Federal Realty Investment Trust. (FRT) — Q3 2023 Transcript

Good afternoon. Thank you for joining us today for Federal Realty's third quarter 2023 earnings conference call. Joining me on the call are Don Wood, Federal's Chief Executive Officer; Jeff Berkes, President and Chief Operating Officer; Dan G, Executive Vice President, Chief Financial Officer and Treasurer; Jan Sweetnam, Executive Vice President, Chief Investment Officer; and Wendy Seher, Executive Vice President, Eastern Region President, as well as other members of our executive team that are here to take your questions at the conclusion of our prepared remarks. A reminder that 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, including guidance. 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 the supplemental reporting package that we issued today, 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 operation. Given the number of participants on the call, we kindly ask you to limit yourself to one question during the Q&A portion of our call. If you have additional questions, please re-queue. And with that, I will turn the call over to Don Wood to begin our discussion of our third quarter results. Don?

Thanks, Leah, and good afternoon, everyone. It's a good time to own high-quality retail-centric real estate. Demand exceeds supply for the best properties, and this past quarter's results, and in fact, the whole year thus far, have made that patently obvious. For the third consecutive quarter, we signed comparable leases. In other words, 95% of all the deals completed during the quarter. The only deals we exclude from our definition of comparable relate to ground-up construction. For over half a million square feet—553,000 to be exact. For the nine months of 2023, that's over 1.6 million square feet of comparable deals, a mark we've never achieved before. It's more than the first nine months of '22, which itself was a record, and more than the first nine months of 2021, which also set a record. You can see it in the occupancy numbers too. While the Bed Bath closures were expected to end and reduce occupancy in the quarter versus last year by 100 basis points, our overall occupancy declined just 30 basis points on a lease basis and 50 basis points on an occupied basis. This indicates something about demand. If you dig deeper, small shop occupancy—the part of the business we often hear the most concern about—increased another 50 basis points to 90.7% on a lease basis, and 80 basis points on an occupied basis. This trend has been a steady and powerful trend for two and a half years now. When you look at occupancy possibilities going forward by analyzing our past, it's reasonable to expect another 100 basis points in small shop occupancy and another 250 basis points of anchor occupancy, largely due to Bed Bath, making for roughly 200 basis points overall in the coming 18 months or two years, depending, of course, on the extent of future bankruptcies that are not obvious to us at this moment. I go through all this to really emphasize the strong health of a business focused on leasing high-quality, retail-centric properties in the first ring suburbs of America's greatest cities. While bottom line results are and will continue to be muted by the higher, though historically reasonable cost of capital that's likely here to stay, rents will likely adjust upward over time to accommodate that reality, especially with tenants in affluent locations. I hope that higher interest rates don't cloud investors' appreciation of the solid underlying business fundamentals that exist today and will likely continue. So let's discuss rents. 100 comparable deals represent 95% of the deals completed this quarter and are certainly representative of the overall company. 