FRT

This High-Yield Dividend King's Tortoise-Like Approach Is a Business Winner

Federal Realty (NYSE: FRT) has created an incredible dividend record, with annual increases every year for 56 consecutive years. This real estate investment trust (REIT) didn't become a Dividend King by accident. It has a well-used playbook that it follows, and one important play in that book is to focus heavily on the rent escalators in its leases. Here's why that matters for this 4.6%-yielding landlord.

Federal Realty's big-picture view

Leases are a bit of minutiae, and Federal Realty's focus on the escalators in its contracts is only possible because of other aspects of its business. For example, while some of its strip-mall and mixed-use peers try to build giant property portfolios, Federal Realty goes for quality over quantity. It owns only about 100 or so properties.

A person sitting across a desk from two people in a negotiation.

Image source: Getty Images.

Those properties, however, are very attractive. The company tends to buy in and around major metropolitan areas where there is material population density combined with high incomes.

When placed on a graph, Federal Realty's average income and population within a three-mile radius of its properties are both materially higher than any of its peers. Looking at the REIT's portfolio from a different direction, it has less exposure to lower-income areas than any of its closest peers. Basically, it is in areas where its tenants want to be.

This provides Federal Realty with a number of benefits. For example, during the pandemic, when occupancy was under pressure, the REIT was fielding incoming calls from potential tenants looking to exit nearby locations so they could get into a Federal Realty property. And, more to the point here, the REIT can negotiate lease terms more aggressively than its peers.

The difference a percentage point makes

During Federal Realty's third-quarter 2023earnings call CEO Donald Wood highlighted the importance of leases. First, he said that anchor tenants, usually large retailers, are the driving force at the REIT's properties. Having the ability to get great anchors drives demand from the smaller tenants that fill out a center. And, perhaps just as important, he said the leases the company signs with those anchors are among the "strongest" those anchors sign.

But what is a "strong" lease? Believe it or not, the difference between a 3% annual rent increase and a 2% or lower increase is huge. A single percentage point might sound like just a small amount, but it adds up over the life of a lease. Some numbers will help illustrate that.

Start with $20 per square foot in rent and then increase the rent by 3% annually for 10 years, and the rate increases to $26.10 per square foot by the end of the lease. Drop that escalator down to 2%, and the rent per square foot is just $23.90 by the end of the lease.

But, more importantly, the tenant pays nearly 5% more in rent over the life of the lease. And when it comes to renewing the lease, Federal Realty's ending rate is likely to be closer to the current market rate. That makes it easier to engage in lease negotiations because the initial rent bump in the new lease will be smaller.

Square Foot Lease Rate

3% Annual Escalator

2% Annual Escalator

10% Rent Bump at Year 5

Year 1

$20

$20

$20

Year 5

$22.51

$21.65

$22

Year 10

$26.10

$23.90

$22

Total rent over lease

$2.29 million

$2.19 million

$2.10 million

Data source: Federal Realty

Some other REITs' leases, meanwhile, don't have regular rent increases. Instead, they have a larger bump in the middle of the lease. Federal Realty's ability to demand higher annual increases comes out on top again.

Assuming the same $20 per square foot in rent and a single 10% rent bump in the middle of the 10-year lease, the ending rent would be $22 per square foot. That's even further behind Federal Realty's $26.10. A lease with a single 10% bump, despite how big that figure sounds, would collect around 9% less rent over the life of the lease. Getting the lease up to market rents would require a far larger increase at the end of the lease as well.

In fact, the 10% lease bump would likely lead to far more tense negotiations at the end of the lease. The landlord would be in a weak position because failing to renew the lease would require it to find a new anchor tenant. And, as hinted at above, having an empty anchor location would depress the performance of the entire property.

Federal Realty does the little things well

Federal Realty's leasing approach is just one piece of the business model. For example, the REIT has a long history of redevelopment and development that serves to keep its properties at the leading edge in the communities it serves.

The key here, however, is that focusing on the little things (like the difference between a 3% rent escalator and 2%) can lead to material long-term benefits. Getting the little things right time and time again is part of the reason Federal Realty has managed to achieve Dividend King status. Nuances like this separate great companies from the pack.

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Reuben Gregg Brewer has positions in Federal Realty Investment Trust. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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