Kite Realty Group Trust (KRG) Earnings Call Transcript & Summary

[Audio Gap] p.m. session at Citi's 2020 Global Property CEO Conference. It is Monday. I am Christy McElroy with Citi Research, and we're pleased to have with us John Kite, Chairman and CEO of Kite Realty Group. This session is for investing clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available up here and on the webcast on the Disclosures tab. For those of us in the room or on the webcast, you can sign on to liveqa.com and enter code CITI2020 to submit any questions or you could just raise your hand. John, I'm going to turn it over to you to introduce your company and your management team and provide the audience 3 reasons why investors should buy your stock today, and then we will begin Q&A.

Great. Thank you, Christy. Hi, I'm John Kite, CEO of Kite Realty Group. I have Heath Fear, our Chief Financial Officer, with us; and Matt Hunt, our Vice President, Investor Relations. So real quick summary of Kite Realty Group. We are a community shopping center owner, own about 85 shopping centers throughout the country, about 12 million square feet. 72% of our rent comes from properties that have a grocery component associated with them. The average size of our shopping centers are only 140,000 square feet, which is an important metric because sometimes we are misperceived to be a power center company, and a typical power center is going to be north of 250,000 square feet. From a demographic profile, our shopping centers are located primarily in the south and west. In fact, 77% of our rent comes from the south and the west. Our 3-mile population in our -- the average 3-mile population is 76,000 people with average household income of just under $100,000, so what we would consider to be higher-income areas. From an operating perspective, we are a very efficient operator. Our NOI margin and our recovery ratios are some of the highest in the business. And we are very focused on continuing to make that even stronger. From a balance sheet perspective, we've done a lot of work in the last year to significantly improve our investment-grade balance sheet. At this point, our debt-to-EBITDA is 5.9x. We have nothing drawn on our $600 million line of credit. And we have enough liquidity to pay for debt maturities through 2025, which is also very important in a market like we're in today. So I think after the significant success of our recent disposition program, which kind of highlighted the strength of our leasing platform, we've had 22 anchor leases signed in the last 2 years, importantly, at 21% comparable rent spreads and 16% returns on cost. So basically, the company has done a ton in the last year to improve the portfolio, and we're very excited about what lies ahead. So that's it, Christy.

Great. So the first question that we're kicking off all the sessions with is: ESG is of increasing importance for all company stakeholders. What is the one thing that your company is doing to improve your overall ESG score over the next 12 months?

Probably the biggest thing is to communicate what we do do. We haven't been good at communicating what we do in ESG, and we've been active in it. We just created an ESG task force within the company that -- which are going to report to me on how we're going to accelerate the programs that we already have. As an example, we just launched one tree planting program. For every lease that we sign, we will plant a tree. We also have an initiative called Kite Cares, which was our charitable arm, is very involved in the community, in each -- or I say the communities, many communities, that we operate in. So I think the primary thing we're going to do there, Christy, is just do a better job of communicating to the public what we actually do do there.

Okay. So just kind of stepping back and thinking about the dispositions that you did last year. You completed $544 million of asset sales. How -- can you talk about how that has impacted your portfolio geographically? And I know that you've talked about sort of initiating an investor education around that effort. Can you elaborate that -- on that a bit?

Sure. I mean I think the biggest thing that the disposition program did relative to the makeup of the company is made it absolutely a company that is predominantly in the south and the west, as I said. So we are able to be better targeted in those target markets. And the theme that, as you know, the theme that we have there is that we want to operate in what we're defining as the warmer cheaper markets. We think these warmer cheaper markets are going to continue to benefit from the movement out of the more expensive colder states. So I think when you see the fact that now our largest market -- as an example, our largest metro area is Las Vegas versus Indianapolis was always our largest MSA. So that's a significant change. Also, our -- that quality that we're pursuing has elevated all of our metrics. Like ABR, for example, is almost $18, which was a few years ago $13. So basically, I think that what it's doing is positioning us to be a player in markets that other people maybe haven't looked at as much as they would at gateway market, and we think these are actually the better markets to be in.

And how are these benefit -- oh, sorry. Heath, were you going to say something?

Yes, go ahead.

