Kite Realty Group (KRG) is among the top long-term deep value opportunities in the REIT market today and should also appeal to income-focused investors as well for the following five reasons:
- KRG's portfolio is already high-quality and should continue to significantly improve, thanks to dispositions and redevelopments.
- The company's already quality balance sheet also continues to show signs of rapid improvement.
- The dividend is extremely attractive, yet remains quite safe.
- Shares trade at a massive discount to NAV.
- Grocery-anchored shopping centers are a fairly e-commerce and recession-resistant real estate sector, making them a great place to find value and safety in today's richly priced market.
The market is likely ignoring this steep value disconnect due to the murky near-term growth outlook from dispositions and repositioning within the portfolio and the guilt-by-association with broader retail, not to mention rising macroeconomic uncertainty. However, the long-term fundamentals of the properties point to continued low-single digit cash flow growth rates, especially considering the improving diversity and recession resiliency of KRG's tenants.
Meanwhile, the steep discount to NAV, the attractive dividend yield, and the low price-to-FFO multiple provide a strong price floor for shares, as they each indicate the REIT is undervalued relative to its own history. Despite the minimal long-term downside risk, investors should adopt a patient mindset and be prepared for short-term volatility due to interest rate, retail, and macroeconomic-related jitters.
#1 Improving Portfolio
As KRG's recent REIT Week presentation indicates, its portfolio of neighborhood and community shopping centers is thriving.
This strong performance is being boosted by its presence in some of the top markets in the country (77% of ABR comes from the top 50 MSAs and destination locations, including high-growth markets like Dallas/Fort Worth/Houston with 8% expected population growth, Naples, Florida with 10.5% expected population growth, and Charlotte/Raleigh with 13.5% expected population growth.
95% of its operating portfolio is leased, same-property NOI grew by 1.8% year-over-year in Q1 thanks to minimum rent and net recoveries growth, and a company record 91.6% small shop leasing occupancy percentage. The overall occupancy rate remains solid at 92.2% (the 2.8% spread with total leased rate is due to the extensive anchor redevelopment operations, implying that overall occupancy should surge in the near future) and ABR of $17.16 per square foot stands at all-time highs and handily beats that of rivals Kimco (KIM) and Brixmor (BRX).
Looking ahead, these numbers should only get even better as the company continues to sell off under-performing and non-core assets as it expects its ABR per square foot to improve to over $18. In all, management expects to sell between $350 million and $500 million in assets in order to optimize the portfolio and balance sheet as well as help to close the gap to NAV found in the company's current share price.
#2 Improving Balance Sheet
The investment grade balance sheet also continues to improve with an even brighter outlook ahead. Net Debt to Adjusted EBITDA currently stands at 6.5x and the company currently faces only a single small mortgage maturity (on a high-quality asset) between now and 2021. Additionally, the company expects that, using the proceeds from its disposition program, it will be able to significantly improve that debt outlook even further:
Another aspect of KRG's balance sheet that often goes unappreciated by the market is the fact that it does not currently have any preferred equity outstanding. As a result, when comparing it to peers, it actually has a lower Net Debt + Preferred to EBITDA ratio (6.5x) than KIM (7.0x) and Site Centers (SITC) (6.8x) and is basically neck-and-neck with BRX. After executing on its disposition program, it should have an even lower leverage ratio (5.9x) than BRX and top-tier shopping center landlord Acadia Realty (AKR). Additionally, its current average maturity duration is 5.5 years, placing it firmly in the middle of the pack among peers, but its disposition and deleveraging program should place it firmly in the top echelon at 7 years, behind only Regency Centers (REG), Federal Realty (FRT) and KIM.
#3 Recession and E-Commerce Resistant Portfolio
Given that 70% of its ABR is anchored by grocery stores, KRG is a fairly recession and e-commerce resistant REIT. The average US consumer makes a trip to a grocery store 1.6 times per week, and this is not expected to change anytime soon. People need to eat whether the economy is strong or weak, and therefore, grocery-anchored shopping centers can rely on sustainable levels of traffic, regardless of economic conditions. The same cannot be said about all retail properties. We just don’t see the internet impacting the grocery store business significantly, and despite the continued growth of Amazon (AMZN), we see no reason to worry here. As a recent report from RCM puts it:
There is a general consensus that grocery-anchored retail centers will be around forever and, as long as they are, will be among the most attractive and highly sought-after investments… Survey participants believe that while consumers are increasing their online purchases, most are hesitant to buy groceries online. Further, when in the middle of planning and/or preparing a meal, last-minute items can’t be purchased and delivered on time when purchased online... No one can buy an ice cream cone, get their laundry, put gas in their car or check out a liquor store on Amazon...”
Furthermore, its top retailers by ABR include growing and well-financed retailers and grocers TJX Companies (TJX), Ross Stores (ROST), and Lowe's (LOW) and, perhaps most impressively, its tenant composition is rapidly increasing its services and entertainment component, both of which are e-commerce resistant and, to a lesser extent, recession-resistant.
#4 Lucrative and Safe Dividend
Perhaps the most attractive aspect of KRG is its dividend. As can be seen here from a large sampling of peers, KRG's dividend yield stands head and shoulders above the crowd:
Data by YCharts
Even closest peers in terms of quality and leverage - KIM, BRX, and SITC - fall well short with their dividend yields coming in about 200 basis points lower on average.