553,000 square feet started with a new rent of $34.51, while the final year of old rent was $31.17. That's an 11% increase on a cash basis and 21% on a straight-line basis. The weighted average lease term of 8.8 years, excluding options, is much more around 16 years when all options are exercised. The average CAGR of contractual rent bumps for this quarter's leases was 2.5%. Tenant improvements per foot have been $31.19 when you don't consider this quarter's option exercises and $16.67 per foot when you do. We have been hearing that our rents are high for the better part of the last 20 years. Admittedly, on a relative basis they are; better properties have higher rents, higher tenant sales, and profitability too. This has been evident. Sustained leasing volume and those economics bode well for the future, especially the contractual rent volumes. The third quarter results benefited from this level of activity over the past six quarters. FFO per share of $1.65 in the third quarter was above consensus, ahead of internal expectations, and up 4% compared to last year's third quarter despite much higher interest expenses and lost Bed Bath income. This is a robust quarter for us. As you may know, we were particularly active in acquisition during the COVID years of 2021 through 2022, totaling $1 billion in new additions to our core portfolio during that time, whereby the post-acquisition leasing continues to exceed our acquisition underwriting. Similarly, leasing activity in properties that have recently undergone redevelopment and/or property improvement plans have also continued to outperform our expectations and we anticipate that to continue. Although large new acquisitions have slowed due to the higher cost of capital, in 2023 we've been able to invest over $120 million at 8%, with a blended IRR above 10%. We achieved this through three avenues: first, the acquisition of our partner’s 22% interest in Escondido Shopping Center; second, the acquisition of the fee interest of the portion of the Huntington Square Shopping Center that we didn't previously own; and third, in October, the acquisition of the fee under Mercer on One in Princeton, New Jersey, which has been one of our best-performing regional shopping centers over the last 20 years. This intelligent but creative capital deployment of real estate is very familiar to us. As strong as the core shopping center business has been, the large mixed-use properties have performed even better. Retail leased occupancy sits at 97%. Residential lease occupancy stands at 98%. Office leased occupancy is at 97%, excluding buildings under development. These properties have powerful traffic counts, and tenant sales make them the centers of the communities in which they operate, attracting customers from significantly beyond just local neighborhoods. To not leave it out, as I’ve mentioned on prior calls, our multi-tenant leasing strategy at Santana West has generated meaningful tenant interest that has advanced to lease negotiations with multiple tenants for more than half the building. While leases are not executed yet, our progress here is noteworthy. Our business remains grounded in superior demographics; it always has been and always will be. Increased density, higher incomes, and real barriers to entry are vital in our business, especially in uncertain economic times. Past cycles have demonstrated this consistently, with 70,000 households boasting annual incomes exceeding $150,000 residing within three miles of our federal centers; there is simply no large open-air portfolio available for the public investor to own that can compare to this one. Naturally, we are all on the lookout for changes in the strength of the American consumer and their spending habits as it has remained surprisingly resilient. We've attempted to analyze the limited tenant sales data we have for the 2023 third quarter and compared it to the 2022 third quarter. As we expected, sales were up across the portfolio. Further analysis shows that properties with the highest average income surrounding them experienced quarter-over-quarter tenant sales that significantly outperformed those properties with the lowest surrounding average incomes. This is no surprise but is an indicator we are monitoring in the months and year ahead. As I stated up front, it's a favorable time to own high-quality retail-centric real estate. Let me now turn it over to Dan before opening it up for your questions.

