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This Legendary Dividend King REIT Is Worth Buying Today

Posted On September 19, 2018 1:37 pm
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Dividend Profile: Generous, Safe, And Rising Income Equals Market Beating Return Potential

The most important part of any income investment, and what ultimately determines long-term returns, is the dividend profile. This consists of three parts: yield, dividend safety, and long-term growth potential.

Stock Yield AFFO Payout Ratio Management Projected Long-Term Dividend Growth Expected Total Return (From Fair Value) 5 Year Valuation Adjusted Expected Annualized Return
Federal Realty Trust 3.1% 80% 6% 9.1% 10.3%
S&P 500 1.8% 38% 6% 8% 0% to 5%

 

Today FRT is offering a generous 3.1% yield, which is far higher than either the S&P 500’s 1.8% or the average dividend aristocrat’s 2.5%. More importantly that dividend is bank vault safe, thanks to a low 80% AFFO payout ratio. For context the average shopping center REIT pays out 97% of AFFO, showing how conservative FRT management is being in creating a very large safety cushion.

Of course the other half of the dividend safety equation is the balance sheet. REITs are a capital intensive sector that naturally has a lot of leverage. So it’s important to make sure a REIT’s debt levels aren’t so high it will be limited in its growth potential or possibly forced to cut its dividend even if AFFO easily covers it.

  • Debt/EBITDA: 5.6 (sector average 5.8)
  • Interest Coverage Ratio: 5.6 (sector average 3.4)
  • S&P Credit Rating: A-
  • Average Borrowing Cost: 3.8%

Fortunately Federal Realty has one of the strongest balance sheets in all of REITdom. In fact, its A- credit rating is the second highest of any REITs, which is why it’s able to borrow at such low rates. And 97% of its debt is long-term fixed rate bonds which means its business model has very low interest rate sensitivity.

Over the long-term a stock’s total returns tend to follow the formula yield + dividend growth. This has proven accurate for stable dividend stocks (business model and growth rates don’t change much over time) since 1956. Under this return model (called the Gordon Dividend Growth Model or GDGM) FRT can be expected to generate 3.1% yield + 6% long-term dividend growth = 9.1%. That’s assuming the stock is starting and ending at fair value (valuation changes cancel out over time).

However, when we adjusted for the stock’s slight discount to fair value we find that the REIT is likely to deliver about 10.3% annualized returns over the next five years. For context the S&P 500’s historical total return since 1871 is 9.2%. And from current market valuations Morningstar, BlackRock and Vanguard expect the S&P 500 to deliver anywhere from 0% to 5% CAGR returns over the next five to 10 years. This shows that, thanks to its superior valuation and yield, Federal Realty is likely to prove a far superior overall investment than the market as whole.

Valuation: A Wonderful REIT At A Good Price

I follow the Buffett principle that “it’s better to buy a wonderful company at a fair price than a fair company at a wonderful price”. Federal Realty Trust is certainly a wonderful REIT but what’s its fair value? While there are dozens of ways to value a stock for stable blue chips like this my favorite approach is called dividend yield theory.

This valuation/investing strategy was pioneered by asset manager/newsletter publisher Investment Quality Trends in 1966. It involves buying blue chip dividend stocks only when their yields are above their historical norms. Using this very simple approach IQT has managed to beat the market over every major time period of the last 30 years, with lower volatility to boot.

Source: IQT

The reason dividend yield theory works well for stocks with consistent long-term growth rates (stable business models) is because over time yields are mean reverting. That means they cycle around a relatively stable level that approximates fair value. If you buy when the yield is above this fair value yield then mean reversion will boost your total returns above that predicted by the GDGM.

  • FRT Yield: 3.1%
  • 5 Year Average Yield: 2.8%
  • 13 Year Median Yield: 3.0%
  • Estimated Fair Value Yield: 2.9%
  • Discount To Fair Value: 6%
  • 5 Year Expected CAGR Valuation Return Boost: 1.2%
  • Expected 5 Year Annualized Total Return: 3.1% yield + 6% dividend growth + 1.2% valuation boost = 10.3% (market 0% to 5%)

Over the past five years FRT’s yield has averaged 2.8% and over the past 13 years its median yield (50% of time it’s above and below this level) has been 3%. I take the average of these two figures to estimate a fair value yield of 2.9%. That implies FRT is about 6% undervalued right now.

Over a 5+ year period a stock trades purely based on fundamentals and valuations tend to mean revert. Thus I estimate that over the next half decade FRT should see a modest 1.2% CAGR return boost from its current valuation. That creates my long-term expected total return (5 year CAGR) of 10.3%. Again that’s higher than the market’s historical return and possibly two to three times what the S&P 500 is likely to deliver over the coming years.

Or to put another way, FRT is about 6% undervalued and thus a good buy given its undeniable blue chip status. Of course that’s assuming you’re comfortable with its risk profile.

About author

Dividend Sensei

I'm an Army veteran and former energy dividend writer for The Motley Fool. I'm a proud co-founder of Wide Moat Research, Dividend Kings, and the Intelligent Dividend Investor. My work can be found on Seeking Alpha, Dividend Kings, iREIT, and the Intelligent Dividend Investor. My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams and enrich their lives. With 24 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and income streams and achieving long-term financial goals.

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