Introduction
Investing in REITs has been out of favor since the FED started tightening monetary policy back in 2022. In particular, both the retail and office sectors have struggled due to secular headwinds in addition to higher interest rates. While caution is warranted, the valuation multiples of some of the securities trading in this sub sector are completely unjustified. One such example is Kite Realty Group (NYSE:KRG) which just reported second quarter earnings last week.
KRG is a retail focused REIT, with the majority of their holdings located in the Sun Belt markets and a focus on grocery-anchored centers. KRG’s share price has been in a steady uptrend since the beginning of the COVID-19 pandemic, yet I believe shares are still trading below their intrinsic value.
Q2 Earnings
KRG reported second quarter FFO per share of $0.53 which beat consensus estimates by $0.03. Similarly, revenue came in at $212.43mn, a $4.06mn surprise to the upside. They reported a net loss attributable to common shareholders, which management claimed was primarily driven by a $66.2mn impairment charge. This is a non-cash expense and therefore is not included in our discussion of FFO or AFFO (the primary metrics used to analyze REIT performance).
In addition to beating estimates, the board raised the quarterly dividend by 8.3% YoY to $0.26/share. This figure has been trending upwards ever since the depths of the COVID-19 pandemic when retail REITs were under immense pressure.
Investor Presentation Highlights
At the end of the second quarter, both S&P and Moody’s upgraded their credit ratings for KRG. This is a positive sign, receiving approval from these respected agencies, and it shows that their efforts to shore up their balance sheet are not going unnoticed.
This is related to their debt maturity profile, which is well staggered, as only 2026 has more than 15% of total debt outstanding maturing in that calendar year (18.8%). Also, they have no debt maturities scheduled for 2024. This is fantastic, as it is all but certain that the Federal Reserve is planning on loosening monetary policy over the coming months.
KRG also reported a record quarter in many relevant categories, such as net debt to adjusted EBITDA. This figure shows how many years of operating earnings net of non-cash expenses it would take to repay outstanding debts. This figure came in at 4.8x for the quarter, significantly lower than their pre-pandemic level. KRG appears to have timed their use of leverage well, as you can see in the chart below that their net debt to A-EBITDA figure was much larger in the years leading up to the crisis.
Management included a comparison of their net debt to adjusted EBITDA figure compared to seven of their primary competitors. This shows that they are the least levered company of this group compared to the amount of operating income they are generating.
Guidance for the rest of fiscal ’24 is solid, with the midpoint of expected FFO per share marking a 2.50% increase YoY ($2.05 ’24 vs. $2.00 ’23). Over the last two years, FFO has come in above expectations 7/8 quarters, with only one miss. This leads me to believe that FFO/share will come in closer to managements high end ($2.08) which is a 4% improvement YoY.
Another positive sign is KRG’s performance against some of its direct peers. Their FFO per share has grown at a CAGR of 4.4% since 2019, which is 57% higher than their next closest peer during that time frame. Showing this level of growth and resilience in the face of a worldwide pandemic that shut down or severely limited the operations of many retail centers is incredibly impressive and shows how talented and driven the management team at KRG is.
The ability to control costs when operating a REIT is incredibly important. KRG’s general and administrative costs as a percentage of total revenue are 140bps lower than the average among their peers.
Industry Trends
KRG provided some interesting data to support the bull case for retail focused REITs in the post-COVID environment. Retail store closings have been extremely low relative to the historic average after a massive spike during the first year of the pandemic. This aberration could be explained as the market digesting the historically high number of closure during 2020 (just under 12,000) and we may see this return closer to the historic average in the coming years.
I believe there’s also a chance that this reflects a change in consumer behavior. Since the onset of the pandemic, we have seen a structural change in people’s working lives. Working from home has become increasingly common, and many retail centers are located in the suburbs.
This idea is supported by J.P. Morgan Head of Commercial Mortgage Lending Troy Applegate who states “Hybrid work is driving the evolution of brick-and-mortar retail… consumers are still making purchases seven days a week. They’re just shopping in different places-mainly, closer to home.” This, I think, is a better explanation for the lower than average retail store closings since the 2020.