Yes, I'll just say, in addition to just the market benefits, there's also a certain durability to our cash flow that's been enhanced by the program. For example, our -- just our sheer exposure to, we call it, our watch list tenant is less than it used to be. By way of example, we have 32 Ascena units at the beginning of 2019, and we ended the year with 13 at only 60 basis points. They dropped off our top 25 list. So just as a natural outgrowth of getting better real estate, we're seeing the quality of our tenancy improve and seeing some of the more troubled tenants having less exposure to them, so another sort of collateral benefit to the program.

And just to expand on that. So as you sort of pivot more into growth mode this year and looking ahead, how do these -- how are these markets benefiting from sort of demographic migration, demographic shifts? And how does this frame your acquisition strategy as you think about putting capital to work?

Well, I mean, I think the way -- for example, when you just look at the statistical data of the daily move-outs from New York, Los Angeles, San Francisco, Chicago, there's direct correlation to the growth in Florida, Texas, North Carolina, as an example, and Nevada, particularly Nevada, as it relates to California. And it's pretty specific. The people that are leaving California are generally going to Denver, Las Vegas, are the 2 biggest ones, and Dallas another one. Whereas in the East Coast, as you well know, a lot of people leaving New York, New Jersey, Connecticut are going to Florida, North Carolina, South Carolina, Tennessee. So look, this isn't going to be -- you won't -- as you know, what we said, if 1 million people leave Manhattan in the next couple of years, you're not going to notice. But they're definitely going to notice it in the markets that they're moving to. So I think it's a longer-term strategy. It's not an overnight thing. But ultimately, this ought to play into NOI growth and cash flow growth. We ultimately ought to be able to drive higher rents at lower cost of operations, which means more cash flow.

And so -- and thinking about that. So Heath, you talked about the durability of cash flow and the changes made. Just in -- just to kind of dig into same-store NOI a little bit?

Sure, sure.

Your forecast for 2020 is 1% to 2%. You talked about assuming no additional rent from any tenant that has filed for bankruptcy, so through February. On Pier 1, it looks like that that's going to be a little bit longer. They may not end up -- they may last a little bit longer in terms of those stores. So how do you think about that? Could the range end up being a little bit conservative?

Yes. So the total disruption was about 190 basis points. And if you think about what could possibly be recovered out of that, Pier 1, like you said, is a great example. We have 4 locations. None of those locations are in the sale list. We assumed in our guidance that -- in our base budget that we wouldn't get any more rent from them after February. I actually called my Chief Accounting Officer this morning to see if we got any rent checks, not yet. But it's March 1 -- this is March 1...

You're talking about Pier 1?

Pier 1.

Pier 1, yes.

But they're post-petition though, right?

Yes, but -- they are post-petition. They do have a DIP commitment. The bids are due March 23. So I think, at minimum, even if ours ended up being on the closure list, you would think you'd probably get 3 or 4 months of going out of business rent. So for us to say we're not assuming any more rent from February is admittedly conservative, but we'll see how it works out. The other tenancy where, potentially, you may see some bit of a recovery is Earth Fare. We lost 2 of those locations. They represent 50 basis points total. While we don't think Earth Fare is administratively solvent, so they can't even pay post-petition rent, one of our locations is being actively bid on. So there's a version of where one of those leases is assumed and then all the pre- and post-petition rent is paid, so that could be another 25 basis points. So I would say, in that 190, maybe 65 basis points is retrievable if the world breaks our way. So yes, but also just don't forget, and on top of that, we have 130 basis points of bad debt reserve for just disruption that we don't know about. So yes, it was 1% to 2%. Yes, it was conservative. Yes, we will try to outperform it.

So if all goes well, Q2 results, you're raising same-store NOI growth range by 65 basis points?

We'll see, we'll see. Yes.

We look forward to July. You talked about leasing 22 boxes in the last 18 months, 240 basis points of same-store NOI or $4.5 million. Can you maybe talk about the timing of commencement of these and how that plays into the trajectory of same-store growth that you're thinking about for 2020?

