question. The active development pipeline seems down to start 2018 compared to previous years. Is this timing-related or have you become more selective in light of the current climate?

It's mostly a timing issue. We delivered phases ahead of schedule, and as stabilized properties become part of a stabilized pool, it may produce a smaller active development pipeline compared to when new projects were constant. We are still very active in redevelopment, and while it's normal for the pipeline to be a bit lumpy, we're optimistic and will be replenishing it throughout the year.

Yes, we have a robust pipeline to draw from in redevelopment and expect that to replenish as the year progresses.

Good morning, everyone. A quick question on tax reform—it’s been generally viewed positively for retailers. Do you believe this could also accelerate the decline of struggling retailers without profits?

I can't predict how it impacts those struggling retailers. It fundamentally hinges on whether those enterprises have solid plans moving forward in all realities. Tax reform will empower those with clear business strategies, making it possible for them to thrive. For others, the underlying problems could lead to more significant challenges beyond just tax changes.

That makes sense. One other question—I've noted you indicated that TI costs are stable, yet there's been talk of labor and material inflation. Do you expect TI costs to remain stable amidst inflation?

Your observation is accurate. We have certainly seen increased pressure but find that we’ve managed to maintain some equilibrium. There will be projects demanding higher TI, but the key takeaway here is that we're observing a stabilization trend overall, which is favorable. It's property-sensitive, as always.

Thanks. Federal's implied cap rate is over 5.5%. At what point will you consider share buybacks? Could you also provide cap rate guidance to the market?

On the buybacks, it's a valid question. While we've been asked about them before, our preference is allocating capital to long-term plans. Short-term market variations shouldn’t disrupt our strategies. That said, with reduced capital needs projected for 2018 and 2019, we could reconsider our approach regarding buybacks. When we reach a certain price point, it becomes harder to avoid, especially if that trading price sustains a solid yield.

Thanks.

Good morning. Dan, can you walk us through your sources and uses? Remind us how much you generate in annual free cash flow and the funding you'll need for ground-ups over the next two to three years, factoring in condo sales.

Yes, the $250 million to $300 million capital spend we discussed earlier is a general figure. After what we've generated from condo sales, it's looking approximately that range. Our free cash flow typically generates around $70 to $75 million after dividends and maintenance caps, which supports our efficient use of capital. Our balance sheet remains well-positioned, with minimal credit drawn at year-end, providing a clear path for 2018 and into 2019.

Okay. Perfect. Thank you.

Thanks, everyone. We look forward to seeing many of you in the next couple of weeks. Have a good day.