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

Welcome to the 10:35 a.m. session at Citi's 2023 Global Property CEO Conference. I'm Craig Mailman with Citi Research, and we are pleased to have with us Kite and CEO, John Kite. This session is for Citi clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AV desk. [Operator Instructions] John, we'll turn it over to you to introduce your company and any members of management that are with you today, provide any opening remarks, and then we'll get into Q&A.

Great. Thank you. So appreciate being here today. We are -- I've got with me here, Heath Fear, our Chief Financial Officer; got Matt Hunt over there on the left, who heads up IR for us; and Tyler Henshaw, Senior Vice President of Finance and Capital Markets. So just a brief introduction for those that don't know, Kite Realty Group is an open-air shopping center company, 1 of the top 5 owners in the United States, publicly traded, own approximately 30 million square feet. The majority of our portfolio is located in the Sun Belt states, and actually, 40% of our revenue comes from Texas and Florida alone, which is probably one of the highest in the sector. 75% of our centers have a grocery store component with them. And we pride ourselves on being, if not the best, one of the best operators. Certainly, when you look at our efficiency ratios, our margins, how we run the business, I think that would back that up. Obviously, we -- for those of you -- most of you know, we completed a merger. It's been a while now, and the results of that have been very, very strong. So that's a quick introduction.

Great. So we'll start with our opening question. What are the top 3 reasons that investors should buy your stock today?

I don't know if I can keep it to 3 buddy, but I'll try.

You can give more. It's a minimum.

Three -- it's a minimum, my favorite. Look, I think, first of all, as I just said, I think we're a proven operator in a space that you need to be a very efficient operator to do well in, frankly. I think when you look at the margins -- our NOI margin, our recovery ratios, if you look at that, we're near the top of the space in that -- in those 2 particular metrics. I think we still have a lot of growth. We still are -- I think we have the largest delta still today between current occupancy and pre-COVID levels. So there's a lot of upside in just purely leasing. I think that when you look at our balance sheet, we're, I think, the second or third best balance sheet in the space, so you put these things together with a significant discount where we're trading from an NAV perspective. And from a multiple perspective, I think the stock still has quite a lot of room to run. But more importantly, I think we can generate a lot of more -- much more free cash flow over the next few years. So I think those are a couple of succinct reasons.

That's great. And you mentioned you guys still have some room to run on the occupancy side of things. There's clearly -- leasing is a little more topical these days given maybe some views of weakening economic conditions towards the back half of the year. We've seen an uptick in some bankruptcies here in the beginning of the year. Can you just kind of lay out how you guys feel you're positioned to continue to lease up in this environment, where maybe tenants are in the cycle of looking at store openings? Is it '24, '25? Kind of give us some insights on how you see this playing out over the next couple of months.

Sure. I mean, as we sit here today, I think the environment is quite good. The supply-demand characteristics in open-air retail today are as good as they've been in a very long time. I think retailers, really, it's a result of the fact that physical retail over the last few years has changed really dramatically. Coming out of COVID, the ways that retailers were looking to grow all circled back to the physical side. So I think we're in this environment that's quite nice as it relates to our ability to backfill any spaces that we would get. And you look at the depth of the retailers that we do business with and, just quarter-by-quarter, when we go through the leasing results and we look at the names, I mean it's amazing how deep the pool really is, and a part of that is also the characteristics or the composition of the portfolio that we own. So from a macro level, I would say, no matter kind of what happens over the next 12 months, it's a good environment for us to lease space. Now it can change. It can change quickly. There's obviously a few retailers that have challenges. That's normal. And generally, we like to replace those retailers anyway. So I think the environment is pretty good.

And could you talk just a little about your exposure, some of these watch-list tenants, whether it's Bed Bath & Beyond, Party City, some of these guys that have been in the news and kind of how that equates, Heath, maybe to what you've embedded in guidance and maybe try to give a little bit of a -- I know it's very early in the year but, at least, have you started to see any cracks on the tenant side beyond the bigger bankruptcies in the news?