Yes. So of those 22 boxes, only 5 remain unopened. Those 5 will open up into the back half. Although it's an important nuance when we're discussing commencement of a lease and commencement of NOI, as you know, sometimes a tenant will have 3 to 4 months of a build-out period in order to get open. So yes, 17 have commenced. You'll see a little bit of a delay into the NOI shape. But for the trajectory of our growth, you're going to see us sort of moderate to the first and second half. And then we'll accelerate into the third and fourth quarter as those additional boxes come online.

So as we think about that, both the fallout side and the commencement side, how should we think about that? Your lease-to-commence spread is at 230 basis points today. How should we think about that through the course of the year?

Yes. So the good news is the biggest moving piece on occupancy is going to be the Dress Barn deals. And so we had 8 Dress Barns. To date, we've signed 5 leases representing 4 locations. We're in negotiations for another 2 and the other 2 are in play. So it will happen at the beginning of this year, so you'll actually see that the leased-to-occupied spread widened because the occupied denominator will take a bigger hit by the virtue of these being out of the denominator. However, the -- since we have 5 of them already leased, that lease -- the violence to the leased percentage will be less than it is to the occupied. So again, it will widen. And then as the year goes on, you'll see it skinny again.

Yes. Eventually, we hope it gets back to the normal 150 to 175 basis points probably.

And how are you thinking about sort of the demand side, right? Demand has still been there. Has that changed at all? And sort of there's still kind of box leasing effort, especially as you get space back. So where is the new demand coming from? And is it still as solid as it was a year ago?

Yes. I mean demand is strong. I mean if you look at the 20 deals we did, 17 different tenants, I think. So you look at companies like Total Wine is really expanding. TJ is still expanding. Ross and Burlington are still expanding. REI has definitely stepped up and started to really look at specific locations. Old Navy obviously has been -- even -- it's interesting. They were going to spin it out. Now they're not going to spin it out. Maybe they realized how important it is. I mean Old Navy is still doing a lot of deals. The fitness area, Christy, you got Planet Fitness and some of those guys. So really -- and then you get into the shop space, and we're starting to see some really interesting tenants that are experimenting, maybe coming out of malls and/or maybe doing both like a Sephora and Bath & Body and Torrid, guys like that. So demand is strong. I mean that is definitely not the issue. The issue you're faced with is, do you want to take -- do you want to take a space back and take the downtime, invest the capital or do you want to just renew the existing tenant, even if it's going backwards a little bit, right? That's the thing that we deal with all the time and looking at. And I think the market gets a little uptight about those type of metrics, but we're more focused on what's the value creation. How are we creating long-term value? Can we compress the cap rate on this asset by changing the tenancy? If you can't, is it really worth investing those dollars, right? So I feel very good about the demand. It's just a timing thing.

Yes, I'll add on also that when you're 97.8% leased, the anchor is at 92.5% leased in the small shop space, the philosophy around leasing is really changing internally. We actually had to change how we compensate our leasing people because it's no longer trying to fill space. It's, hey, we have 7 boxes of 280 boxes left. That's our entire inventory. So at this point, it's really incumbent upon us to become picky. What's the best tenant, at the best rent, at the best economics, with the best merchandising mix for that particular center? So we're really trying to pivot the discussion because we are so full.

And so just on that, I mean, if you think about the -- you mentioned fitness as an area category. You recently had -- we've heard of some trouble with 24 Hour Fitness. These are pretty heavy CapEx deals. And so how does -- or do you think that's tenant-specific? Or does that sort of change your view about the risk associated with the economics of fitness-type deals?

I think it's both. I think it's tenant-specific to them, but I also think you have to be very cautious on those. And we've talked about that openly with you in the past that those are big dollars and so we're very selective. I mean we haven't done a new large-format deal, like an LA deal or a lifetime deal in a long time. Look, they can be awesome, but you're just investing a lot of money there. So you just have to be very thoughtful about, is that -- do we need that for this location?

You've had an effort and initiative to increase fixed CAM. Can you talk about that -- your success with that and how your recovery rate has been impacted?

