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Morningstar | Re-Leasing Spreads Off, but Expense Control Leads to 3Q Outperformance for Federal Realty

While fundamentals were mixed, Federal Realty beat our bottom-line projections for the third quarter. We are maintaining our $141 fair value estimate and no-moat rating. The percentage of the portfolio leased was down 30 basis points to 95.2%, matching our estimate, while physical occupancy remained flat at 94.1%. Total re-leasing spreads were only 5.8% in the quarter, the lowest level since 2011, though the trailing 12 months is still at 12.0%. While we expect re-leasing spreads to decelerate over the next few years into the low single digits, we will be closely scrutinizing next quarter's results to see if the third quarter was just a blip or a sign that spreads are slowing much faster than we anticipate.

The occupancy drop combined with the lower-than-expected re-leasing spread led to comparable revenue being up only 2.2% year over year in the third quarter. However, Federal did a great job reducing expenses as comparable expenses were down 0.7% for the quarter, which increased margins for the comparable portfolio by 90 basis points to 70.8%. As a result, Federal Realty reported comparable net operating income of 3.5%, ahead of our 2.2% estimate. The property expense saving, combined with general and administrative expense being lower than expected, led to a $0.03 funds from operations beat to $1.58. Federal increased FFO guidance for 2018 at the midpoint to $6.21 from $6.18, which puts our 2018 estimate only 0.3% above the updated midpoint. While there were some worrying signs in the quarter, Federal Realty showed that it is still able to execute on driving growth higher than its lower-quality peers.

Federal Realty was able to provide some explanation as to why the lower-than-expected re-leasing spreads were a one-off item. It had a larger-than-usual percentage of gross leasable area up for renewal get re-leased by existing tenants, which typically pay a lower re-leasing spread than a new tenant does. The renewal lease spread was only 1.9%, lower than the high single digits it has been averaging on such leases over the past few years. This was driven by two anchor tenant renewals that make up more than half of the area renewed this past quarter that signed deals at new rents that were flat with last year's rent paid. One of the anchors has been experiencing 3%-3.5% annual rent bumps since the initial lease was signed in 1995, significantly higher than the flat to minimal rent bumps signed by most anchor tenants. The new lease will continue to grow at 3.5% annually, so we really like that Federal will be able to see incremental growth from such a large tenant each year rather than having to wait for the lease to end to realize revenue growth. The other anchor tenant exercised its second five-year option in a market that has had significantly supply built just across the street in the past few years, so the fact that Federal is able to retain it as a tenant without giving concessions or having to spend on improvement costs for a new tenant is a mild positive, given the circumstances. We want to see re-leasing spreads return to double digits next quarter, but we are satisfied with the explanations management has given as to why this particular quarter was below the company's trendline.