2023-09-19 08:15:00 ET
Summary
- Independence Realty Trust has benefited from the migration of people from expensive coastal cities to the Sunbelt and Midwest during the pandemic.
- IRT's financial management has improved, with lower leverage ratios and a rebounding dividend following the 2020 dividend cut.
- The Midwest market is expected to hold up well, positioning IRT's portfolio favorably compared to oversupplied markets in the Sunbelt.
- But debt remains high, and I am somewhat skeptical in management's ability to hit their leverage targets.
Independence Realty Trust ( IRT ) is a multifamily/apartment real estate investment trust ("REIT") concentrated in Sunbelt and Midwestern states.
In the past, such as in my January 2022 article on IRT , I've recommended avoiding IRT because of the REIT's history of poor financial management. For a long time, IRT operated with a high payout ratio (over 90%), high debt (over 8x debt to EBITDA), relatively high general & administrative expenses, and regular rounds of dilutive equity issuance. The low stock valuation required greater reliance on use of debt, which made IRT's leverage ratio high, which in turn prevented the stock valuation from meaningfully increasing.
Ironically, IRT may have been saved by COVID-19. The pandemic-era migratory pattern of people moving from expensive, high-crime, locked-down coastal gateway cities into the Sunbelt and Midwest gave IRT's portfolio of Class B apartments a huge boost.
This increase on the revenue and EBITDA side lowered leverage ratios and caused G&A expenses to drop as a share of total revenue to a level more in line with Sunbelt multifamily peers. And while IRT remains non-investment grade, management believes they have a line of sight on attaining an investment grade credit rating in three years or so.
Moreover, after a dividend cut in 2020, IRT's dividend has been rebounding back toward its pre-COVID level while the REIT's payout ratio remains safely in the mid-50% territory.
Has IRT now turned a corner, facilitated by surging rent growth over the last few years, toward better and more shareholder-friendly financial management? Or did IRT simply "get lucky" from COVID-19 for a little while only to slip back into underperformance?
My thesis is that IRT should see a little more fundamental outperformance thanks to its Midwestern exposure and paucity of debt maturities over the next few years. And if interest rates drop soon, then IRT's outperformance should continue. But IRT's stock price (different than its fundamentals) should continue to underperform as long as interest rates are going higher.
So, in short, my view can be summed up as:
- IRT's stock price will probably continue to underperform in the short-term
- IRT should perform better if and when interest rates begin declining
- Overall, I prefer a larger and lower-leveraged peer to IRT as my favorite Sunbelt multifamily pick
Post-COVID & Post-Inflation Update On Independence Realty
If you're unfamiliar with IRT, you can read my January 2022 article or this recent article on IRT from my friend Philip Eric Jones.
In short, IRT owns 120 apartment properties with over 35,000 units, most of which are located in the fastest growing Sunbelt states. Most of the non-Sunbelt portfolio is clustered in Midwestern states like Ohio, Indiana, and Kentucky.
As we all know by now, the Sunbelt was a huge beneficiary of COVID-19, as relatively open and lower-cost Southern states received a big influx of domestic migrants from locked down, high-cost coastal cities like New York and San Francisco.
But that domestic migration pattern has largely ceased as Sunbelt rent rates have risen, making the cost of living a bit more comparable with coastal cities, and job-switching has cooled down considerably.
Population inflows and soaring rent growth catalyzed a big wave of apartment development across the Sunbelt, which is now resulting in a bout of oversupply as the influx of people into the Sunbelt has slowed.
But one area of the country still showing strength in the apartment rental market is the Midwest, which hasn't seen the same surge in apartment construction. From Milwaukee to Columbus, apartment rents remain relatively affordable, occupancy rates remain high, and far less new supply is coming to market.
Hence we find this projection from CBRE that while multifamily rents are expected to drop in certain oversupplied markets like Phoenix, Las Vegas, Atlanta, and Tampa, most areas of the Midwest are expected to hold up or see further rent increases over the next year.
If this projection is to be trusted, then IRT's portfolio is relatively well-positioned.
While IRT's apartments in Atlanta (14% of NOI), Colorado (8% of NOI), and Tampa (5% of NOI) could see downward pressure on rents over the next year, its apartments in Indianapolis (5% of NOI), Oklahoma City (5% of NOI), Southern Ohio, and Northern Kentucky should offset this with upward pressure on rents.
Moreover, IRT insists that this wave of new supply in its markets should not significantly impact its results and in fact is really nothing new.