Yes. Well, that's sort of the economic success and then there's other noneconomic collateral benefits of going to fixed CAM. Fixed CAM or rather typical CAM is it can be a very stressful process. It's a lot of back-of-house work. You're doing CAM conciliations. It can become contentious with your tenants in terms of they're going to hire an auditor to make sure you've been charging them correctly. So we've always had this tension around CAM. By fixing the CAM, you've done the tenant a service, you've done us a service. We can budget better. They can budget better. And there's really no dispute or reconciliation process that happens at the end of the year. So that's the one operational benefit. It's just -- it's going to improve our relationship with our tenants by not having to have these uncomfortable conversations. But in terms of what it does to your margin, we've been successful. About 40% of our leases are now fixed CAM. By the end of 2021, that number should exceed 50%. And for better or for worse, a lot of our tenants are much more willing to allow us to have increases in fixed CAM. So it's really helping push our recovery ratio to one of the best in the class, which is over 90%. So we're going to continue to do it. We hope to have 100% of the portfolio over the next decade to be in fixed CAM as these leases burn off.

You said greater than 60% by 2021?

Greater than 50% by the end of 2021.

Greater than 50%.

Yes, we have about a 90% success rate on new leases and probably 70-ish percent, sort of blends to a high 80% for our leases.

Any questions from the room? We've seen some strip center REIT JV partners look to monetize their investments to reduce retail exposure. Can you maybe update us on the status of your Nuveen JV that you formed just, what was it, less than 2 years ago? Is this still a source of the acquisition capital for you? Or is there some risk there that they look to potentially not want to be there anymore?

I mean, look, I think, as it relates specifically to Nuveen, we have a great relationship with them. And we're kind of in constant communication just on the assets that we own together and then also on the possibility of expanding that. So I think -- but we're also kind of very well aware of the overall market and there's potential opportunities outside of Nuveen for us to be looking for potential joint venture partners. And first of all, when we -- just to be clear, though, when we did this, we weren't looking to reduce retail exposure. It was really more of a cost of capital situation, which is clearly there right now, where we need to be thinking about if our cost of capital is going to be as disruptive as it is today. We have a great operating platform, and we want to put that operating platform to use. So I think that's an opportunity for us down the road, Christy, but as said, we look at it in a very measured way.

Questions? So from a redevelopment perspective, your 10-K states that you're currently evaluating several other redevelopment opportunities in your properties. I didn't know if that was referring to the shadow pipeline properties that you list in your supplemental or if there's sort of properties that you're evaluating or bigger projects that you're evaluating sort of on the longer-term time horizon. Can you expand on that? I think it was new language in the K.

No. I think it's probably more of a cover language that says we're always looking at the portfolio, and we're always trying to mine the portfolio. But as it relates to CapEx, I mean, there's really only 3 projects that we're working on that's going to require CapEx, and those are the ones we've disclosed.

The Indianapolis ones, yes?

Yes, yes.

And as you look at commencing construction there, how do you think about mitigating the associated risk, especially this late in the cycle? I think the last cycle, as you were kind of going into the downturn, you had some development exposure. What do you think about mitigating that risk this time around?

Well, I think -- first of all, I think we have substantially mitigated it just by its size. We only have 3 projects that are material, and we've done a lot of work leading up to this to mitigate the risk. Part of it is also bringing in outside partners, as it relates to the other product types, who will also have capital requirements. So I think it's more -- mitigating the risk is making sure you understand it. Our history is such that we have the benefit of being ground-up developers over 40 years. So we do understand that when you generally look at a project and someone brings a pro forma in, it's usually not going to be accurate in the end, and you've got to build in a lot of risk mitigation relative to your returns. So I think it's choosing the product while being very conservative in your underwriting and then having a strategy around whether you're going to hold or sell. So...

Yes. I would add, Christy, that it's intentional that we don't have a lot of forward commitments in terms of redevelopment right now. Even before coronavirus was a thing, we sat back and said, "Look at 2020. It could be an odd election cycle." It was pretty late. And the expansion, do we really want to have $200 million to $300 million of forward commitments on very, very complicated mixed-use projects? And by the way, mixed-use is not easy. It's very easy to get it wrong, especially when you're dealing with uses that have a lot higher -- I'm sorry, a lot tighter yield returns. What's interesting about the 3 that we have going right now is that, in each instance, the partner approached us. So they will all involve a multi-use portion of it, but it was sort of organically sourced. What worries us, and I think maybe the story maybe 7 to 5 years from now, is this mad dash in our space to rush to do densification and multi-use and solve the pipelines in reverse rather than having that organic inquiry. So again, sitting at the end of 12/31 with $600 million in our line, being able to satisfy our maturities through 2025, without this huge commitment going forward and the stuff that we do have being very organic, we're feeling very, very, very ready for whatever the 2020 shall bring.