Yes, sure. So for the 2 tenants that people are giving the most attention to, Bed Bath and Party City, we came out with guidance earlier this year. We basically said that we're setting a 75-basis-point reserve for those 2 tenants. We have about 140 basis points of ABR exposure to Bed Bath & Beyond, which is split 90 basis points to the full-line store and 50 basis points to Buy Buy Baby, which we think is a viable platform on a go-forward basis, and about 70 basis points to Party City. So when we're establishing those, that 75-basis-point number was really our best estimate of what we thought the disruption could be, sort of putting our tenant head on. We looked at health ratios. We took the information we had with direct conversations with the tenants and did our best to handicap how we thought this whole thing would shake out. So that's what the 75 basis points relates to. Then we also had a 125-basis-point, call it, general bad debt reserve. Typically, in a year, we'll experience between 75 and 100 basis points of disruption that's based on revenue. So going into '23 and realizing that there's some uncertainty in the macro level, we thought it was prudent to go ahead and add a little bit more to the bad debt reserve. So I think we came out with a fairly conservative outlook in terms of how 2023 was going to shake out. And then in terms of cracks, I don't think the word crack suggests something -- a departure from the normal environment. I think John said it best, is we're really returning to an environment where tenants fail. And so when we had 18 months where nobody was failing because, to the extent someone was weak, they were purged by COVID, that was the anomaly, right? So we are used to this environment. So this is -- this feels normal to us. Anyone here thinks about where you were shopping 20 years ago, you'd realize a lot of names are gone. So it's part of our business, is a tenant cycle in and out. And that's what also keeps us relevant and vibrant. Do we want a bunch of stores back all at once? Of course, not. But do we want tenants that are going to drive traffic, compress cap rates across properties? Yes, we do. So again, we're kind of in a more normal environment, for lack of a better word.

And maybe to look at a potential silver lining to this, right? A lot of the Bed Bath & Beyond stores are kind of below market from an in-place rent. You will have some downtime. But as you guys think about your ability to potentially accelerate the take-backs on some of these, what do you think downtime could be CapEx and then sort of the near-term boost to that growth profile of being able to accelerate the recapture of the mark-to-market?

Yes. I mean, obviously, every -- it's case by case. So each shopping center has got different personalities. But generally speaking, if we get back a box that's 30,000 square feet, plus or minus, we're obviously already getting a lot of inbound queries on these spaces right now. So each space that we have has a list of names associated that are interested in the space. So it cuts down on the marketing time, I would say, that you would generally have if someone just closed unexpectedly. But from the perspective of leasing it and putting someone actually in paying rent on an anchor space like that, it's going to take 12 to 18 months. I mean that's generally the time line. The cost, the great thing that's been going on in the last -- for us, in the last couple of years is any of these boxes that we've gotten back, we really haven't split them. I mean I think you guys remind me, it was like we did...

46 deals.

46 deals, and we only split 2 of them, I believe. So that's -- that saves a lot of money, obviously. So I think costs, I mean, it's just -- I wouldn't want to throw a number out that's -- because it's case by case. And we're always looking to get the highest return on capital, and it's really how we judge these things. So -- but we also -- we don't want to get in a situation where the rent is high because you bought it up. So we're not looking to do that either. So that's why I wouldn't just give you something that's a blanket answer for that. But the good thing is the demand is there. We went through this before. I mean we went through this with Stein Mart, pre-COVID or during COVID, and we took back several boxes, and we leased them at very significant spreads to the previous rents, and we have to spend a lot of money. So we'll see how this one plays out. And we're not sure exactly the timing of what would happen. And for right now, I mean, they're -- it's an ongoing business. So we're not exactly sure where that will end up.

It seems like relative to some of the tenant issues a couple of years ago, the size of some of these tenants today that are in the news is there's a lot more demand for that size, right? Could you talk about as you guys are looking to backfill some of these potentially in, you're getting some inbounds, right, that pipeline of tenants in that 30,000-ish square foot size range and how maybe this time differs a little bit than maybe Toys or Stein Mart just from a size perspective and just the breadth of the pool of backfill opportunities?

Sure. Well, I think one of the biggest differences is that we're in an environment where tenants can't dictate things like that like they used to. So in other words, if a tenant's desired square footage was 34,000 square feet, and the box we have is 30,000 they're going to try to make that work because the opportunities are slim, vice versa. I mean you could have a box that's 30,000, and they want more than that. They want less than that. So I think it's -- the biggest advantage we have today is tenants are much more creative and they're much more willing to work with us to get to something that we both can agree on. So I think -- and also, you mentioned Toys, for example, I mean those were large boxes. Those were 60,000-square-foot boxes or between 50,000 and 75,000. And those were difficult because of that. So this is a very nice size space that we're talking about. And the same goes for Party City, which is much smaller, much easier. Now on those deals, it's pretty easy to split them. It's not that expensive because of the size, and sometimes, you want to do that on a smaller deal to get a couple of really good users versus one. So I don't know if you want to add to that.

Just one thing I would add, and again, this is silver lining. Back in the day, Bed Bath was a marquee tenant. So unlike a tenant like Circuit City, for example, they didn't have a great real estate, and they're willing to pay a little less. For the most part, Bed Bath is located in the better parts of your -- we have -- they're in good real estate and good real estate, for lack of a better phrase. So we're pretty bullish on our ability to release those spaces even when we get them back.