Thank you, Don, and hello everyone. Another strong quarter of bottom-line FFO growth despite higher interest costs. Even with the headwinds, stronger property operating income has driven nearly 4% FFO growth for both the third quarter and the first nine months of 2023. The $1.65 per share beat consensus by $0.03 and was $0.02 above the upper end of our guidance range. With respect to this continued strong performance, we can point to the following drivers: higher property-level operating income than forecast, driven by higher minimum rents as we opened tenants ahead of schedule and retained tenants for longer; an increase in overage percentage rent and specialty leasing; higher term fees than we anticipated, in addition to lower property-level expenses. Despite the offset of increased interest costs and higher general and administrative expenses, as you can see, we had another very strong quarter. For our comparable metric, property operating income growth continued at 3.8%. On a cash basis, comparable property operating income growth, excluding term fees and prior period rent, also stood at 3.8%. Year-to-date through the first nine months, cash basis comparable property operating income, excluding term fees and prior period rents, is at 4.6%, at the upper limit of our expectations, and this will result in an increase in our 2023 outlook for that metric, which I will touch upon later. Overall, this contributed to a property operating income growth of 7% for the third quarter and 7.5% year-to-date. Term fees in the comparable pool for this quarter rose to $2.4 million compared to $1.3 million in the third quarter of last year. Prior period rent this quarter was down to $900,000 from $1.7 million in the third quarter of '22, essentially neutralizing these two adjustments. Details for term fees and prior period rent in the quarter are disclosed in our 8-K. Year-over-year occupancy showed continued progress, with our overall occupied metric landing at 92.3% and our leased percentage at 94.0%. Both metrics are significantly higher than we had forecast due to strong leasing and our team's efforts to secure tenants and ensure rent collection. When accounting for the negative 100 basis point occupancy impact from the Bed Bath departures during the quarter, our occupied metric grew by 50 basis points and our leased metric grew by 70 basis points. This means our signed but unoccupied percentage now stands over 250 basis points for 27 million, comprised of roughly 17 million in recognized total rent in our existing portfolio, with an additional 10 million of total rent in our non-comparable pool, where leases are signed and the space is to be delivered. I want to emphasize the strong quarter of comparable retail leasing, with 11% cash rollover and 21% rollover on a straight-line basis, achieved with significantly less capital than we've historically required. Given that we had a higher proportion of new leases signed during the quarter—largely resulting from the mix—last quarter had a high percentage of renewals. Tenant improvements and landlord work per square foot for these new leases decreased substantially to $41 per square foot, resulting in a blended $31 per square foot, which includes renewals. Strong new leasing activity was evident via 61 new deals totaling 423,000 square feet of retail leasing, accounting for 75% of the volume in the quarter, with more than half of this leasing being for space that was vacant as of June 30. This was a significant driver of the strong occupancy gains in the third quarter, net of the Bed Bath departures. Historically, Federal's disclosed leasing volume, rollover, and capital metrics have reflected arm's-length negotiated transactions and have not included option exercises. Options are tenant-choice opportunities and do not involve any associated capital. In an effort to continuously improve our disclosure, we have expanded the retail leasing schedules and our 8-K to include option exercises. We reported 482,000 square feet of option exercises this quarter, which incidentally posted a robust rollover of 9%. Importantly, this brings our total reported capital amounts down from $32 per square foot to $70 per square foot, including these option exercises. This expanded disclosure can be found on page 23 of the 8-K supplement. Note that we have also highlighted the percentage of total leases signed each quarter that are comparable, with our trailing 12-month average being 95% by number and 97% by GLA. We believe this presents a more comprehensive picture for the investment community, particularly regarding rollover. Now, regarding the balance sheet, at quarter-end we maintained $1.3 billion of total available liquidity, comprised of $1.2 billion accessible under our revolver and roughly $100 million in cash. Concerning our leverage, our net debt-to-EBITDA ratio remained steady at six times, and we expect it to return to the fives in 2024. Our ongoing $750 million pipeline of active redevelopments and expansions provides a competitive advantage for us, given its scale. We have only $180 million remaining to spend against our $1.3 billion of available liquidity, with much of that remaining amount designated for leasing capital, which is good news for us. This pipeline should continue to drive incremental property operating income growth into '24, '25, and '26. Now let's discuss guidance. We are increasing our forecast for FFO per share for 2023 to a range of $6.50 to $6.58, up from the previous range of $6.46 to $6.58. Guidance now reflects a 2023 FFO growth over 2022 of 3% to 4%, with 3.5% as the midpoint. We have managed to navigate retailer bankruptcies to date extremely well. As I previously discussed, we have relatively modest exposure to expected near-term retailer fallout. Our credit reserves will likely conclude lower than the originally anticipated 100 to 135 basis points range, with a revised credit reserve estimate now at 85 to 95 basis points. The expected dip in occupancy this quarter was much less than forecasted, as only two of our Buy Buy Baby locations and one of our Christmas Tree Shop locations were assumed to close. Coupled with strong performance in accelerated rent commencements and the already mentioned strong leasing volumes for the quarter, our comparable growth perspective is robust. Given solid results for the first nine months, we are increasing our 2% to 4% comparable property operating income growth range to 2.75% to 3.75%. For comparable property operating income growth adjusted for prior period rents and term fees, we are adjusting the 3% to 5% range to 3.75% to 4.75%. On a cash basis, adjusting for prior period rent and term fees, we are increasing our 3% to 5% outlook to 4% to 5%. Additionally, as previously discussed, we expect to continue to capitalize interest expense for Santana West for the remainder of this year and through at least 2024 and have refined our G&A assumption down to $51 million to $53 million for the year. As always, we have provided an updated summary of the key assumptions for our guidance on page 27 of our 8-K. We will provide detailed guidance for 2024 during our year-end call in February. And with that, Operator, please open up the line for questions.