The other thing is we prefunded the 2020 spend as well through the disposition program.

Remind me of the 2020 spend and how you're thinking about spend in '21, '22.

So the 2020 redev spend, there was only about $16 million left on the Big Box Surge, and then we have another $3 million left on our Eddy Street development. The other 3, we'll see. We may have some commence towards the back end of the year. And there may be some nominal there, sort of beautification projects, but nothing material. So again, 1 of those 3 may start, but nothing significant in 2020. And then in 2021, we're really designing these redevelopments in a way that we're bringing in joint venture partners, who'll likely contribute the land as portion of our equity. We're looking at potentially doing public-to-private partnerships to help us with our investment -- our side of the investment. So we want to do it in a way that's not going to really take our leverage to a place that we worked really, really hard to get at. So last thing we want to do is sell a bunch of assets, bring our leverage down to 5.9 and then relever back to 7 on some speculative redevelopment. That is not our intention.

Yes, that was kind of going to be one of my next questions. You foreshadowed it. So just -- I mean you've gotten your leverage down. I think it's 5.9 today, right? As you think about sort of starting to ramp up redevelopment activity that there's a drag inherent on your leverage metric in doing that, right? So it sounds like you're cognizant of that and are very aware of...

Very. Absolutely.

Yes. Yes.

Okay. I mean in what sort of leverage -- I know you worked hard to get below 6x. So I'm assuming you expect to operate within that 5.5 to 6x on a go-forward basis?

That's correct.

Okay. And Heath, you mentioned coronavirus as a macro risk. Just how has your thinking evolved in the last week or so in terms of the impact that this could potentially have on retail, the global supply chain, brick-and-mortar retail in the U.S.? How are you thinking about that?

Right. I mean, look, at this point, it's obviously early. And in my personal opinion, it's a pretty big reaction to something, but all of our conversations at this point have been that the majority of our retailers, from a supply chain perspective, have already done a ton of work to diversify away from China as a single source. Obviously, there will be other parts of that region that may be disrupted from this. But as we sit here today, no one has told us, "Oh, we have a big problem because of the supply chain disruption." As it relates to the consumer, obviously, too early to say. I would say my guess is the last few weeks have been pretty good for the guys like Target and Walmart and Costco, et cetera, from all the stocking up that's been going on. But right now, it feels as though, again, very early, hard to say. But the retailers that we're in conversations with feel pretty -- not a lot has changed so far. But I think it will be -- we've got to let this play out and see how -- what plays out.

Yes. Any questions? Everyone's so quiet today.

I know.

Like, I am not even getting any questions in there...

Well, it's post lunch. You got a little post-lunch...

That's true. Everyone needs some coffee.

Everybody needs a nap.

Everyone keeps grabbing for their hand sanitizer.

Well, I don't have -- yes -- have you brought the ice cream out? You got to bring the ice cream out.

Yes, that will come out in a little bit. So understanding that your 2020 FFO growth is more under pressure given the dispositions of last year, how should investors think about the more stabilized FFO growth rate for your company in 2021 and beyond?

Yes. I mean I think, look -- I think we've been pretty -- we were pretty transparent that this is the trough year. Interestingly, if you look at the assets that we retain today and assume that we only own those assets in 2019, 2019 would have been $1.44 and 2020 is projected to be $1.50 at the midpoint. So we would have growth in those assets. So -- but I think as we look to 2021 and 2022 and 2023, we've been clear that we want to -- we think that the sustainable NOI growth when you're not having a lot of disruption is then that 2% to 3%. And hopefully, you're closer to 3%. So you would think that your FFO can grow in that same kind of range or better depending on redevelopment opportunities, et cetera. So our complete focus after this is to pivot the company to be able to take advantage of its balance sheet and maintain the quality of it and grow organically to get back to that kind of growth pattern in both FFO and cash flow and then also in NAV.