What -- just generally, the mark-to-market on those boxes, do you think?

So we have one Bed Bath where the rent is disproportionately high. If you eliminate that one, the rents are around a little over $11. That stands in contrast to around our in-place rents for boxes, which is around $14, and also, for last year, the rents on the boxes that we did were in the $15. So there's a nice mark-to-market opportunity. Again, it's all space by space. But if you just want to do sort of generalities and look at, historically, where these things have priced, it feels like we're going to have some nice spread opportunities.

I think there's also some opportunities to diversify our tenant mix as well. So we might have situations where we don't have a grocer in a center. So here's another opportunity for us to bring a grocer to the center. So I think it's -- look, it's usually -- it can be painful a little bit in the beginning. But then when you get to the other side, it's worth it. So I think that's probably what this will end up being. And that's why we underwrote guidance the way we did. So we were very specific about that. And I think, hopefully, that's helpful to everybody.

And you brought the diversity of tenants. Kind of how do you think diversifying your portfolio will fare in a choppier macro environment?

Yes. I think we're actually positioned very well for a choppy environment. When you look at the fact that we own a good mixture of the different retail genres, we own mixed-use. We own lifestyle. We own some power. We own grocery. We own neighborhood. We're exposed enough to the different product types that, despite a choppy environment, there's going to be a portion of that benefiting from some trade. But overall, when you look at what's happened during COVID, I mean that was the ultimate stress test, and our centers actually performed. I mean it took a little bit for everybody to figure it out, but they performed. And I think, again, in this next cycle, whatever that might be, I think our portfolio is positioned quite well.

We have a question coming in. You talked about occupancy upside at the start relative to pre-COVID levels. What other unique organic drivers or upside you have left? Maybe talk about margins, et cetera.

Do you want to hit that? Margins?

Margins, we actually have a page in our deck. We thought that the -- to get ourselves back to historical-type margins, it would take us between 2 and 3 years, and we're actually back at that levels -- that now. However, the good news is we're not looking at those margin levels or those recovery ratios as a ceiling. So we think that we'll continue to get more efficient and to drive those margins higher. Part of that is continuing to put tenants on fixed CAM. In addition to that, there's -- part of the organic story here is all the entitled land that we picked up through the merger, 2 very large projects. One is Carillon, and one is One Loudoun. One Loudoun is the wealthiest county in America, and post merger, we took 40 acres of land, and we rezoned it, and now we have the right to do 1,745 residential units, which is a really value-enhancing proposition for the Loudoun County area. So that's a project where you would likely see us, once we get through this large leasing -- re-leasing exercise, spending some of our capital. And then also, on Carillon, which is real estate that we're less excited about that anything we do there will be on a very capital-light basis. But again, it's nonincome producing land right now that we could potentially monetize or, again, perhaps recontribute and take small minority interests. But those are 2 levers that we can pull when the time is right, organically. John, anything else?

I mean I think well said. I think we're very -- we're obviously focused on our organic growth right now, but we do have the opportunity to get some external growth vis-à-vis the developments that are out there, the developments that we're finishing and then also the fact that our balance sheet is in extremely good position, so if something interesting could come along, we could take advantage of it. So I think we're going to see where that goes, but we're definitely positioned to continue to grow.

And just as you look at some of your key operating metrics, whether it's expense recoveries or NOI margins, you're kind of near the top of the peer group. Kind of how do you guys feel like you got about that to distinguish yourselves? And what's the opportunity from here to stay above peers or even improve it further?

Yes. Look, I mean I think -- I appreciate the question. I think when you look at the history of the business, you have to kind of look how all these companies may have a history and they have a culture. Our business grew from nothing, really. And so we were always in this place where we needed to be -- had to be efficient. And over time, that becomes your culture. I mean we have a culture that is very driven, and we are always looking to improve our margins. We are always looking to kind of think through how we structure the business. So if you grow up culturally thinking I'm always scared of what's around the corner, you operate tighter. So bottom line is that's what we do. We kind of came in this business at a time when you had to do that. And as we've grown and, obviously, have a much stronger company, we still operate it as though we have to count every penny on for our margins. So that creates more free cash flow, and it becomes a virtuous cycle. I also think that when you look at the way that we executed on the merger, it is another example of that kind of grinding mentality when you take on a very large opportunity like that and, in a very short period of time, bring the margins to where -- our margins where and really get people culturally to understand how we drive that. So it sounds kind of, I don't know, a little soft, but it's just -- you have to be thinking about that all the time. You want to add?

