Shopping Center REITs - Dividend Outlook 2021

Summary

• Most of the shopping center REITs have suspended their common dividends.
• Payout ratios were far too high anyway, averaging 97% of 2019 AFFO.
• A review of dividend tax allocations provides helpful insight.
• An expected dividend 'reset' to sustainable levels will come in 2021.

Image Source

A Quick History of Shopping Center REITs

Shopping center REITs represent an established category within the REIT space, dating back to Federal Realty's (FRT) IPO in 1962. Typically anchored by a grocery store, these local community centers are a suburban mainstay and historically churned out 3% NOI growth like clockwork. Yet there has been stress on the shopping center REITs over the last few years, resulting in elevated dividend payout ratios. These problems can be attributed to three general areas:

• The trend toward lower leverage is dilutive to cash-on-cash returns. For example, Retail Opportunity (ROIC) went from 9.5x Net Debt/EBITDA in 2012 to 7.1x in 2019. That's a tough headwind for dividends, even as the ROIC portfolio performed well.
• Portfolio cleanups have been expensive. Acquisition sprees left more than a few REITs with far-flung portfolios and complicated JV structures. Shopping center REITs have now embraced the Federal Realty model - fewer centers, upscale demographics, and constant reinvestment to remain competitive. Kimco's (KIM) downsizing from 888 properties in 2012 to 409 properties at the end of 2019 illustrates the dramatic shift in portfolio composition, echoed by SITE Centers' (SITC) 62% decrease in store count over the same time frame.
• Backfilling tenant vacancies requires capex dollars. Shopping center REITs have done a decent job of maintaining occupancy in a weak retail environment. But recurring capex spending for tenant improvements and leasing commissions has been high. For the REITs profiled in our shopping center group, recurring capex increased from 12.0% of EBITDA in 2015 to 17.5% for 2019. This reduces free cash flow and crowds out dividend capacity.

2019 Dividend Payout Ratios Were Far Too High...

The following chart shows AFFO dividend payout ratios for 2019 and the status of dividends for 2Q'20. Of the group, only Regency (REG) seems to have entered 2020 with a clear margin of safety. It can probably be argued that even a garden-variety recession would have caused dividend problems, let alone COVID-19.

Source: REIT/BASE

Reading the Taxable Tea Leaves

The following chart examines how much of each REIT's dividend was comprised of ordinary income. As a general rule, the higher the percentage of ordinary income reported to the IRS, the safer the dividend. Dividends with material portions of capital gains and return-of-capital are shaky, in our view. While tax allocations can vary year-to-year, taking an average of 2017-2019 provides a useful look at dividend policy.

Source: REIT/BASE

Let's see how this data works in reality. Federal Realty and Regency Centers have the highest proportion of ordinary income at 100% and 94%, respectively, and these were the only two REITs in the group that have not suspended their 2Q dividends. While this could be an amazing coincidence, we doubt that's the case. Both FRT and REG focus on upscale centers that attract stronger national and local tenants. Even if some rent has to get deferred, it's our understanding that the deferred portion remains taxable. So, for these two REITs, where the dividend is already close to the taxable floor, there's simply no point in suspending the 2Q dividend only to have to make it up later.

It's a completely different story for some of the other shopping center names. Kimco and RPT Realty (RPT) have low dividend coverage from ordinary income and higher (100%+) AFFO payout ratios. These characteristics point to dividends that were already on the aggressive side in 2019, with no room to accommodate stress on the business.

While management teams and boards are naturally reluctant to cut the dividend, a global pandemic and 50-60% rent collection requires drastic action to conserve cash. Not to be callous, but if there's a silver lining from the fallout of COVID-19, it's the opportunity to bring the dividend back to reality, starting with a deferral in 2Q'20 and continuing with a reset to taxable minimums for 2021.

Dividend Outlook: 2020

Trying to estimate 2020 REIT taxable income - in late May - might be an exercise in futility, given the fluid situation with tenant rent payments and store closures. Yet there are some takeaways from the 1Q earnings calls that point to how the year might go.

Every REIT, of course, intends to pay at least 100% of its 2020 taxable income to maintain REIT tax status. The question then is what's taxable. If rent collections pick up in the second half and the remaining deferred amount is still taxable, REITs will probably need to pay a 'true up' dividend in 4Q to balance the books. It's possible that smaller dividend payments resume in 3Q, but we think boards will wait until the end of the year before declaring any significant distributions.

