- 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.
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.
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.
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.
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.
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.
This article was written by
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.
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