Federal Realty Investment Trust: Dividend-Capture Covered Calls, Aristocrat Income

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This article reviews shopping center-focused retail REIT, Federal Realty Investment Trust (FRT), and provides the details for a “dividend-capture” covered call option trade that is currently worth considering for its relatively high income. Specifically, we review the health of the business, valuation, risks, dividend safety, and our opinion on investing. However, we first start with the details for this time-sensitive options trade (it needs to be executed prior to the ex-dividend date on September 21st)

Federal Realty Investment Trust

Dividend Yield: 5.3% (Dividend Aristocrat)

The Trade

Buy Shares of FRT, Sell Call Options on FRT with a strike price of $85 (~5.5% out of the money, it currently trades at ~$80.52), and an expiration date of November 20, 2020, and for a premium of at least ~$1.45 (this comes out to approximately +9.8% of extra income on an annualized basis, ($1.45/$80.52 x (365/67 days, annualized)). Furthermore, this trade not only generates attractive premium income for us now, but it gives us the possibility of also capturing FRT’s dividend as long as the shares don’t get called away from us prior to the ex-dividend date on September 21st. The dividend payment is $1.06, which equates to 7.2% of extra income on an annualized basis ($1.06/$80.52 x (365/67 days, annualized)), and it can actually be higher if you exit this trade prior to expiration.

(Image Source: TD Ameritrade)

Further still, in our view, FRT is a very attractive long-term investment (we’ll explain why later in this report), so if the shares don’t get called, we’d be happy to keep them. And if the shares do get called, we still get to keep the premium income we generated for selling the calls, and possibly also the dividend income. Plus, if the shares do get called, then that frees up our capital to move on to another “dividend-capture” covered calls trade. This trade will net us 7.2% to 17.0% (i.e., 7.2% + 9.8%) of extra income (on an annualized basis) on our $80.52/share investment. Rinse and repeat.

Your Opportunity

We believe this is an attractive trade to place today and potentially over the next few days as long as the price of FRT doesn’t move too dramatically before then, and as long as you’re able to get your arms around the workings of this trade as well as generate annualized premium that you are comfortable with.

(Image Source: YCharts)

Our Thesis

Our thesis is basically that FRT is an attractive long-term dividend investment trading at an attractive price (we’ll dig into the fundamentals later in this report). Furthermore, the income generated by this trade (i.e., upfront premium income + the possibility of receiving the dividend) is also attractive. If the shares get called before the ex-dividend date, we’re moderately happy; if they get called after the ex-dividend date, we’re even more happy; and if they don’t get called at all, we’re happy to keep owning this attractive long-term Dividend Aristocrat.

Important Trade Considerations

Two important considerations when selling call options are contract sizes and earnings announcements. With regard to options contracts, they trade in lots of 100, so you need to be comfortable purchasing 100 shares of FRT in your account. Secondly, it’s important to pay attention to earnings announcement dates, because this is often when news comes out that can move the stock price significantly, thereby impacting your trade. Importantly, FRT is expected to announce earnings around the end of October (before this contract expires). Realizing this can add volatility to the share price, we remain comfortable with owning the shares, especially considering the relatively attractive upfront income generated by selling covered calls on this Dividend Aristocrat.

More About Federal Realty Investment Trust

If you don’t know, Federal Realty Investment Trust is a shopping center-focused retail REIT that owns high-quality properties in eight of the largest metropolitan markets (Chicago, Boston, New York, Philadelphia, Washington DC, Miami, Los Angeles and Silicon Valley). Its portfolio consists of 104 shopping centers spread across ~24 million square feet of retail space and 2,800 residential units. FRT’s portfolio includes grocery-anchored centers, super-regional centers, power centers and mixed-use urban centers. Its properties are present in best-in-class locations which are densely populated (162K average population) and affluent (median household income of ~$127k).

The REIT’s tenant base is highly diversified (see figure below), with no single tenant accounting for more than 2.6% of its annual rent. In fact, the top 25 tenants only account for 28% of its total annual rent. As per the Q2’20 update, 24% of its rent comes from essential services such as grocery, drugs and banks. Another 21% comes from residential and office tenants, which have largely remained relatively immune to the COVID-19 pandemic. The remaining 55% of its rent includes exposure to industries such as restaurants (15% of the portfolio), apparel (16%), health & beauty (5%), fitness (4%), experiential and others (9%). These sectors have been impacted because of the shutdown, but are slowly recovering.

Tenant Diversification (as a % of Annual Rent)

(Source: Company Presentation)

As state economies are reopening, the percentage of tenants that are open in its portfolio has accelerated to 92% as of July 31 (versus just 47% as of May 1). As a result, cash collection has shown strong momentum tracking those re-openings. Cash collection for the second quarter finished at 68% and has accelerated to 76% for July 2020.

(Source: Company Presentation)

FRT boasts of a strong development pipeline, with all projects in first-ring suburbs of major metropolitan markets with significant demand drivers. The attractive location of these properties reduces the risk of leasing. In fact, commercial space in these development projects is already 66% leased. The company noted that its properties remain in demand despite the crisis. During Q2, it signed nearly 100,000 square feet of new and renewed office deals, in addition to the 277,000 feet of retail deals. And regarding the retail space, it was leased for 11% more rent than the previous tenants.

