By Allison Landa

Federal Realty Builds on Basics to Grow From Within

As Federal Realty Investment Trust (NYSE: FRT) hit its 42nd birthday on May 25, 2004, the company had embraced the positives of predictability.

"If stability and consistency can be equated with boring, then we want to be known as a very boring company," says Chief Executive Officer and President Don Wood. After briefly turning its corporate emphasis to large-scale, ground-up Street Retail development in the mid- to late-1990s, the company has refocused on the shopping centers that have underpinned its success.

FEDERAL REALTY INVESTMENT TRUST

1626 East Jefferson St.; Rockville, MD 20852 301-998-8100 www.federalrealty.com President & CEO: Donald C. Wood Senior VP, CFO & Treasurer: Larry Finger Core Markets: The Northeast, Mid-Atlantic and California • 52-Week High: $49.50 (11/4/04) • 52-Week Low: $33.51 (5/10/04)

Seated at a table at Congressional Plaza in Rockville, Md., Wood is surrounded by a perfect example of his corporate strategy, which is the balance between solid, good-credit national chains and unique specialty retailers. "You can only obtain that balance in the best locations. I don't mean to say that everything goes back to location—but, in our business, everything goes back to location," Wood says.

Congressional Plaza sits within the greater Washington, D.C. area, which also serves as Federal Realty's core market. The high-density, high-income locale is home to affluent residents who are willing to drive to shop at Congressional's mix of big-name stores and specialty offerings. Its blend of tenants is carefully calculated and precisely sequenced, and the local economy holds a combination of stable government jobs and lucrative private-sector positions.

"Washington is incredibly strong," Wood says. "The government acts as a buffer, keeping the economy strong in bad times, and in the good times, the private economy expands and does extremely well, so there's less volatility in Washington than in most markets."

Through third quarter 2004, Federal owns 109 retail properties totaling 16.8 million square feet, with a market cap of $2.5 billion. The company boasts a portfolio-wide occupancy rate of just less than 95 percent.

Strongholds in Strong Locations

		Upside-Downside Samplings of what analysts are saying about Federal Realty Investment Trust

Today, 29.1 percent of Federal Realty's total square footage lies in the Washington, D.C. metro area, where in addition to Congressional Plaza, the company owns Bethesda Row, Pentagon Row, and more than 20 other regional shopping centers. The company's other core markets are Boston, New York City Suburbs, Philadelphia, Northern California and Southern California—markets that have high population densities and significant affluence with high barriers to entry.

These factors, Wood says, sharpen the company's competitive edge. "It is very difficult for there to be significant changes in competing supply because you're in such dense locations," he says. "It's a critical hedge that keeps our earnings growing steadily and improves our ability to continue increasing our dividend."

Federal's dividends have increased 37 years running, something Wood lauds as one of the company's strongest assets. "We protect that record like gold," he says.

Federal is all about high-quality retail and provides a distribution network to tenants through two main types of holdings: shopping centers and Main Street retail property types. Shopping centers have been Federal's mainstay throughout most of its history. "The company has pulled together what we can demonstrably show is the highest-quality shopping center portfolio in the country," Wood says.

In a November 2004 report, Merrill Lynch analysts Steve Sakwa and Craig Schmidt wrote that Federal's 61 shopping centers are "well insulated from the growing threat of supercenters (both Wal-Mart and Target) given that the majority of its assets are located in high-density markets with well above average household incomes."

Wal-Mart and other discounting retailers are considered a growing challenge to grocer-anchored REITs since they often provide similar services at lower costs. Nearly 70 percent of Federal's shopping centers are grocery anchored. The company's firm foot in the door of the country's premier locations provides a strong block against the Wal-Mart intrusion, according to Federal Realty's Vice President of Capital Markets and Investor Relations Andy Blocher. "A landlord's best defense to compete with Wal-Mart is strength of location," Blocher says. "Federal Realty's focus on densely populated, affluent areas in the nation's best markets has proven effective in combating the Wal-Mart threat to date."

Main Operating Principles

Expansion from within drives Federal's consistency-based model. The company banks on revenue from high re-leasing spreads, with average rent increases of more than 16 percent over the last six years. "We generate higher internal growth from our existing portfolio—on a consistent basis... and that acts as a wonderful foundation for our business plan," Wood says.

Internal growth comes from renewing existing tenants and re-leasing to new tenants in existing holdings. "The only way you're going to get re-leasing spreads that strong is if the supply and demand equation is tilted in your favor," Wood says.

In its November report, the Merrill Lynch analysts note that Federal's shopping-center portfolio enjoyed a strong lease-from-within performance during the third quarter 2004. "(Federal) delivered above average results this quarter with the strongest re-leasing in the community shopping center sector," they wrote.

Having an existing portfolio from which to expand puts Federal at a distinct advantage because they can pick and choose when it comes to acquisitions, Wood says.

"It gives us a little more leeway and allows us to take more time in making only those acquisitions that lead to enhanced, long-term growth," Wood says. "In these days of sub-7 percent cap rates, it is wonderful to be far less dependent on external growth than many of our peers."