And you hit upon the merger, you guys -- it's been some time now since it closed. You've already kind of benefit from some of the fruits of bringing that on to your platform. If you had to look at maybe your 5-year plan of integrating that, kind of where do you think you are from getting those assets fully on board with Kite's kind of management style, getting the rents that you want in there? I guess essentially, how much juice is left to squeeze out of that portfolio relative to the benefits you've seen over the last 2 years that's helped you with some of these upside to guidances and upward revisions that people become accustomed to?

Sure. I mean, look, I think if you look at our investor presentation, we actually did a page. And at some point, I guess we'll stop talking about the merger, but we did a page on Page 6 of our investor presentation that laid out what our original goals were with the merger and what the time lines that we thought it would take to get there and what's actually happened in those -- in that 2 years. And clearly, we achieved our goals much faster than we thought we would. But as we said, we still have lease up. So when I think about it from a perspective of what is left to squeeze, I mean there's leasing to be done. In terms of the margins, I think we've gotten the margins in line much quicker than we thought we would. Part of that, as I said, the way that the team came together culturally to drive forward helped that a lot. So I think, yes, I mean, the balance sheet is way improved. Our ABR is up. Our cash flow is up. Quality is up. So it's kind of hard for me to point to something that was a bad result of this transaction, but we still want to keep growing it. And I think that would be done on the leasing front. And then also the fact that we were able to get this entitled land really for free essentially, that gives us a lot of upside there as well.

And we talked in your -- in the beginning about the 3 investment valuation continues to come up, right? The stock has done relatively well. But given the growth in NOI and earnings, the multiple has not necessarily closed the gap to some of the peers. I mean, from your perspective, kind of what's the opportunity for investors there as you're looking at your ability to sustain that premium growth profile with the snow pipeline that buffers against maybe some of the near-term choppiness in tenants that people should be thinking about as they look at where your cash flows are being priced versus maybe some others where you guys were admittedly paying the penalty box post RPAI for doing a merger of that size maybe going away from the -- your -- I'm going to butcher your cheaper, warmer strategy?

Look, I think, obviously, we're -- as you said, the stock has actually, on a relative basis, performed well last year. It's performed well over a 3-year period, over a 5-year period. But that's cold comfort when you know that you're trading well below where you should be. So it's nice that that's held up in a sense, but -- and I'm talking on a total return basis. But clearly, we need to get out and explain to people that there is still tremendous upside here. And I think when you do perform well on a relative basis, sometimes people just look away because they need -- they're looking for another idea. And I think in this case, you need to look back on this idea because the bottom line is you look at it from a multiple basis, you look at it from an NAV basis. And it's just trading at a discount that we have to bridge. We have to close the gap. We've done it before. We're very focused on it. It's something that we don't like. I mean we were one of the few people. If you look at our [ stuff ], and you go to the last page or -- I have it in front of me right here, Page 18. It's not the last page. But we put all the components of our NAV on 1 page. And all you really have to do is attribute a cap rate to the shopping centers and the cap rate to the ground leases, and you are definitely going to come up with a number well above where we're trading. So I think that's -- the message is that we want people to understand there still is a great opportunity here. We're very focused on this. We're driven to continue to make smart capital allocation decisions. Sure, I think when we did the merger, it was large. It was probably unexpected, and people generally take a pessimistic view when something like that happens. But it's very clear that it was an outstanding transaction, and everything we said would happen did happen. So I mean that's all -- I don't know what else can you add to that?

And going back to the -- your comment about leverage, right, you guys are about 5.2x debt to EBITDA. Can you talk about just where that is relative to your target ranges? And what type of optionality that gives you on the acquisition side but also maybe rolling that leverage into where your cost of capital is and how you guys are viewing deploying any capacity you may have here in the near term?

Yes. So we've said many times that our target leverage is somewhere between low and mid-5s. So we're actually sitting at our target leverage right now. In terms of whether it's raising capital or allocating capital, I think the beauty of our balance sheet now is it's allowing us to be patient. On the capital raising side, we're not ones to fight against the benchmark, we're not interest rate speculators, but we are able to look at our balance sheet and our credit metrics and look at our indicative spreads on doing, for example, an unsecured public bond and say to ourselves that there's a lot of uncertainty in that spread, so we're just going to kind of wait, right? So again, our balance sheet allows us to be patient. On the capital allocation side, same thing. We have discussions internally. We asked ourselves, okay, so what's -- we're going to acquire something, what is our current IRR hurdle? And that's something that's a little difficult for us to understand right now. Are we higher for longer? Are we headed for a recession where we're going to reset rates? So again, our balance sheet -- and again, our ability to grow simply by leasing is allowing us to be patient on both sides of that equation. To the extent we acquire things this year, I think there's probably 3 buckets of the way we look at it, either it's sort of small [ enough works ] on the margin. Two, it's match funding. So I can kind of be cap rate-agnostic if I'm just swapping NOI, selling something that has $5 billion NOI. And then I'm buying some that has $5 billion NOI and the purchase price is within a reasonable range, okay, that's fine. Or if you come across something which is generational and it's not inconceivable in this environment working with the private side where you have secure borrowers that are looking at writing significant equity checks or unable to refinance on their current terms, you may find an opportunity. And when we were at 5.2x, we have the ability to take a swing at something generational, right? So those are the kind of things that we've been looking at. But again, the #1, I think, mantra for this year for us is let's be patient and we have the balance sheet that affords us that optionality.

