Kite Realty: Why This REIT Is A Top Pick For Income Investors (NYSE:KRG)

The Kite Realty Group (NYSE:KRG) is a fantastic real estate Investment trust (REIT) that has emerged even stronger after its transformative M&A transaction with Retail Properties of America in late 2021. Since then, KRG has unlocked synergies and increased its EBIT and FFO margins, making it a solid investment alternative in the sector today. Moreover, its grocery-focused real estate strategy and inflation-protected high ROIC on new leases make it a gem among REITs. My valuation model suggests that KRG is slightly undervalued, with a 5.6% upside potential from current levels. Its fantastic business model makes it a solid “buy” for long-term income investors.

Business Overview

Kite Realty is a REIT based in Indianapolis focusing on creating grocery facilities that serve as neighborhood and community centers. Primarily concentrated in Sun Belt markets, KRG owns and operates 180 open-air shopping centers and mixed-use assets covering around 28 million square feet. Mixed-use assets combine a blend of residential, commercial, and even industrial spaces where people can live, work, and play with a sense of community. KRG’s properties are located strategically and have high-quality characteristics that generate high occupancy rates.

KRG’s properties are located strategically and have high-quality characteristics to generate high occupancy rates. The communities they form are anchored around grocery stores. The properties usually host a variety of businesses such as retail shops, restaurants, service providers, and sometimes health and fitness centers to attract consumers and promote foot traffic to create an environment for retail success.

The location of the properties in the Sun Belt region in the southernmost states of the US, from Florida to California, is an advantage for KRG. This area has a warmer climate that favors population growth and development. Most of the states in this region have favorable commercial environments attracting businesses and startups. The increment in population, fueled also by migration from colder states, feeds greater demand for housing and services. These conditions benefit the real estate market, leading to higher rental rates and property prices.

KRG’s Nearly Six-Decade Journey

KRG has nearly 60 years of real estate experience and was listed publicly in 2004. KRG expanded on October 22, 2021, with the $7.5 billion merger with Retail Properties of America, Inc. (RPAI), creating a top-five open-air, grocery-anchored shopping center. The combined company retained the KRG’s executive team headed by the CEO, John A. Kite. The Bed Bath & Beyond (OTCPK:BBBYQ) bankruptcy affected KRG’s leased spaces and rent. KRG is planning to re-lease these spaces. KRG had a $1 million impact on their Funds From Operations (FFO) due to the financial adjustment made because of the lease rejections by Bed Bath & Beyond. However, the overall performance remained stable despite this adjustment.

KRG’s primary operation through 2024 is leasing, taking advantage of the demand for space evidenced by the company’s ability to sign new and renewed leases at higher rates with a 14% average increase compared to the previous rates for the same spaces. The company leased 214 properties in the third quarter following its main capital allocation strategy of leasing, which has more than 30% returns on capital, followed by developments with 6% to 10% and acquisitions with 5.5% to 7.5% yield.

Valuation Analysis

To understand the company’s valuation, it’s vital first to realize it’s significantly different after the merger with Retail Properties of America in late 2021. Since then, the company’s revenues jumped significantly as the combined operations entered into effect. The merger’s rationale was to increase its presence in the Sun Belt markets. Still, more importantly, it was supposed it’d increase margins as property development would kick in, coupled with an ostensibly lower cost of capital due to being a larger combined entity. M&A transactions often don’t work out as expected, and the estimated synergies often don’t materialize. However, the reality is that if we look at KRG’s revenues and EBIT margins before and after the acquisition, I think that results will speak for themselves.

As you can see, the revenue increased by 114.84% in 2022 YoY. However, the benefit of expanding margins hadn’t yet materialized. Yet, for the trailing twelve months, KRG has seen a notable EBIT margin expansion from 8.2% in 2022 to 14.5% in the TTM period. This is the highest EBIT margin since 2020 and certainly higher than 2021 margins before the merger. Thus, evidently, the union was a resounding success.

However, this M&A success didn’t purely come from the combined operations of the two companies. The reality is that post-merger KRG quickly doubled down on its aggressive leasing and acquisition strategy in its then solidified foothold on the Sun Belt region. In 2022, KGR focused on increasing its average base rent (ABR) per square foot, which continued into 2023. The result is quickly expanding margins, key value drivers for KRG today in 2023.

As of 2023, I think it’s fair to say that most of the revenue benefits have been realized from that transformative merger. This is evidenced by the analysts’ revenue estimates for the company, which show a notable revenue stabilization into 2023 and 2024. However, I believe KRG can continue improving its EBIT margins because it maintains a high ROIC of at least 30% for all new leases in the TTM. This implies the company has ample real estate opportunities, leading it to pick only high-quality leases and investments consistently. Moreover, 82% of the company’s new and non-option renewal leases will invariably have a 3% yearly revenue bump. This means that KRG should enjoy predictable revenue increases from these leases, a nice feature in this uncertain real estate market. The kicker is that 41% of these new non-option renewals also have CPI protection built into them, which means KRG is quickly becoming an inflation-protected investment.

From a valuation standpoint, KRG is a rather straightforward entity. As you can see above, I’ve used its recent FFOs as a percentage of total revenues to forecast and discount those flows into the present. I’ve assumed a relatively safe 3% revenue growth into the 2027 period, coupled with FFO margin stabilization of 55.0%. Then, I simply discounted those FFOs using the company’s WACC rate of 9.3%, which is highly inflated due to KRG’s beta of 1.4 and CAPM rate of 11.4%. Yet, the valuation suggests that the company is barely undervalued after adjusting for its cash and debt, with an upside potential of 5.6% from current levels. However, I believe this REIT will be a great capital compounder over time, and its dividend yield of 4.84% makes KRG a good “buy,” especially for income investors.

The Main Risks to the Investment Thesis

Nevertheless, it’s worth considering that KRG is not without its risks. In particular, I think the main risk is related to real estate prices declining and interest rate sensitivity, but this is mainly a macroeconomic risk and not particularly specific to KRG. Still, KRG’s high ROIC opportunities may diminish over time, particularly as market saturation and competition in grocery real estate increases. If this happens, KRG would have to start accepting less lucrative leases, which would undoubtedly diminish its FFO margins and, by extension, hit the valuation upside I previously modeled. Moreover, KRG’s geographic concentration in the Sun Belt region has proved profitable but could expose KRG to regional economic downturns or disasters. Another risk is the potential excess supply of properties for lease that could reduce demand for rental spaces in general. However, I rate these risks mostly tail risks with a low probability of occurring.

Conclusion

Overall, KRG’s focus on building a grocery-anchored portfolio is fantastic. This type of real estate strategy focuses on high organic traffic that synergistically boosts real estate values and incomes for the company’s portfolio. Moreover, its transformative M&A has been proven successful, which further lends credence to management’s ability to continue delivering shareholder value over time. My valuation model suggests that KRG is slightly undervalued, with an upside of 5.6% and a price target of $21.83 per share. However, this gem should continue to compound investors’ capital over time, and I think it’ll provide great returns along the way. This, coupled with KRG’s compelling dividend yield of 4.84% and safe FFO payout ratio of 49.16%, gives KRG a comfortable “buy” rating at these levels, especially for long-term income investors.