One such acquisition was Mount Vernon Plaza, which Federal bought in April 2003. The property, located in Fairfax County, Va., was initially bought as two adjacent, separately owned shopping centers. "We looked at that and we knew that the value would not be in buying one of those shopping centers, but if we could figure out how to buy both of them ... and then go to Fairfax County and to our tenants, putting them together to create a dominant retail destination, we could see significant returns," Wood says.

The plan worked. Federal envisions completing the property's redevelopment in the next 18 months. "We're adding tenants like Bed, Bath & Beyond, PETsMART, Staples, and Michaels, along with the anchors that are already there such as Home Depot and TJ Maxx. The grocer, Shoppers Food, is expanding and renovating to create a first-class supermarket. What we're creating is a single powerhouse retail center where historically there were just two (average-sized centers) without a compelling mix of merchants," Wood says. "But it definitely is a lot of work. If we had to make acquisitions as the sole way to grow our earnings, we wouldn't have been able to take the time necessary to put this all together."

The Santana Row Story

In the mid-1990s, Federal took a strategic gamble. The company decided to step away from its standard shopping center fare and concentrate more heavily on its Street Retail concept. Federal currently maintains 48 Street Retail projects, ranging in scope from small retail spaces in urban areas to larger mixed-use projects. The company has built two of the latter type: Pentagon Row in Arlington, Va., and Santana Row in San Jose, Calif.

"We started diverting our attention from our bread and butter and began building large urban mixed-use projects," Wood said. "We changed the risk profile of the company, making it a riskier place to invest in at that time."

Santana Row proved a vivid example of this risk. The company acquired land for the project in 1997, just as the Silicon Valley tech economy was heating up, and broke ground two years later at the height of the boom. By the time the project—with its 500,000 square feet of retail space, 255 residential units, and a 213-room hotel—was ready for leasing at the end of 2000, Silicon Valley had entered a recession, and Federal was feeling the pinch. "We built Santana Row in the middle of Silicon Valley at precisely the wrong time," Wood says. "We made a very big bet, a $500 million bet. We decided to do it all ourselves. In hindsight, we should not have done that. We should have partnered with other companies, but nonetheless, we made a bet to build a wonderful, but very complex, community."

Legg Mason analysts David Fick and Nathan Isbee were more blunt about the move in an April 2004 report. "Santana Row was a financial disaster and resulted in a turnover of the company's previous senior management."

That shakeup occurred in March 2002, when Wood took over Federal's leadership from then-CEO Steven Guttman. "Santana Row opened ... at a time when unemployment was high, consumer confidence was falling, and signs of a quick national or regional economic rebound were not visible," Wood wrote in a letter to shareholders at that time.

The Santana Row situation worsened in August 2002 when a fast-moving fire destroyed 250 apartment units that were still under construction. The ruined portion of the project was quickly cordoned off, and Santana Row made its debut two-and-a-half months later. The damaged apartments are currently being rebuilt and will be available for lease in the first quarter 2005. Current tenants include Gucci, Sur La Table, and fashionable clothing boutique Anthropologie.

Today, Wood sees Santana Row as a key to future growth rather than a past boondoggle. "Somewhere in this continuum of time between 1997 and 2004, Santana Row went from being our greatest risk to our greatest opportunity," he says. "I believe that happened around 2003 ... It's gained wonderful traction, the momentum is all in the right direction, and it has become one of the best opportunities for growth that we have in our entire portfolio."

The numbers back up Wood's assertion. Fick and Isbee note in an August 2004 report that the project's Phase I retail space was more than 90 percent leased, and that the residential space was nearly 99 percent leased with average rents of $2.05 per square foot. "Santana Row continues to move toward profitability," according to Fick and Isbee. "Although still not anywhere near the late-1990s project pro forma, the open spaces are performing well."

Back to Basics, Toward the Future

Though Santana Row is now stabilizing, the complexities associated with the development of Street retail drove the company to re-evaluate its focus. At the end of 2001, Federal returned to shopping centers as its main area of concentration. "We went back to the basics," Wood says, "the basics being development, redevelopment, and acquisitions of strong necessity-based shopping centers."

And despite its Santana Row difficulties, Federal has hardly abandoned Silicon Valley. In March 2004 it announced the purchase of Westgate, a 637,000 square foot mall in San Jose, for $97 million. A combination power center/mall, the 1960s-era Westgate features national retailers such as Target, Nordstrom Rack, Barnes & Noble, Old Navy and Safeway. The average household income for the area surrounding the mall exceeds $100,000, a figure well in line with Federal's goal of owning centers in affluent areas.

"It's only five miles away from Santana Row, yet we merchandise these two properties very differently," Wood says. "We merchandise them based on what the surrounding community needs. Westgate Mall is very much a necessity-based shopping center."

In a Legg Mason report, Fick and Isbee emphasize Federal's expansion from within its current holdings. "Federal Realty's renewed focus is on extracting growth and value from existing mature shopping centers in its core portfolio," the two wrote.

And Wood wants to continue doing what Federal does best—owning and operating strong, high-quality retail locations. "I don't believe the shopping-center business is rocket science," he says. "The ideas we try to put into play at Federal are ideas that good, smart real estate people are trying to do all over the country. The difference is, in my humble view, we have better raw material with which to work."