Investors Real Estate Trust Is Attractive But Has A Leveraged Balance Sheet

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About: Investors Real Estate Trust (IRET)
by: Ploutos Investing
Summary

IRET owns a portfolio of apartment properties in the U.S. Midwest and Great Plains.

The REIT should benefit from above-average population and employment growth rates in its major markets in the next few years.

IRET currently pays a 3.9%-yielding dividend, and its shares are trading at a discount.

Investment Thesis

Investors Real Estate Trust (IRET) delivered a good Q2 2019, thanks to robust demand in its major markets. Looking forward, the REIT should continue to benefit from favorable demographic trends, and strong market fundamentals in its major markets. The company also has value-add initiatives to grow its revenue and improve its operating efficiency. However, it still has a leveraged balance sheet. IRET currently pays a 3.9%-yielding dividend, and its shares are trading at a discount to its peers. While we like its growth outlook and discounted valuation, we are not comfortable with its balance sheet, and hence, we believe a pullback will provide a better risk and reward profile especially because its shares have surged by nearly 50% year to date.

Chart

Data by YCharts

Recent Developments: Q2 2019 Highlights

IRET has a good quarter in Q2 2019 as the company saw same store revenue growth of 3.1% year over year. The company also increased its occupancy ratio from 94.2% in Q2 2018 to 94.3% in Q2 2019. Its net operating income also increased by 2.6%. The increase was offset by slightly higher operating expenses primarily due to higher insurance costs.

in thousands

Q2 2019

Q2 2018

Change

Same Store Average Scheduled Rent per Apartment Home

$1,028

$1,009

1.9%

Weighted Average Occupancy

94.3%

94.2%

10 bps

Same Store Revenue

$40,024

$38,804

3.1%

Expenses

$16,974

$16,345

3.8%

Net Operating Income

$23,050

$22,459

2.6%

Source: Created by author; Q2 2019 Supplemental

Earnings and Growth Analysis

IRET's markets are stable markets

IRET has a portfolio of apartment properties located in 12 markets in the U.S. Midwest and Great Plains. As can be seen from the map below, its properties are located in Montana, North Dakota, South Dakota, Nebraska, Colorado, Kansas, Iowa, and Minnesota.

Source: August 2019 Investor Presentation

While most of the markets in IRET's portfolio are not top-tier markets, these are stable markets with above national average growth rates. For example, its largest market Minneapolis (about 22.9% of its net operating income) is expected to grow its population by about 0.8% annually in the next 5 years. This is slightly higher than the projected national average of 0.7%. Growth in employment of 0.7% is also expected to be higher than the national average of 0.6% in the next 5 years. Its third largest market Denver (9.6% of its NOI) is expected to have population and employment growth rate of 1.3% and 1.2%, respectively, in the next 5 years. These figures are also higher than the national average.

Vacancy in Minneapolis/St. Paul (Source: August 2019 Investor Presentation)

Favorable demographic trend

In PwC's latest report, the organization also observed the trend of younger generation population that seems to prefer rent to owning homes. As can be seen from the chart below, homeownership rates by age of household in the United States have gradually declined in the past two decades. We believe IRET's residential rental business will benefit greatly from this new demographic trend.

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Source: Emerging Trends in Real Estate 2019

Value-add initiatives

IRET has value creation initiatives that aim at adding/improving amenities (e.g. laundry coin to card conversion) and renovating its existing properties and units (e.g. common areas, adding LETD lighting, etc.). Management has approved $33 million of value-add projects in 25% of the homes in its portfolio. As can be seen from the table below, the estimated return on investment is expected to range from mid-teens to high 20s. There is a tremendous opportunity for value creation as there are about 42% of homes that still have not been renovated since before 2008. We expect these value-add projects to help grow its NOI and improve its operating margin.

Source: August 2019 Investor Presentation

A leveraged balance sheet

IRET has a staggered debt maturity profile with a weighted average interest rate of 4.18%. We think there is an opportunity for it to reduce its interest expense as its debt maturing in 2020 has weighted average interest rate of 5.26% especially because we may see a few more rate cuts by the Fed towards the end of the year or even in 2020.

Source: Q2 2019 Supplemental

One area where we think investors should keep in mind is that IRET has a leveraged balance sheet. The company's total debt is about $694.9 million at the end of Q2 2019. The company generated adjusted EBITDA of about $82.6 million in the past 12 months. Using this figure, we have a total debt to adjusted EBITDA ratio of 8.41x. This is significantly higher than its peers whose ratios are usually in the range of 4-6x.

Valuation Analysis

IRET expects to generate core funds from operations of $3.62-3.72 per share in 2019. Using the midpoint of its guidance, IRET is trading at a price to core FFO ratio of 19.6x. This is much lower than other residential REITs that are trading in the range of 24-26x. We think this is warranted, given its smaller scale and its leveraged balance sheet.

A 3.9%-yielding dividend

IRET currently offers a quarterly dividend of $0.70 per share. This is equivalent to an annual dividend yield of 3.9%. The company went through a period of transformation in the past few years (hence the dividend cut) and is now a pure-play residential REIT. It was a diversified REIT before.

Chart Data by YCharts

Other Risks and Challenges

Macroeconomic risk

Although people always need to find a place to live, it will be challenging for IRET to raise rental rates in an economic downturn. This is because layoffs will likely result in lower demand for apartment rentals.

Elevated supply risk

Favorable long-term demographic tailwind and a lengthy period of short supply have the potential to trigger lots of new constructions. If there are a lot of new supplies coming to IRET's markets, it may negatively impact management's ability to raise rental rates.

Investor Takeaway

We have a positive outlook on IRET's major markets. IRET is still trading at a discount to its peers. We feel this is warranted, given its leveraged balance sheet. Therefore, we feel a pullback will provide a better entry point especially because its shares have already surged by 50% since the beginning of the year.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.