Kite Realty (KRG) is one of those smaller shopping center REIT names that can be easy to forget about when the whole sector falls out of favor. KRG didn’t know that COVID-19 would hit in 2020, but it entered this year having improved both its portfolio and balance sheet. While its bottom-line numbers were hit hard in the second quarter, early indications suggest that the rest of the year should see significantly better numbers. On account of the long term viability of its business model, I rate shares a buy.

Not Virus Proof, But Not Out

What a difference a couple of months make. Whereas KRG’s portfolio was essentially shut down in April, 94% of its portfolio was open by August:

(source: 2020 Q2 Presentation)

Still, the reopening efforts happened late enough to wreak havoc on the financials.

Same-store NOI declined 9.8% YOY. FFO plummeted 30% to $0.30 per share. Substantially all of the declines were attributable due to a $5 million increase in bad debt expense – this refers to uncollectible rent primarily due to COVID-19.

There’s reason to believe the rest of the year should be much better. KRG collected 80% of 2nd quarter rent (plus another 9% deferred) and 87% of July rent. Furthermore, I anticipate that occupancy rates should not plummet and KRG should be able to backfill any occupancies with reasonable speed, as KRG has fortunately dramatically improved the quality of its portfolio over the past couple of years:

(source: 2020 Q2 Presentation)

Perhaps the most telling metric regarding portfolio quality is the dramatic rise in average base rent:

(source: 2020 Q2 Presentation)

While this past quarter’s results were ugly, there is no indication that the retail landlord model is broken. I remain highly confident that quality names like KRG can recover given enough time. Does KRG have the privilege of time? We need to look to the balance sheet to answer that question.

Balance Sheet Health

In addition to an improved quality portfolio, KRG also entered 2020 with an improved balance sheet. What timing – the lower leveraged balance sheet clearly has come in handy, as the increase in bad debt expense has led to an increase in leverage to 7.1 times debt to EBITDA (up from 5.9 times in 2019). That’s still a respectable ratio, and KRG is in no immediate danger of violating any covenants. It’s worth noting that KRG also has no debt maturities until 2022:

(source: 2020 Q2 Presentation)

KRG’s conservative leverage profile even after two quarters’ worth of COVID-19 financial impact suggests that it should have no issue raising additional debt if needed to fund any capital expenditure requirements. The balance sheet is a distinct source of strength for KRG.

Valuation And Price Target

Shopping centers are hated – and KRG’s valuation reflects that. KRG has already cut its quarterly dividend 84% to $0.052 per share, thus dividend yield isn’t a great metric. Based on 2019 FFO, KRG trades at 7.5 times FFO. KRG generated $129.7 million in adjusted FFO in 2019 (which is essentially free cash flow as it subtracts maintenance capital expenditures). With a market cap of $940 million, KRG trades at 7.3 times that number. That’s dirt cheap.

KRG provides the following diagram in their investor presentation which shows clearly the pessimism of Wall Street. Even assuming a 7.25% cap rate and a 15% permanent loss in NOI, KRG would be worth $13.67 per share, over 20% higher:

(source: 2020 Q2 Presentation)

While KRG didn’t command a low cap rate prior to 2020, I suspect that if COVID-19 hadn’t occurred, then KRG would have been able to command a cap rate in the 6% range due to the improved quality of its portfolio and balance sheet. That equates to a share price of $18.30 per share (again assuming 15% permanent loss in NOI, which seems overly pessimistic). With roughly 60% total return upside, I am quite optimistic for KRG’s upside.

Risks

  • KRG might not be able to collect deferred rents. It was only a couple of months ago that shopping center landlords were adamant about receiving all rent in spite of government shutdowns. Now they’ve logged a significant amount of rent as uncollectible. Until KRG receives the rent as cash, investors shouldn’t assume that deferred rent equates to collected rent.

  • If governments force further shutdowns, then investors should anticipate more uncollectible rent. While I remain confident that the U.S. can finally move past the pandemic, it is worth noting that cases continue to mount in many states. The worst might be yet to come.

  • I expect occupancy rates to be significantly lower by year-end as more tenants go bankrupt or fail to renew their leases. I expect KRG to have little issue replacing vacancies due to the limited number of tenants at its shopping center properties. Still, it is unclear how much demand there will be from prospective new tenants.

Conclusion

If you’re invested in shopping center REITs, as I am, you’re likely in the minority. There is a saying that Wall Streets’ hate uncertainty and the exact real estate aftermath from COVID-19 remains uncertain. That has led KRG to trade at the deeply discounted valuations it does today. I remain confident in its quality portfolio and conservatively leveraged balance sheet. With shares offering roughly 60% upside to my estimate of fair value, I rate shares a buy.

I Am Overweight High-Quality Retail Real Estate

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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.

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