Hey, good afternoon, and I'll do my best to stick to the one question. Don, you guys sold. I realize it's small, but you sold one of your Third Street Promenade assets in Santa Monica. And I remember, over the years, that has been sort of one of the highlights that that retail has been a highlight for you. I guess things have changed. But stepping back, are there other areas of the portfolio that used to hold better opportunity, and what's happened in the past few years as populations have shifted. Are you now reassessing? So we may see more sales of assets that previously we wouldn't have seen you guys sell.

Thanks for the question, Alex. The answer is a hard no. Santa Monica Third Street is a really unique situation, frankly, in the country. We made a fortune on Third Street. And if I show you the IRRs from when we owned it until the time of the sale, they're really spectacular. However, there is no doubt that COVID changed Third Street significantly. There is downside on the street. We're not optimistic about our ability to continue what we had. Now at a different basis, it may make sense again. But please don't extrapolate Third Street Promenade to other assets within the portfolio; it's a unique one-off.

Yeah. Thanks. Good afternoon. Don, maybe just sticking on the transaction market and looking for opportunities. One of your peers in the shopping center space is kind of pivoting and putting a fair number of assets on the market for sale. I'm just curious if any of those larger format assets might hold appeal to Federal?

From a sales perspective for us, Steve, the answer is not really. It's the same process that we would normally go through each year. As you know, you can always expect $100 million, $200 million, sometimes even $300 million of sales, depending upon the marketplace. I don't foresee that for us at this point, nor looking ahead. I'm really happy, frankly, with our positioning. On the other side, when it comes to buying, there will be buying opportunities, but I’m not sure if that’s now, to be truthful. It’s hard to imagine with all the debt coming due and the situation the banks could find themselves in over the next couple of years that there won't be some really attractive opportunities. We'll see as time progresses. Not today would be my answer.

Hi. Good afternoon. I was just hoping you could talk a little bit about the signed but not occupied pipeline and expectations for that NOI to come online. Can you also cover the timing between developments, redevelopments, and the kind of normal course assets in the same store pool? If you could provide some color on that, I would appreciate it. Thank you.

Sure, sure. You'll see roughly about 10% of the aggregate number of the 27 million coming in the fourth quarter. I think the balance of it will largely come over the course of 2024. I believe it will be fairly front-end loaded in the first half of the year, a little more weighted than the back half of the year. It will not be materially different in terms of timing when you look at everything, inclusive of the space coming online for the non-comparable properties. So largely 10% in the fourth quarter and then the balance in 2024.

Hey. Good evening. I have a two-part question on guidance here. First is on the implied Q4 FFO per share guidance range, which at $1.59 to $1.67 feels a bit wider than usual. What could lead you to the top or bottom of that range? Also, regarding development funding, you reasonably took equity funding out of guidance but maintained disposition expectations. How should we think about funding development at year-end and into 2024?

Yes, look, we narrowed the implied range to $1.59 to $1.67. It is what it is. I think we did an exceptional job this quarter of getting rents started faster than expected. If we can repeat that, we'll see occupancy growth in the fourth quarter as a result of the significant leasing we had. While it may seem a bit wide, I don't believe we should read too much into this. It also depends on fine-tuning our general and administrative expenses for the remainder of the year. One of the things we got right was delivering early on programming, which will positively contribute through the entire quarter compared to what we had expected. Additionally, we must consider the headwinds of interest rates and what happens in the last two months. Our development funding is supported by our undrawn $1.2 billion credit facility. We are cautiously evaluating modest asset sales, and we believe our $180 million left on our $750 million development pipeline and $1.3 billion of liquidity positions us well over the next several quarters.