So I think the -- just following up on those comments. I think the investment community feels more comfortable in sort of your dividend and payout ratio, those pre kind of execution of your disposition strategy, there were more questions around it. But as you think about sort of where you're settling post dispositions, how do you think about growing retained earnings overtime to add free cash flow as a source of capital for growth?

Yes, I mean, growing free cash flow per share is a big deal. So I think we're very focused on getting back to that, and we think we've recalibrated the portfolio such that the retained assets and any assets that we would add to the portfolio are going to have less CapEx needs than the ones that we disposed of. So you don't just get the free cash flow from the margin, you also get it from spending less CapEx. So I think as we move forward, we feel very good about that. Obviously, we put stress on it in the interim, but we're very comfortable that we're going to continue to move forward and cover it, and grow cash flow. Because that's what we're good at doing. We've always been good at that, but we just -- we had to go through this process to get the balance sheet right-sized and to get to the portfolio of assets that we wanted to own that we thought could grow at a higher percentage. So that's -- I mean I don't know if you want to add to that, but that's...

No, listen, we're well aware that free cash flow is your cheapest form of capital. So for us, it's going to be our #1 priority to continue to grow that in the future.

And as you think about either the -- I think that your stock has continued to trade at a discount to consensus NAV. This is something that you're focused on, especially up to the last couple of weeks. You talked on the call about where your stock trade is not being able to find assets in that range in the private market. But beyond the external factors that you can't really control, how do you think about narrowing that discount?

Well, I think, first of all, we've got to do a better job of getting investors to appreciate the quality of the portfolio. And look, we understand it. We've owned a certain portfolio for a long period of time. We just completely transformed that. We have to educate people as to what I said in the beginning, which is 80% of our rent comes from the south and the west and our ABR is $18. We -- predominantly, these properties have a grocery component associated with them. They're not power centers. So its education is a big thing. And I think education and execution. We've got to pivot and execute. But I think I've got to keep talking about the fact that when you look at what is in the private market and you look at where these things transact, and we look at assets that are complementary to our portfolio, all day long, those assets are in that kind of 5 to 6.5 cap range, and we're trading at above an 8 cap again. So I think all we can do is continue to execute, but educate also.

Yes, it's funny. We have a fond saying in the company that it's not enough to give investors 20 good reasons to invest in you. You have to remove the 4 or 5 obstacles to not invest when you're our size, right? So I think leverage, asset quality are some of those obstacles that we spent a lot of time removing last year. This year, it's perception. That's one of the things we want to tackle. We are not a power center company from Indiana. In fact, our largest exposure in a single MSA is Las Vegas. I think the other thing -- the other obstacle we need to remove is that we're actually going to be able to grow FFO into 2021 and that we're not going to go ahead and announce some plan to sell another $200 million to $300 million of assets and continue the dilution. So I think it's just sort of stair-stepped it. Last year, we made up a good portion of our relative and our absolute discount. We almost took about 1/3 of our absolute discount away. I think if we continue to just execute to focus, to continue to deliver on exactly what we promised, we'll see that start to chip away. The bottom line, there's no silver bullet, unless we find oil underneath one of our assets.

Yes, I don't even know. That wouldn't be good today. Because if we find something, some solar power or...

Maybe lithium or something like that. I don't know but...

Yes, look, I think even just telling people simple stuff, like if we are trading at a 6.5 cap, we'd be at $26, basically. $25.80 something. I mean you just have to keep putting it out there, executing, and reminding people, take a look at the portfolio, it's a lot better than you think it is.

Right. All right. Let's do rapid fire. Will the U.S. strip center sector have more or fewer companies a year from now?

Hopefully, fewer.

What will same-store NOI growth be for the sector in 2021? And for reference, in 2020, guidance is for 1.8%.

2%.

What will the 10-year treasury yield be? 2%?

I said 2%, but now I'm laughing about the next question. You should preface who wins the election for this next question?

Yes, we can, if they win. So...

Okay. Because there's 2 -- I got 2 answers for you.

Then you start to get into politics and...

I got 2 answers.

Yes, I know. I know. What will the 10-year treasury yield be 1 year from today?

1.25%.

And in what year will the U.S. enter recession?

I mean it depends on the election and the virus, probably, after the election.

2020?

Yes.

Late 2020.

No. I am going to say '21.

'21. Thank you.