- Kite has transformed into a growth stock.
- Yet it still trades like a value stock.
- There is significant room for multiple expansion.
The Buy Thesis
The disparity between fundamentals and that which is implied by Kite Realty’s ( KRG ) market price leads me to believe that KRG is just severely mispriced in the market. I think the correct multiple for a company with KRG’s fundamental trajectory is around 16X implying a fair value of about $29 or roughly 45% upside from today’s price.
This article will examine KRG’s fundamentals, updated for the just released earnings to ascertain where FFO is headed going forward. We then apply our risk assessment and valuation framework to estimate fair value.
Strong leasing
Kite Realty traded up about 2.5% on 8/3/22 after reporting earnings and I think this is the headline the market was seeing.
“Leased approximately 1.2 million square feet at 13.2% comparable blended cash leasing spreads”
13.2% lease spreads are good, but not all that special. We are seeing similar overall leasing spreads across quite a few real estate sectors at the moment.
The thing that made KRG’s leasing stick out to me was the breakdown of that 13.2%. See, some of KRG’s leases have renewal options in which the tenant can renew at a pre-negotiated rate. Thus, a significant portion of the leasing activity did not represent a mark-to-market, but rather tenants still getting well below market rates. Here is how it is presented in the supplemental:
“Cash leasing spreads of 49.1% on 26 comparable new leases, 8.0% on 119 comparable renewals, and 13.2% on a blended basis. Excluding option renewals, the blended cash spreads for comparable new and non-option renewal leases was 18.7%.”
Non option renewals had spreads of +18.7%. It is common for retail REITs to allow renewal at below market rate because renewal allows them to forgo tenant improvement costs and leasing commissions.
It is the new leases that show where market rates truly are. On these, KRG got a 49.1% roll up. There is value embedded in their asset portfolio that is not yet reflected in FFO.
Also relevant to this discussion is the occupancy growth. A sequential tick up of 20 basis points in occupancy as well as the $41 million of SNO NOI (signed but not open net operating income) shows that demand is high even at the higher price point KRG is now charging.
Visibility of near and medium term growth
Things in the economy can change, but the rolling nature of leases affords a high degree of visibility into future cashflows. Data points from this quarter and last quarter show that KRG’s existing leases are likely somewhere between 20% and 40% below market.
This will fuel growth for the next seven years as only a portion of leases expire each quarter. So far, the impact on same store NOI has been somewhat muted due to the minimal lease expiries in 2022.
2Q22 same store NOI grew only 3.8% in the quarter which is good, but a far cry from the leasing spreads. The NOI growth was roughly in line with a normal historical quarter.
However, much heavier lease expiry in 2023 and 2024 portends an acceleration in same store NOI growth.
So far, the strong leasing has led to increases to FFO with two guidance raises already this year.
Bigger lease volume will lead to bigger FFO/share growth. With 13.7% and 14.6% of leases rolling in the next two years, the leasing spreads will have a bigger impact on FFO. I think KRG can grow at a low double digit pace for the next five years.
Nature of KRG’s growth
There are a few factors working in KRG’s favor:
- Still upswing from pandemic recovery
- Heavy sunbelt concentration of portfolio
- Undersupply of retail properties
Developers have largely stopped building new retail properties for quite some time which has taken the sector from oversupplied to undersupplied. The undersupply is particularly pronounced in sunbelt markets that have strong job growth and KRG has a significant presence in these markets.
There is also an influx of demand for retail square footage as the pandemic accelerated retail bankruptcies leading to the current period of almost no bankruptcies. With minimal store closure and high store openings, occupancy is ticking up. Well located properties with affluent catchment radii are getting interest from a wide range of retailers.
This allows Kite to not only lease up vacant space, but to choose which retailers to put in the space such that they can micromanage the tenant ecosystem. Kite puts significant effort into creating vibrant tenant mixes with synergy and is careful to avoid those that would cannibalize each other’s sales.
Just as an example of Kite’s tenant strategy, here is one of their properties below which features an Athleta next to a gym and an Italian restaurant.
Each of these drives its own foot traffic and a customer could reasonably go to all three in a single visit.
More overall foot traffic to the shopping center leads to higher sales per square foot which in turn facilitates future rent increases.
It doesn’t feel like it now because the last six years have been so brutal to retail real estate, but when shopping centers get this virtuous cycle going it can be a powerful driver of value.
KRG’s risk
As a shopping center REIT it naturally has some cyclicality. If you scroll back up to the long term historic same store NOI chart, there are clear negative years during the great financial crisis and especially during the pandemic. After each downswing there tends to be a rapid upswing, recovering and then exceeding previous NOI.
Thus, cyclicality is not a long term risk but rather a stress test, so I prefer retail REITs to operate on the conservative end of the spectrum so that they can have the available liquidity to take advantage of downturns and slingshot into the recovery.
KRG has a clean balance sheet with just over 5X net debt to EBITDA. Interest expense is 4.5X covered and it passes all of its debt covenants with flying colors.
Its debt metrics have earned it solid investment grade ratings.
Interest rate sensitivity
KRG is moderately exposed to interest rates. While their debt is mostly fixed rate or swaptioned to fixed rate, the term is rather short.
Although the debt maturities are nicely laddered, the weighted average remaining term is 4.2 years. If interest rates continue to rise they would potentially be looking at refinancing at higher rates.
I don’t think this is a huge deal as rents will be going up significantly more than cost of debt, but it is something of which to be aware.
To recap the fundamentals, KRG has a long runway of double digit growth and slightly below average equity risk due to a conservative balance sheet. These data points inform our valuation.
Valuation framework
For any given earnings multiple, there is a certain amount of growth that is implied by it. A high multiple stock must grow quite significantly in order to justify its multiple such that shareholders can receive an acceptable long term return. Similarly, a low multiple is baking in some sort of bad news, the magnitude of which depends on just how low the multiple is. A moderately low multiple implies stagnation of earnings or the cyclical equivalent of that while a very low multiple implies negative growth.
With the S&P at 21X earnings and the REIT index at about 18X FFO, Kite Realty’s 10.9X current year FFO is quite a low multiple. The range of 10-12X FFO relative to where the index average is today implies that KRG is either low growth with high risk or stagnant.
Looking at KRG’s fundamentals, however, I just don’t see it. Every aspect of the business looks healthy to me with a long runway of moderate to fast growth. Risk looks fairly tame with a conservative balance sheet and laddered debt maturities.
Such metrics would normally cause a REIT to trade at a premium multiple, but one must be careful to take tenant improvement costs and leasing commissions into account.
Each of these costs hits after FFO making FFO often significantly higher than true earnings for retail REITs. One could use AFFO for the valuation to account for these factors, but I find that also unreliable because the capex costs come in a lumpy fashion. Thus, a stock would look cheap or expensive depending on whether a given period was high or low capex.
Instead, I prefer to look more at run rate capex. Which for a shopping center REIT is generally going to be somewhere between 5%-20% of revenue.
So while KRG’s growth and risk level would typically warrant a 20X multiple, accounting for capex takes its fair value multiple to about 16X FFO which represents about $29 per share.
At that price, KRG’s take-home cashflow would be about in-line with the REIT index and its growth looks to be a bit faster at low double digits compared to 7% for the index.
A $29 price is also backed up by NAV which using a private market cap rate on KRG’s NOI is somewhere around $27-$30.
Wrapping it up
I find KRG to be deeply undervalued at $19.68 and see significant upside ahead. It may take a few quarters for the growth in retail to break the market narrative of retail weakness, but when it does I anticipate a swift uptrend in price toward fair value.
For further details see:
Kite Realty Is Kicking Growth Into High Gear