The following excerpt from Kimco's 1Q'20 earnings call supports the need for additional 2020 dividends:

Alexander Goldberg - Piper Sandler "Hey, good morning and thank you. First just on the dividend, you guys suspended the common dividend, but it sounds like you are still going to pay the preferred. So based on where you have paid the common so far, and presumably you are going to pay preferreds the rest of the year. Do you guys need to pay a common dividend, the balance of the year to satisfy a tax compliance with REIT status?"

Glenn Cohen - CFO "Based on where we are currently and based on our own internal forecast, the answer is yes, we would still need to pay a further dividend to cover taxable income."

Dividend Outlook: 2021

2021 is where it gets more interesting. Shopping center REITs have been struggling with elevated payout ratios for years. Now's the chance to place dividend policy on a firmer footing by setting the 2021 dividend just above taxable minimums. While it would normally be useful to use the prior year as a baseline for 2021 projections, 2020 just isn't that kind of year.

Instead, we'll use 2019 for the baseline as outlined in the chart below.

Source: Author Estimates

Our 2021 dividend estimates are based on the following key assumptions:

• Management teams bring dividend payments down to taxable minimums in order to preserve cash.
• Capital gains income subsides with fewer asset sales.
• As a rough guess, we've modeled a 10% decrease in 2021 ordinary income as compared to historical levels.

We think it's unlikely that 2021 NOI will bounce back to pre-COVID levels. We suspect that occupancy will drop several points and some of the deferred rent will end up being written off. Movie theaters and restaurants might require more significant lease adjustments, including placing tenants on percentage rent. It's all about defense now, so leasing efforts will therefore focus on maintaining occupancy at the expense of rate, and landlord outlays for tenant improvements and leasing commissions will remain elevated.

Vacancy will clearly be higher on the other side of this crisis, no good prediction on how much higher at this point - Don Wood, CEO Federal Realty Trust.

At all costs, shopping center landlords must try to minimize the vacancy creep by carrying their small shop tenants across 2020 and delivering them safely into a stronger 2021. Both FRT and KRG announced on their earnings calls that they were forming specific funds to assist with tenant working capital needs, and other REITs might follow these initiatives. As noted by Kite Realty in a recent presentation, there is a high cost to replacing any of these tenants. To paraphrase KRG:

Short-term dislocation in rents is much more benign than permanent dislocation. For example, a small shop tenant with $22/psf of total rent annually could cost $30/psf in tenant allowance to replace. This tenant allowance would equate to 16 months of current rent, excluding down time.

The good news for the REITs is that they have an abundance of liquidity to cover their own operations and tenant needs for at least the next 18 months. Drawdowns on revolving credit lines have created substantial war chests and near-term debt maturities are modest. The REITs also reported that rent collection in the 50-60% range for April/May was generally sufficient to cover operating costs, interest expense, and a modest level of capital expenditures. So, absent the common dividend payments, there should be very little 2Q cash burn.

Conclusion

We believe that shopping center dividends will ultimately reset at lower rates for most of the group, with FRT and REG being the two exceptions where current dividends might be sustainable. Certainly, 2020 and 2021 will be 'reset' years for the group; yet we see open-air shopping centers as being favorably positioned relative to regional malls, particularly in an environment where high unemployment increases the focus on basic goods and services.

Thanks for reading, and we look forward to your comments.

Analyst’s Disclosure: I am/we are long REG, ROIC, SITC.PK, KIM.PM. 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.

Comments

[Joe X]

Guys - ROIC just reinstated the dividend at $0.11 ($0.44 annualized) versus our annualized estimate of $0.55. I think what's going to happen is that some of these initial dividends will increase sequentially through 2021, particularly if tenants on cash accounting get their businesses running at a higher level as the vaccines roll out.

Hope everyone is staying safe and healthy in the meantime.

Rgds,

Joe X.

[Joe X]

Guys - Urban Edge (UE) just announced that it will reinstate dividends in 2021 starting at $0.15 in the first quarter. This is very close to the $0.16 we had predicted on our article. The 2019 dividend was $0.22/qtr.

This is actually very good news from UE. They are essentially providing $0.60 of annual dividend guidance now, which speaks to confidence on 2021 leasing/occupancy trends.

Rgds,

Joe X.

[Joe X]

Guys - as an update on forward dividends, BRX just announced a $0.215 dividend for 4Q'20, which kind of sets a run-rate of $0.86 for full-year 2021.

In the table above we had predicted $0.85 for 2021.

We'll see how the rest of the predictions play out over the next few months, but dividends are clearly being right-sized against expectations for 2021 taxable income.

Rgds,

Joe X.