Good evening. Thanks a lot for taking my question. How does the updated credit reserve guidance compare to historical levels? Related to that, regarding the tenant watch list, you continue to see strong momentum within the small shop space. Does that represent a larger portion of the tenant watch list compared to the anchor space? Thank you.

Yes, regarding the 85 to 95 basis points, that's in line historically. We usually end up around 100 basis points. I think we've performed slightly better historically since we experienced less impact from Bed Bath & Beyond than we originally forecasted. This has been a positive result of our portfolio management over time. As for the watch list, we have minimal exposure to the names that are causing concern. Names like Rite Aid, Big Lots, Joanne, and Express represent only about 25 basis points of our total rent exposure, which is insignificant. Therefore, near term, we feel comfortable about the watch list but will reassess for 2024 as we go through our budgeting process.

Thanks. Good evening. You started the call with the expectation of 100 basis points of small shop occupancy and 250, I believe, for anchors to be gained over the next 18 months to two years. Would you expect your leasing spreads to remain comparable to what you've seen of late for that period?

Yes, I believe so, Dori. That's a good question. We discuss frequently the importance of leasing to the right tenants, the appropriate level of merchandising, and what they contribute to the shopping center. We tend to be selective. Leasing up too fast may leave money on the table. It's crucial for us to acquire the right tenant and get compensated appropriately. We are also mindful of the credit quality of our small shop tenants and their guarantees, ensuring we rarely engage with first-time retailers. It’s about finding the balance between occupancy and profitability, and this balance is something we take very seriously.

Great. Thank you. Can you provide an update on any office lease progress at One Santana, including reports that PwC may be looking for space there? Thank you.

Jeff, I cannot provide the names of any tenants. My prior comments here are clear regarding where we are, the deals we are negotiating, and how close we are getting. However, we currently do not have signed leases yet. I can share that we are optimistic about our progress in this area.

Yeah, I guess a follow-up to the prior question. If we were to consider leasing at Santana West, if you were to secure a tenant, would the capitalized interest fully burn off there, or would it be a proportional amount? Thanks so much.

We expect to continue to capitalize interest through the remainder of this year and into 2024 to deliver space to tenants. We anticipate being able to match any reduction in capitalized interest with the rent starts, so that should be expected.

Consistent with what we've discussed in the past, there are no changes in our expectation regarding that policy.

Hi, this is Ravi Vaidya on the line for Haendel. Hope you guys are doing well? What's your early read for '24 same-store NOI? Some of your peers expect next year's same-store to be above average again. Can you discuss that and the levers you may pull to achieve an above-average same-store level for next year?

Look, as I mentioned in my statement, we are going to provide guidance for 2024 in detail during our February call. Regarding same-store metrics, we will be increasing property operating income next year, as I’ve confirmed previously, but that’s about all I can disclose at this stage.

Hi, good evening. I guess a question on the residential piece of the business. Obviously, the multifamily REITs had a pretty tough earnings season. What are you noting in terms of rent renewal rates or something similar? How should that segment perform in the next few quarters?

Yes, you should have a positive outlook on that. Our residential presence is concentrated in just four to five locations, all within mixed-use properties positioned well for higher rents due to their locations. We are observing strong demand, particularly at Assembly just outside of Boston and in Silicon Valley. Considering cost pressures on housing and mortgage rates, renting high-quality, amenity-rich locations looks quite advantageous. Thus, while I cannot speak to the broader residential market, I urge you to view our mixed-use environments positively.

Hi. It looks like your weighted average lease term fluctuates each quarter but remains consistent in the 6.5 to 7.5 years range. Is there a desire to drive shorter lease terms to capture more upside, given the low retail supply?

The answer is that it depends on the deal. When you secure a lucrative starting rent with considerable bumps, we will lock that in. The difference in the 8.8 years this time compared to 6.5 or 7.5 is purely due to mix. There are cases where we're actively trying to keep it shorter, but overall, portfolio-wide, I would like you to focus on those contractual bumps in rent because they truly define our value over the lease's duration.