53 Consecutive Years of Dividend Increase

FRT is a Dividend Aristocrat (i.e., a company that has increased its dividend payout for 25 consecutive years, or more) and has the longest record of consecutive annual dividend increases within the REIT industry. It has delivered 53 consecutive years of increased dividends, with the most recent increase coming in Q2-20. Specifically, FRT increased its quarterly dividend by ~1% to $1.06 during Q2. And at the current annualized dividend per share of $4.24, it delivers a dividend yield of ~5.3%, which is fairly attractive. The payout ratio was ~92% for the first half of 2020, which is on the higher end but is likely to further improve going forward as growth resumes. The REIT noted in its Q2 earnings call that it remains confident in its ability to support a dividend of $4.24 based on FFO expectations going forward.

(Source: Company Presentation)

Additionally, FRT has ample liquidity and a strong balance sheet to fund any short-term dividend shortfall. For example, the company’s credit metrics remain strong, with a net debt-to-EBITDA ratio of 6.5x and fixed charge coverage at 3.6x. As of Q2-20, it has almost $2 billion in liquidity, with $980 million of available cash and an undrawn $1 billion credit facility.

(Source: Company Presentation)

Further, the debt maturity schedule is in excellent shape, as the weighted average maturity is 9 years, with limited near-term maturities (just $340 million through year-end 2021).

(Source: Company Presentation)

FRT is one of only six “A rated REITs,” which provides it with continued access to the unsecured bond market at attractive interest rates. This leads to lower cost of capital and an improved ability to raise capital. Importantly, easy access to capital supports the company’s ability to sustain and grow its dividend. In fact, management has no near-term liquidity concerns and expects ~$1.3 billion in cash and unused credit line by February 2021, noting the following during its most recent Q2 earnings call:

“On February 1, 2021, even when and assuming that the declaration and payment of our next two full quarterly dividends, which could be declared in August and November and paid in October and January. Even assuming the continued and unabated construction at the partially completed projects at Santana West, Assembly Row, Pike & Rose and CocoWalk, even assuming the collection of rents only marginally better than the 76% plus that we collect in the last month of July and assuming no asset sales or equity issuance during that period. With all of those assumptions, we still wind up with $1.3 billion worth of cash on February 1, 2021.”

This gives us comfort and confidence in FRT’s ability to sustain and grow its dividend in the future.

Proven Track Record During Downturns

FRT has a long history of managing through (and outperforming) during difficult times with smart risk-adjusted capital allocation decisions throughout investment cycles. And perhaps worth mentioning, the company has delivered a total annual return of 10.3% since 2003, higher than other shopping center REITs (~4.7%) and the S&P 500 (~9.7%). History and track record arguably matter significantly at a time like this, and at the very least, it gives us more confidence that FRT can successfully manage through the current challenging environment.

(Source: Company Presentation)

Valuation

On a price to (forward) Funds from Operations (“FFO”) basis, FRT is trading at ~16.2x. And as can be seen in the table below, the REIT has the lowest dividend yield among peers. These metrics suggests the market perceives FRT as significantly less risky 0 a quality that may appeal to many income-focused, risk-averse investors. The REIT’s price-to-FFO multiple is a touch on the higher side versus peers and a reflection of its higher quality. Specifically, we see it as a validation of FRT’s unique strategy which has resulted in outperformance against peers since 2003, and its record of 53 consecutive years of dividend increases (which is unparalleled in the REIT industry).

(Source: Yahoo Finance, Company data)

Risks

Tenant bankruptcy: FRT is exposed to the risk of tenants not being able to meet their rental obligations. While the company is well-diversified with no significant tenant concentration, it seems unlikely to threaten its dividend safety. However, should one or more of these tenants face financial trouble, it could lead to future cash flow interruption.

Interest rate risk: In the US, the Federal Reserve has cut interest rates to essentially zero, and even though we expect rates to remain relatively tame, dramatically rising rates could create challenges. For one, REITs are often seen as an alternative to bonds, and higher interest rates could mean decreased demand for REITs, thereby causing a decline in the share price. Also, higher interest rates could put significant downward pressure on earnings as interest costs rise. Again, we see rising rates as extremely unlikely.

Lower consumer spending: With projections from respected institutions such as the IMF pointing to a potentially deep global recession, we believe consumer spending and confidence will continue to be challenged, especially for retail-focused REITs. However, the US government has put forth extensive and rapid stimulus (arguably not nearly enough), and FRT is in much better financial shape than peers. Nonetheless, lower consumer spending remains a significant risk.

Conclusion

In our view, FRT’s business has the financial wherewithal to survive this crisis and to continue raising the dividend. It has strong liquidity, a history of smart capital allocation, and it is in much better shape than peers. Furthermore, if you are an income-focused investor, the “dividend-capture” call option strategy described in this article provides an opportunity to earn even higher income than simply owning FRT shares outright. Despite the very real risks, we like the business, the price and the income-generating options trade opportunity.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FRT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.