The explanation is certainly not about dividend safety, as the midpoint of guidance for this year when taking into account the dispositions is FFO of $1.71 against a dividend payout of $1.27. Of course, with all of the redevelopment spending going on, the AFFO will be significantly lower than the FFO payout. That being said, however, management recently doubled down on how comfortable it is with its dividend payout, stating:
when it’s all said and done, on an annualized basis, the AFFO we think will still be covering the dividend, would be obviously tighter, much tighter than it had been before, but we’re fine with that because the majority of our CapEx investments in the Box Surge Program, in the 3-R program will have already been spent ... we’ve looked at that very closely, and we are comfortable with that.
When factoring in the fairly easy liquidity of the company's properties (given their smaller size and the strong bid for them in the private marketplace), the company's strong and improving balance sheet, and - most importantly - the e-commerce and recession-resilient nature of the portfolio, the dividend appears to be one of the safest 8%+ yields available today. KRG is a very attractive pick for those looking for rich and reliable current yield.
#5 Attractive Valuation
Last, but not least, deep value investors will find a lot to like here as well.
First and foremost, the company trades at a deep discount to NAV. At about 30% below the underlying value of its real estate (assuming a 7% cap rate, which lines up well with recent comparable dispositions across the sector) KRG's market capitalization is the second cheapest in the sector (behind only CDR, which is suffering from the sector's worst ABR, NOI margin, and leverage, all in far worse condition than KRG's) despite having the sector's highest recovery ratio, a middle of the pack and very stable balance sheet, and one of the highest ABRs per square foot in the sector.
Finally, as previously discussed, the dividend yield is top in the sector despite being well supported by cash flows, liquidity, portfolio quality, and management commitment.
By virtually any metric, KRG looks very cheap. The discount to NAV is especially attractive because, as the company's dispositions indicate, there remains a very strong private market bid for its assets. Therefore, its NAV is actually supported by plenty of current market data and management has the ability to tap into private markets to help close the valuation gap between public and private markets.
Why the Opportunity Exists
There are five main reasons why grocery-anchored shopping REIT shares are currently undervalued:
- U.S. retail shopping centers are significantly overbuilt: The ratio of retail space to population in the U.S. is twice what it is in Canada and four times the rate in Germany.
- E-commerce is on the rise, with giants like Amazon leading the way and leading to increased brick-and-mortar retailer bankruptcies despite a growing economy.
- Interest rates are rising (some estimates indicate that every quarter-point increase in rates may result in millions of dollars in lost value, depending on the retail real estate portfolio size).
- The three previous factors create an environment that decreases pricing power for retail landlords and, therefore, encourages retail REIT CEOs to sell off properties rather than acquire or develop additional ones, leading to shrinking cash flows per share and a reduced growth outlook as well.
- By many metrics, we are late in the expansion phase of the economic cycle, and if/when a recession hits, certain types of retail businesses will certainly be among the most heavily hit, especially those already struggling in the current robust economy.
While each of these risk factors is significant and should not be ignored, they have been overblown in the case of most shopping center REITs, resulting in a highly favorable risk-reward profile for these stocks and giving investors an opportunity to lock in outperformance over the long term at current prices. This is because:
- While retail is overbuilt overall, as previously pointed out, many of these REITs have sold off most of their non-core properties where they lacks competitive advantages. Furthermore, these REITs are investing heavily in bolstering their remaining properties' quality and are attracting good tenants and strong demand. This should significantly mitigate the impact of retail store overbuilding.
- Thanks to their favorable allocation to e-commerce and investment-grade, recession-resistant tenants, shopping centers are weathering the e-commerce disruption fairly well and are well-positioned to survive the next downturn.
- Many of these REITs' strong and improving balance sheets give them ample flexibility to support their dividend, while simultaneously making whatever investments they need into their properties to sustain performance should e-commerce and/or a downturn begin making a significant dent in their performance.
While all of these factors clearly apply to KRG as well, it is also being undervalued even more than peers due to the fact that it is smaller and its management team has tended to be less outspoken and promotional with investors and analysts as larger peers BRX and KIM have been. However, this may soon change as management stated at REIT Week that part of its plan to close the discount to NAV moving forward includes:
Campaigning for new/underrepresented investors and better sell-side coverage.
KRG's implied cap rate, dividend yield, and P/FFO are at a significant discount to recent private market, public market, and historical data. Not only that, but the company's balance sheet is sound and the portfolio continues to progress in virtually all areas. Investors should, however, keep a keen eye on disposition activity in 2019 - both volume and cap rates - and how management uses that cash. As the company plows the vast majority of it into redevelopments and deleveraging, it will be interesting to see how the market reacts and if it rewards management with a higher multiple in exchange for reduced risk.
Shares offer investors a very attractive and strongly supported dividend alongside significant share price appreciation potential. As the company proves negative market sentiment wrong and returns to growth in the coming years while also continuing to improve its balance sheet, we believe that shares should see significant multiple expansion as well as a return to meaningful dividend growth.
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Disclosure: I am/we are long KRG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.