Location, Location, Location
A common phrase within the real estate industry is that there are only three things that matter when it comes to purchasing a property: “location, location, location.” KRG carefully selects where they purchase properties, with 69% of their annualized base rent (ABR) coming from the Sun Belt markets.
The state with the most concentration within their portfolio is Texas, comprising 27% of their ABR. As of the end of FY2023, Texas had the second-largest population of any state in the U.S. with 30.5mn inhabitants. This figure has been growing at ~2% a year going back to the 1990s, and with higher population counts comes more consumer demand for retail goods. This is an obvious tailwind for KRG that has allowed them to excel over the past few years and continue to grow.
The markets they operate in that are not located within the Sun Belt region are also expansionary, with Seattle containing many consumers with high discretionary income due to Silicon Valley and New York being home to some of the wealthiest consumers in the world. While sales at retail stores do not translate directly to revenue for KRG, it does incentivize businesses to open and compete with one another in these areas and the more demand there is for retail spaces, the more rent KRG can charge.
Valuation
Having given some background on recent financial/operating results as well as macroeconomic trends, I want to use three different methods to try and measure the intrinsic value of KRG’s shares. First I compared the forward P/AFFO multiples of KRG to four of its competitors (FRT, BRX, KIM, and REG). Among these four, the average forward P/AFFO multiple was 18.66x, compared to KRG’s measure of 16.49x. This gives KRG shares an intrinsic value of $27.31 with 13.13% implied upside.
On the flip side, if we use the sector average of 15.69x, KRG shares appear slightly overvalued with an intrinsic value of $22.97/share (4.85% downside). Their higher forward P/AFFO multiples among these companies reflect analyst estimates that adjusted funds from operations will grow at a rate faster than the average REIT. Therefore, I think the first comparison is more apt.
The next model I used to determine the value looks at the historical P/FFO multiple over the last 10 years compared to the TTM multiple. Currently, the trailing multiple is about 3.17% higher than the 10-year average. This is not necessarily a cause for concern, as a firm that is growing FFO per share should be trading at a higher multiple. Considering the aforementioned FFO per share growth of 2.5-4%.
I looked at all the past years where the P/FFO multiple was higher than the TTM average. The average FFO per share growth rate over these years was -1.19%. This is heavily skewed by 2021 where P/FFO was at a decade high 15.48x but FFO per share contracted 37.96% YoY. If we remove this year from the dataset, we see the average is 11.06%. This is a small data set. Therefore it should not be entirely relied upon, but it does show that in the recent past the firm was growing FFO per share at a higher rate when multiples were in this range.
The final model I used is the dividend discount model. Here I gathered dividend payouts and growth rates over the past 5 years, as well as analyst estimates going forward. These estimates seem conservative, so they work well for the base case scenario. I then computed a weighted average cost of capital using these inputs:
I ran this model multiple times, making slight adjustments to the two variables that drive the valuation: growth rate and the cost of capital. The conservative case used a 2% terminal growth rate with a cost of capital of 8.19%. This yielded an implied share price of $17.47 (27.91% downside). In a base case scenario, I used a growth rate of 2.5% and the WACC from the equation in the chart above. This game an implied share price of $20.94 (13.57% downside). Finally, for the optimistic assumptions, I used a 3% growth rate and a 7.19% cost of capital. This gave me an implied share price of $26.06 (7.54% upside).
Takeaways
While there is a case to be made that this stock is cheap, the majority of the models I used concluded that the stock is moderately undervalued to slightly overvalued. I love a severely undervalued stock, but what I love even more is a stock trading at or slightly below its intrinsic value with solid fundamentals and a clear growth trajectory. This description encapsulates perfectly my view on KRG. Not too cheap, not too expensive, but a great company at an extremely reasonable price.
Today while writing this article the share price rose 1.9% and over the past month, it is up 9.16%. Clearly, investors are taking notice of this company, and it is only going to get more expensive when the FED begins to cut rates over the coming months. I label this stock a buy and believe it makes a solid addition to any well diversified portfolio.
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