2023-04-20 11:41:30 ET
Summary
- Killam Apartment REIT is a Canadian residential REIT with a high exposure on the East Coast.
- Home prices in Canada have been rising significantly due to higher demand and a constant supply.
- The REIT has an outstanding debt of almost C$2 million; however, the FFO is still likely to grow.
Investment Thesis
Killam Apartment REIT (KMP.UN:CA) (KMMPF) is well positioned in the market compared to its peers and its FFO will likely grow in the future even with the maturities they have to pay in the next few years. Moreover, as the demand/supply equation remains out of balance in Canada, real estate prices will most likely continue to grow putting upwards pressure on rents and keeping occupancy of rental apartments high as people become renters by necessity (i.e., unable to afford to buy).
Overview
Killam Apartment REIT is a residential REIT operating in Canada with a focus on the East Coast. As seen on the map below, they are mainly situated in Nova Scotia (33.4%), Ontario (24.3%), and New Brunswick (20%), all of which are markets that have seen substantial real estate appreciation over the past 5 years. In fact, according to the Federal Reserve Bank of Dallas , inflation-adjusted prices in Canada have increased the most of any G7 country with over a 350% increase over the past 45 years (compared to just 150% in the US). Some analysts have concluded that this trend has become overextended and will inevitably reverse in the near future. My reasoning is different. I believe that there are structural reasons that have contributed towards this strong overperformance of Canadian real estate. The main structural difference, especially compared to the US, has to do with the demand and supply equation for new apartments.
US Federal Reserve Bank of Dallas
On the demand side, Canada has seen a substantial increase in population, driven primarily by immigration. With strong immigration quotas already announced for the next three years, it’s almost certain that population growth will continue. On the supply side, supply remains at some of the lowest levels ever, which inevitably will continue to put upwards pressure on real estate prices. Higher prices will directly translate into higher rents and also higher occupancy for rental apartments as people are less likely to be able to afford to buy, these become renters by necessity. I believe Killam is well positioned to take advantage of this trend.
Killam Apartment REIT Investor Presentation
Their portfolio is heavily focused on apartments (89%) and their occupancy is very high standing at 98.3%, this has increased a lot over the last couple of years and it was at its peak in Q3 of 2022. Quite notably the average occupancy has increased since the REITs formation which speaks volumes and is a testament to improving management and efficiencies.
Killam Apartment REIT Investor Presentation
Their residencies are high-end with an average rent per apartment suite of C$1,289. This is important because in tough economic times, higher-income renters are less likely to default on their rent payments. In Q4 2022 this has increased by 12.1% for new tenants and by 2.1% for lease renewals. According to Killam's annual report , their same store NOI increased by 4.7% over the course of the year 2022 this is due to new acquisitions and three new developments in Ontario. Overall, I would characterize their growth are solid.
The company's current FFO stands at around C$132.6 million which translates to an FFO of C$1.11 per unit. Going forward growth will slow as the high debt burden weighs on FFO and is expected at 2% in 2023. Beyond I see the REIT growing at 3-5% annually.
Financials
Looking at the financial statements for 2022, Killam Apartment REIT has an outstanding debt of nearly C$2 billion. The vast majority of it is fixed with a weighted average interest rate of 2.74% which is low compared to other REITs. They have two lines of credit with limits of C$155 million and C$15 million and C$9 million in cash available. As seen below, their maturities are very well distributed over the next years, however, last year, they had to refinance C$130.3 million in maturing mortgages resulting in C$182.6 million of new debt, therefore C$52.3 million in net proceeds. Considering the amount Killam Apartments has to pay in the next years and the amount of cash they have, it is likely they will have to refinance again. In the current high-rate environment, this will inevitably put pressure on their FFO, which is reflected by low forecasted growth. The net debt/EBITDA is 11.21x and the interest coverage ratio is 3.31x.
Killam Apartment REIT Investor Presentation
Valuation
The share currently stands at C$16.9 and the company is trading at 15.14x P/FFO with a historical average of 16.2x. Given that the discount to the historical average is quite modest at the moment and taking into account the fact that we have higher interest rates, the REIT doesn’t seem overly undervalued. For my valuation, I will assume a conservative 15x FFO multiple (i.e., flat from today). Analysts forecast growth for 2023 at 2% and potentially a bit higher in the following years. Considering this and last year's FFO per share of C$1.11, the expected price of the stock in three years is roughly C$19, up 12% from today.
Fastgraphs
Killam's most relevant peers like Canadian Apartment Properties Real Estate Investment Trust (CAR.UN:CA) and and AvalonBay Communities (AVB) in the US are currently trading at 20.24x and 17.7x, respectively. Killam’s multiple is lower, but I think that’s fair, as they are less present in high-growth markets such as Ontario. In particular, CAR.UN:CA has a portfolio with more exposure in Ontario (46%) compared to Killam (24%). So it is expected that the P/FFO is going to be somewhat lower for Killam, resulting in a lower multiple. Again, this doesn’t scream undervaluation to me.
The dividend payout ratio currently stands at 63% so the dividend is unlikely to get cut and will probably rise in the future as FFO rises, though the increases will most likely be modest at 1-3% per year. The dividend yield is 4.10% which is quite high for Canadian REITs in fact, it is almost the highest it has ever been.
To conclude on valuation, the REIT is about fairly valued here at C$17. FFO will likely grow by several percentage points a year, but with no return from multiple expansion, the total return is likely to underperform the broad index.
Final Thoughts
All of the above discussion points lead me to assign a HOLD rating for Killam, despite the positive outlook for the Canadian real estate market as a whole. I will reconsider my stance if the price revisits the recent low, creating a larger margin of safety.
For further details see:
Killam Apartment REIT: Promising But Needs A Larger Margin Of Safety