[Scott27]

Great insights on what % of divi is ordinary income vs potential fluff. I don’t recall seeing this called out so clearly on any other article on REITs I have read here in the past year. Thanks

[Joe X]

Kite Realty (KRG) finally cut its dividend 84% for the second quarter, which is consistent with the actions taken by the rest of the shopping center group. Again, the percentage of KRG's dividend covered by ordinary income had been declining for at least the past two years, providing a leading indicator that the dividend was at risk.

Rgds,

Joe X.

[srvalue]

Thanks for the great insights. Any specific reason why you haven't included MAC, TCO, SPG ?

[Visual Capital]

@Joe X From your analysis I can understand why you're REG. Could you elaborate on what you find alluring about ROIC (I'm guessing the next highest % ordinary income) and SITC.PK?

[Joe X]

@Visual Capital - ROIC reported one of the highest April collection rates at 68% of base rent and CAM, and more recently said that they've received 71% of May base rent. So they seem to be doing ok on being able to cover operating costs, interest, and capex. Can't wait to see the 2Q numbers for the group, although there's likely to be a lot of noise with rent deferrals and receivable write-offs.

I would say that ROIC might be something of an asset play as well. Not easy to assemble a West Coast shopping center portfolio, and ROIC is kind of bite-sized and might be of interest to private equity. ROIC also has a very advantageous debt maturity schedule - nothing due in 2020 or 2021, then just $24.5 million in 2022. This gives them plenty of flexibility to work through tenant/operations issues over the next year or so.

The SITE.PK has a fairly high coupon at 6.25% and is callable now. I'm guessing management will want to take out at some point with either debt or common equity, so it's really just an opportunity to generate some yield and maybe a small capital gain if bought below par.

I will caution everyone that when CFO's were talking about "breaking even" for 2Q, I didn't hear anyone say that included preferred stock dividends. We'll see how the numbers shake out for 2Q, but I wouldn't say there's a margin of safety at the moment. The corporate bonds though are well covered and might provide some decent yield.

Rgds,

Joe X.

[dkMazz]

Your numbers look flat out wrong. ROIC for example (according to SA) had 125.7m shares outstanding and FAD of 133m. That's a payout ration of ~75% [(125.7 * 0.8)/133].

WRI had 2.09 AFFO/share for a payout ratio of ~75% (1.58/2.09).

I could go on but I've got better things to do than check them all. Even if your numbers are closer to the truth than SA's, I still have a problem with statements like, "Now's the chance to place dividend policy on a firmer footing by setting the 2021 dividend just above taxable minimums".

Why? So you can perhaps get your dividends at some indeterminate future date rather than right now? Never understood that logic.

FWIW I bought every stock on that list in the last month EXCEPT FRT and REG.

[Joe X]

@dkMazz - one thing to keep in mind is that we do our own numbers here and they may vary from other sources. As you probably know, ROIC does not publish AFFO/share, but does give you all the pieces on p. 6 of the 4Q'19 supplemental to DIY. So let's take a look at 2019:

$138.067 - FFO

- $3.083 - straight line rent
- $15,618 - MTM lease adjustment
- $25.648 - recurring capex

= $93.718 - AFFO

125.741 - diluted shares

= $0.745 AFFO/share

$0.788 - dividends / share

= 105.8% AFFO Dividend Payout

Note that this calculation does not add back $2.6mm of financing costs and $8.5mm of stock comp. We consider these real economic costs to the investor and that's our point of reference.

Rgds,

Joe X.

[Other Side Of Trade]

Interesting point of view. Thanks for the article. Long FRT, KIM and UBP (common and preferreds).

[newbieslp]

Sobering, yet realistic projections. 10% drop for 2021 ffo may even be optimistic.

New follower.

Slp

[Joe X]

Thanks Sip.

[Landlord Investor]

Interesting that 2 of your 4 positions in this sector are in the preferreds yet your article doesn't discuss preferreds. Any thoughts you could add as to why you like the SITC and KIM preferreds? You didn't cover BFS or their preferreds but that's a solid REIT as well.

[Joe X]

@Landlord Investor - you're correct on the preferred holdings, it's really just a way of trying to generate some income in the space while waiting for the common dividends to get turned back on. Assuming that cash collections don't materially worsen for the group, there's plenty of liquidity to cover the preferred dividends. Traditional preferred analysis like looking at fixed charge coverage (might not even be 1.0x for 2Q) clearly isn't going to work for the next couple quarters - it's all about excess cash balances for any margin of safety. I will also add that it's critical to maintain access to the fixed income markets, and passing on the preferred dividends would send a really bad signal to your banks and bondholders.

Thanks for the comments.

Rgds,

Joe X.

[Bigsmitty]

Good analysis, Thanks

[Joe X]

Thanks Big.