The most pertinent point here is that newly delivered apartments are trying to capture higher rent rates in order to justify the high costs of constructing the property. But it isn't exactly the case that these higher-rent apartments have no effect on IRT's existing stock of Class B apartments, because the fierce competition for renters has led these higher rent properties to offer significant concessions such as 2, 3, or even 4 months of free rent.
So, by the technical rent rates on contracts, these new apartments appear to be much higher priced and therefore unlikely to compete with IRT, but in reality, the all-in cost is approaching the same for both IRT's existing properties and the newly delivered ones.
As such, while IRT's apartments aren't directly competing with the new supply, there is some trickle-down effect.
So far, we haven't seen IRT's rent or NOI growth impacted that heavily, especially when compared with its larger Sunbelt multifamily peers, Mid-America Apartment Communities ( MAA ) and Camden Property Trust ( CPT ).
Q2 Same-Store NOI Growth | 2023 SSNOI Growth Guidance | |
IRT | 6.3% | 6.5% |
MAA | 8.6% | 6.35% |
CPT | 6.2% | 5.0% |
Having a substantial presence in the Midwest and certain secondary Sunbelt markets like Oklahoma City and Northern Kentucky should help IRT, but we'll have to wait and see how it holds up compared to peers.
Balance Sheet
Since December 2016, when IRT completed the internalization of its management structure, it has massively outperformed its larger and lower-leveraged Sunbelt peers.
IRT's exclusive focus on Class B Sunbelt apartments has worked extraordinarily well. The Sunbelt has enjoyed above-average population and job growth, and Class B apartments have had the widest appeal to financially stable long-term renters.
Moreover, during this period, MAA and CPT had debt-to-capitalization ratios around half that of IRT. Low interest benefit the higher leveraged players and acts as a relative drag on the performance of the lower leveraged players.
But since interest rates began rising at a fast clip, IRT has underperformed its larger and lower-leveraged Sunbelt multifamily peers:
I think that underperformance will continue for as long as interest rates are rising, or rather, not falling. If rates plateau at this level for a while, I think IRT continues to underperform.
The irony is that while IRT has much higher debt than its larger Sunbelt peers...
Net Debt To EBITDA | |
IRT | 7.2x |
MAA | 3.4x |
CPT | 4.2x |
...IRT has arguably the most favorably laddered debt maturity schedule.
Here's IRT's debt maturity schedule:
Here's MAA's debt maturity schedule:
And here's CPT's debt maturity schedule:
CPT Q2 2023 Presentation
As you can see, IRT has the lowest amount of debt (as a share of total debt) maturing in the next few years.
On the other hand, IRT does not have an investment grade credit rating, while MAA and CPT both enjoy A-/A3 credit ratings that should help them refinance debt at relatively favorable interest rates.
What's more, while IRT's management insists that IRT's net debt to EBITDA ratio should reach the mid-6s by the end of this year, that metric has been moving in the wrong direction this year. IRT ended 2022 with net debt to EBITDA of 6.9x before seeing it bump up to 7.3x in Q1 2023 and sliding slightly to 7.2x in Q2.
As previously stated, the drop in net leverage from 8.2x at the end of 2020 to 7.7x at the end of 2021 to 6.9x at the end of 2022 is great to see, but it is also due mostly to the extraordinarily favorable environment for Sunbelt apartments during that period.
Whether IRT is able to hit its mid-6x target by the end of 2023 or mid-5x by the end of 2025 will depend more on management's execution, the future path of interest rates, and what effect supply growth has on IRT's ability to increase NOI.
Bottom Line
Levels of debt are a matter of personal preference. For such stable assets as Class B apartments in the Sunbelt, many investors would prefer a heavier use of fixed-rate debt in order to push up returns on equity.
My personal preference is to go the opposite direction, utilizing little debt in order to earn a high credit rating. My favorite pick in the Sunbelt multifamily space is MAA. It has the lowest debt, which not only increases safety and stability but results in significant capacity to increase leverage to opportunistically buy discounted properties, if and when those opportunities arise.
Plus, during periods of rising interest rates and/or cyclical weakness, MAA generally endures less volatility than higher leveraged names like IRT.
IRT has enjoyed a very nice run over the last few years, and management appear to be acting in the best interest of shareholders at this point -- that is, now that the dividend has been cut to a more sustainable level and COVID has given its markets a boost.
But my money is still on MAA for the long run.
For further details see:
Independence Realty Trust: Well-Positioned Due To Midwest Exposure (Rating Upgrade)