Yes. I guess the only thing I would add to that is with leverage at 5.2x net debt to EBITDA, I think we're second or third lowest leverage in the space. And we like that, right? So I don't -- I think we like being in this position of strength. It gives us -- it affords us that opportunity to think ahead. But we do like operating the business in this lower-leverage format, and we've operated it at much higher leverage through our history, and it's just a tougher business to run when you're higher leverage. So we're going to stay in this range, but as he said, it definitely puts us in a position to be opportunistic if it was worthy of that. But I don't -- right now, it feels like this is the right place to be.

And as your snow pipeline starts to transition into the operating portfolio, I know, Heath, we've talked about in the past, the free cash flow opportunity, right, as it also goes to this leverage piece. I mean, as you look out 2 to 3 years from now, kind of what could be the growth in your FAD here that could be that incremental capital you can put out at very low cost?

Yes. We typically don't guide to cash flow, but I will tell you that we are positively cash flowing over the course of the next 2 years, and we're looking at spending upwards of $175 million on leasing. So if you go 3 years ahead from now and you assume that we were done with our leasing, our cash flow gets significantly higher than it is now. And that's when it becomes really interesting and fun for us where we can pull out our capital allocation menu and look at the opportunity in the world around us and decide what are we doing with this free cash flow. So -- but in the meantime, we are perfectly happy. Last year, we earned 37% return on cost on leasing. In this environment, that's the best dollar spent for us. So for right now, we'll continue to lease, and we look forward to 3 years from now while we just have capital to get more creative.

And I want to circle back. I got a question going back, John, to your comment in relation to my question about your valuation here. Really, what is the catalyst to close that gap other than just valuation as a catalyst, which is typically a condition, not a catalyst in the REIT space, right?

I mean I think in this particular instance, it's a tough question because normally, you would have something glaringly wrong with the operation to be in that position. So you could say the catalyst was to fix the balance sheet or to own better assets, whatever. In our case, I think we've proven that this company is very strong and very worthy of being valued higher, so I think the catalyst has to be continuing to execute to continue to explain and be as transparent as possible to the investor base and get out there and get it done. I mean I can't point to one individual characteristic, I think, that would change it. But again, we have been through this before. One of the things I think we need to make sure people understand is the quality of the real estate. Maybe there was some confusion around that initially. So we're doing -- we're trying to do a much better job of getting investors and everyone else out to physically experience it. So that's something that we need to do. But I think it absolutely will come. We've been there before. And over time, we just keep plugging and generating the results.

And moving on, we've been asking sort of ESG, what's your #1 priority here for 2023?

You go ahead, yes.

So on the ESG front, we really experienced some quantum leaps at Kite. We've always been a really good corporate citizen. We haven't been the best historically in really communicating that out. So last year, we filed our first corporate responsibility report. And looking forward to this year, I think 2 of our major initiatives -- at least around the E front, we're looking at doubling our spend on environmental initiatives. That's something that we're excited about. Another thing that we're going to commit ourselves to is that we're starting to establish and set ourselves up to hit certain Science Based Targets. So again, it's been a journey for us. We had massive year-over-year improvements, '21 into -- I'm sorry, '22 to '23 and expect to experience similar improvements this year as well. So again, it's -- we've always been a good corporate citizen. But now we're rightfully so we're making sure that we're communicating out to the street, not only because it helps the investability of the stock, but I think it's important for folks to know that Kite cares and that we're a responsible corporate citizen.

Great. And rapid fire. Same-store NOI growth for retail, not Kite in 2024.

2.5%.

What's the best real estate decision today: buy, sell, build, redevelop or hold?

I would say hold and lease and then redevelop.

And then will there be more, fewer or the same number of public companies in the strip space in a year from now?

Well, there should be fewer, but it will probably be the same.

All right. Thank you guys so much.

Thank you.

Thank you.