Hey, thank you. Don, as we think about the traditional lease items that tenants favor, like renewal options, co-tenancy, and use restrictions, are you noticing tenants yielding on some of these as availability shrinks and demand rises, especially at the anchor level? Can you provide tangible examples of instances where you've seen previously tough negotiating tenants make deals today that they wouldn’t have made a few years ago due to the reduced availability?

That's a great question, Alex. I'll have Wendy provide you with the specifics.

I would say the answer is yes overall. We are observing that the best specialty brands, especially, are struggling to find the types of properties they desire, resulting in higher demand for locations like Bethesda Row. We have a waiting list of 10 to 12 tenants eager to open stores in Bethesda Row. It's quite exciting. We recently signed a deal with Bloomingdale's department store for a new location at The Grove, covering just over 21,000 square feet. While I can't discuss the specifics of that deal, the timeframe from initiating the lease to signing it was a mere 40 days, indicating a strong desire on their part to complete the deal in a powerful area that benefits both them and our shopping center.

It's important to note that we maintain a strict stance on waste terms and are not giving away too many concessions. The leverage has shifted in our favor significantly due to the space shortage, allowing us to secure favorable deals with great tenants. It’s indeed a positive environment.

Thank you. Just revisiting Michael's earlier question about the implied fourth quarter guide. Dan, could you provide a bridge for the implied sequential deceleration, highlighting the drivers affecting FFO from the third quarter run rate to the midpoint of the implied fourth quarter guide, please?

Yes, I think we are probably being a bit conservative on some of those numbers. A good year could influence G&A, which would rise. The numbers may reflect a bit of caution and increased G&A in the final quarter, which explains the midpoint of the implied guidance.

I am curious to know about the plans and thoughts for Mercer Mall following your acquisition of the fee interest. What potential expansions or conversions are on the table, and what’s the timeline?

Certainly. The acquisition of the fee, which occurred in October, was something we had structured into the deal 20 years ago. Exercising that option today does not affect our long-term plans for the property. We have ongoing initiatives for Mercer that would have progressed regardless of this acquisition, and they have yielded positive outcomes thus far. Wendy, would you like to add some further details?

Absolutely. We are actively working on rebranding the property as Mercer on One, and you will soon see new signage reflecting this remerchandising effort. DSW is downsizing but will remain a presence, and we have two new tenants lined up to fill spaces adjacent to them. Additionally, we have successfully backfilled the portion of Bed Bath & Beyond that we acquired at the end of last year with Crate & Barrel. There’s a lot of exciting development at Mercer, reflecting our commitment to increasing rents driven by strong market demand and ensuring a return on our investments.

Just to reiterate, our investment in that fee represented $55 million, yielding an 8.7% return, with the credit for previous diligence yielding a great opportunity to invest in a property we already owned.

Yes, and I’d like to add that Mercer is a perfect example of what we do best. We had a clear strategy to control a significant piece of land we can now manage. Our focus on long-term ownership was essential to our strategy, and we did not gamble on whether we would hold the fee. We had that arranged contractually. The timing is right now, and the income stream we’ve gained from that land has proven effective, especially as we see market challenges affecting inside malls and adjacent properties. Mercer is stronger than ever.

As I review your redevelopment pipeline, most projects are set to stabilize by next year. When can we anticipate the activation of future projects in your pipeline?

That's a great question, and something we spend a lot of time considering. The elevation of interest rates leads to a higher threshold for returns, making it crucial for us. Given our residential entitlements and our experience with retail redevelopment that integrates residential components, we believe it's more practical to start these projects in the long run. You can expect to see more of these redevelopments of retail properties in 2024, alongside some of the larger projects that focus on residential opportunities we already have in the pipeline.

We look forward to seeing many of you in the next few weeks. Thanks for joining us today.