As I completed my recent mini-series on the best and worst performers of the third quarter, retail REITs were one of the sectors that were over-represented among the market laggards. Seven of the worst 50 performers in the third quarter in the S&P 500 were REITs, with retail REITs like Regency Centers (REG), Federal Realty Investment Trust (FRT), and Kimco (KIM) among the laggards.
Federal Realty Investment Trust is an interesting story. The stock was down over 12% in 3Q, taking its year-to-date decline to more than 40%. While equity markets have punished the retail-focused REIT, the company was recently able to borrow in unsecured debt markets for 5-years, paying investors a coupon of just 1.25% per year. By tapping unsecured debt markets, the REIT is not directly encumbering any of its commercial real estate assets.
In December 2019, I waded into a discussion about a mid-cap retail REIT, Tanger Factory Outlets (SKT). In that article, I noted that a yield-weighted dividend growth ETF owned 22% of that retail REIT, and that a potential cut to the dividend could lead to forced selling by the dividend growth fund that owned such a big proportion of that REIT. That event would unfold, and the stock is down roughly 60% since that date, battered by both the selling of dividend-focused investors and the pandemic’s negative impact on brick-and-mortar retail.
Federal Realty Investment Trust, like Tanger before its cut, has an exceptionally long track record of increasing annual dividends. Federal Realty Investment Trust has increased shareholder payouts for the past 53 years, managing to lift its dividend over multiple business cycles, various market crises, and high and low inflation environments. The dividend growth history is a testament to the success of multiple management teams, and an item the REIT highlights frequently to investors.
This dividend growth history has included the REIT among the Dividend Aristocrats (NOBL), a group of S&P 500 constituents that have paid increasing dividends for more than 25 years. Together these companies have produced higher absolute and risk-adjusted returns than the broad market, but are, like FRT, lagging in 2020.
Will the negative operating environment for retail-focused REITs end FRT’s very long dividend growth streak? In the short-run, that seems unlikely. Monetary policy from the Federal Reserve could play a big role in helping to extend this streak as indicated by the 1.25% coupon on its recent five-year bond issuance. As I highlighted in early April in The Fed’s Alphabet Soup Explained, the Federal Reserve’s Primary and Secondary Market Corporate Credit Facilities targeted purchases of investment grade corporate bond issues with less than 5-years to maturity.
While the Fed has in actuality purchased very little corporate debt, its backstop has spurred market participants to aggressively bid up the price of short-dated corporate bonds, driving spreads meaningfully tighter. The graph below shows the credit spread over Treasuries for bonds with 1-5 years to maturity in the Bloomberg Barclays U.S. Investment Grade Corporate Bond Index. As you can see in the graph below, credit spreads have rarely been lower over the past two credit cycles. Despite the negative economic environment, and the pandemic-driven uncertainty for a wide section of the credit markets, short-dated corporate bond markets have rarely been able to pay a lower premium over Treasuries to compensate investors for credit risk. While FRT paid a wider spread (105bp) than the market on average, this tightening of credit spreads has extended to businesses like FRT that have been uniquely challenged in this stress environment.
On the graph above, the blue line shows the average spread for investment grade corporate bonds with 1-5 years left to maturity. Spikes during the Great Financial Crisis and the very short-term spike in March 2020 stick out as outliers. The red line takes the current average spread level (68bp over Treasuries), and draws a line to frame current levels clearly with previous market environments. Spreads took years after the last crisis to return to levels akin to the current environment, and have rarely been as tight as current levels. The quick intervention by the Fed in this crisis has allowed spreads to rebound much quicker than the previous crisis. By reducing the chance that liquidity risk could spiral into solvency risk for good businesses, the Fed has helped to spur the recovery in equity prices as well.
Of course, the graph above is just the spread component of a bond’s yield. When one includes very low Treasury rates, the financing conditions look even better. Below is a second graph that shows a history of the yield-to-worst of investment grade corporate bonds with 1-5 years to maturity. The current level of 0.89% is only marginally above the all-time low of 0.86% set last month.
This extremely attractive financing environment is benefitting companies like Federal Realty Investment Trust. While the stock is down over 40% on the year, reflecting the challenging environment for brick-and-mortar retail, the company just borrowed nearly $400M for a fixed rate of 1.25% for the next five years. That is a rate lower than the most recent inflation readings, suggesting that FRT is borrowing at negative real rates.
Over the company’s fifty-plus year history of rising shareholder payouts, they have successfully faced a myriad of economic environments. The pandemic may accelerate the secular decline in brick-and-mortar retail, presenting a more challenging operating environment than the company has seen over its long and successful history.
The company will term out near-term debt maturities, using the cheap financing to reduce interest expense and improve its debt maturity profile further. The company will then have a couple of choices with proceeds from this recent issuance and future bond issuances. Choices include developing new properties, renovating existing properties, or acquiring properties from stressed sellers with higher costs of capital. The company’s hard-won single-A bond ratings should benefit them in a stressed environment.
Some investors may prefer the company choose to use this cheap funding to repurchase its hard-hit shares, which now sport an indicated dividend yield of 5.7%. Borrowing at 1.3% to retire shares at 5.7% can aid the company’s ability to continue to grow shareholder payouts on the margin, at least in the short to intermediate term. Of course, this action will also increase leverage, and potentially weigh on the company’s high credit ratings. While the company has not traditionally repurchased shares, this could be an option to support its battered equity owners. Despite the market cap of the company falling meaningfully in 2020, the company still trades at over 2x its book equity, perhaps limiting the efficacy of buybacks.
In the short-term, one thing equity investors may disfavor is the company developing new properties. Retail square footage per capita in the United States is roughly a third greater than that in Canada, double that in Australia, and 5x that in the United Kingdom, France, and Japan. With the pandemic-driven acceleration of the shift to e-commerce, the United States is likely to find out that it has far too much retail space. While dense in-fill locations in primarily coastal markets have been a winning trade in recent decades for FRT, that footprint has been negatively impacted in this virus-impacted drawdown. Acquiring properties at capitalization rates (net operating income divided by valuation) that provide a large spread to FRT’s cheap funding cost can be a winning trade, but new development seems like a riskier proposition in this environment.
Financing costs have never been lower over near-term horizons for investment grade companies. These low coupons look uncompelling from a bondholder’s perspective for businesses facing secular stress. From an equityholder’s perspective, this low cost financing presents opportunity. Management teams in stressed sectors, however, may need to execute different playbooks than over previous stress environments. Federal Realty Investment Trust, which issued recent five year debt at just a 1.25% coupon, provides an excellent example of that dichotomy. This unique stress period is producing winners and losers across sectors; within a given sector, how companies choose to navigate the environment will determine their fate, making confidence in management’s strategy an increasingly important part of an individual stock decision.
Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance and investment horizon.
Disclosure: I am/we are long NOBL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.