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

Presentation with Kite Realty. I'm joined today by John Kite, CEO; Heath Fear, CFO; and Tyler Henshaw, Senior Vice President of Capital Markets. I'm Lizzy Doykan, I work with Jeff Spector in covering the retail REITs at Bank of America. So I will kick it off by turning over to the team for any opening remarks and the latest state of the business. And then we'll head into Q&A, and we can open it up. We like to make this interactive, so please feel free to jump in at any point with questions.

Great. Thank you, Lizzy. I'm John Kite. I'll just give a very brief overview of the company. Hopefully, most of you know. But Kite Realty Group or a shopping center based, open-air shopping center REIT. We're the fifth largest publicly traded shopping center open-air REIT. We have about 181 operating properties, over 2/3 of those properties are in the Sun Belt. About 40% of our revenue actually comes from Texas and Florida alone, just those 2 states. The majority of our shopping center is about 75%, 76% of them have a grocery store component to them, heavily skewed towards neighborhood and community shopping centers. Our balance sheet is currently one of the strongest in the sector with 5x net debt to EBITDA, over $1 billion in liquidity. We have one of the most efficient operating platforms in the sector. Our NOI margin is about 74%. G&A revenue is less than 7%. So we believe that we're a very efficient open-air shopping center operator and that is the quick summary.

Great.

Why don't we start with talking a little bit about retailer demand. Has that held up the way that it has through the summer? Are we seeing any signs of softness, any changes to store opening plans or lease negotiations as there are ongoing concerns about consumer spending?

Yes. No. I mean, the answer -- the quick answer is no. We have seen no real change in the environment in terms of demand generators in our space. So we are seeing robust small shop demand, robust anchor demand, and in the current environment, that seems to be continuing. Obviously, we'll have to wait and see where the economy goes as a whole but right now, I would say that the demand is quite favorable and we're able to drive rents. I mean if you look at a couple of the factors that we look at, for example, if you -- the one that we talk about a lot is our nonoption renewal spreads, which -- what that means is these are tenants that are expiring -- leases that are expiring and the tenant doesn't have an option, so we have the ability to negotiate a new deal with them. And the TTM on that is 12% rent spreads, and that requires no capital. So that's a really strong indicator that we're able to raise rents by 12% and not have to put money into the space. We're in a good environment. So that's one of the most important metrics we look at.

There's been a lot of questions on the quality of the lease and if that's remained intact. And again, I guess, just asking about how lease negotiations have been going, just discussions for '24, 2025 and beyond. Has that changed at all?

We currently -- no. I mean, currently, the retailers that we're working with -- still feel strong enough about their business that they're committing to spaces. And one thing to remember is that the average, certainly, when you're talking about a large national retailer that's signing an anchor lease, this is a 10-year minimum commitment. So they're kind of looking through maybe a 1- or 2-year period of time. They're looking through that. So with that in mind, we really haven't seen any change. We haven't seen any -- the changes that we've seen have been more landlord favorable environment where we can kind of dictate the terms a little bit better. So this is why we're pushing on annual rent growth. That's why we're pushing on elements of the lease that we're trying to tighten up and make more favorable. So from my perspective, I think -- I don't think that's changed. Heath, do you have -- anything you want to add?

No, I think to your point, John, it's -- we're using the momentum as an opportunity to actually improve the lease terms for the landlord. And I think a lot of us in this sector are used to the leverage being in the tenant's camp. And so this is an opportunity for us to not only drive rents, and we're having a lot of success with driving rents in our small shops. But even on the anchor deals where they're a little bit more resistant to revisit traditional rent bumps. Can we do better with co-tenancy language, can we do better with exclusives, et cetera? So we are pushing as much as we can and as we should. It's -- the supply demand dynamic is in our favor. So I think it's a comment upon not only Kite, but our peers to really take advantage of this opportunity.

The open-air shopping centers have showed -- they've demonstrated a lot of pricing power and Kite has been sort of at the top of reporting leasing spreads. So what is really driving that outperformance on a lot of those core metrics? And where do you see that going? How can that be sustained?

Well, obviously, we can only speak for ourselves on how we approach the process, but a lot of it has to do with the fact that we approach the process from the perspective of strength. And we believe the environment is such that we're in a position where we should -- we should be pushing the envelope as it relates to driving rent growth and the things that we've talked about improving in terms of the lease structures, et cetera. I think we've led the way and a lot of these metrics for the last couple of years. Obviously, the transaction that we did in -- with -- 2021 with RPAI as a part of that and the ability for us to consolidate that into our operating platform and really drive that from an operational perspective, maybe a little more than before so. But all in all, it's -- the fact of the matter is we're in a good environment with low supply and we're able to push and we run the business in a very granular bottoms-up kind of grinding way where -- that's what we do every day, and that's our job.

How long do you think the level of leasing spreads can be sustained for? How do we -- how should we expect that to moderate over time?

Yes, I don't know. I mean, I think, as I said a second ago, if you look at the nonoption renewal spread, which is the one that I would pay attention to. I think the new leasing spread is -- it's a big headline number, but it's very much driven by capital. And everybody is putting different levels of capital into these transactions. And so if you look at the nonoption rule spread -- and again, that, as I said, has been 12% on a TTM basis. That's quite a bit higher than the historical norm. So how long does that go, assuming that the environment stays reasonably similar to today, I think it continues. If we get into a much more difficult overall economic environment, it's going to be more difficult. But we're also in a very unique situation in our sector where there's very little supply. So a lot of the other sectors that have had maybe better growth have much more new supply that's come online in the last 2 years, 3 years, like significant amount of new supply. We are the exact opposite, supply has fallen off the face of the earth since 2007. So it's going to help, I think, sustain our sector probably longer than others based on that dynamic.

And then turning to costs. I know Kite has had a pretty early and heightened focus on transitioning retailers to fixed CAM. So how is occupancy costs trending for your tenants today? And how do we think about that going forward?

Yes, it's an occupancy cost -- obviously, it's one of the propositions of Open Air when you look at other retail formats. And then we're still much lower than it is to be in an open-air format than it is to be, for example, in an enclosed mall. But we are not seeing any tremendous pressure on occupancy costs. I'd say in our sector, things run somewhere between 7% and 9% on average. So again, no wholesale changes, to which you would anticipate there to be much more pressure on occupancy cost if our tenants weren't able to achieve their sales objectives. So again, it feels pretty good, which is really allowing us to drive these rents, so we were pushing up against very high occupancy costs on our small shops, for example. I don't think we'd be able to achieve -- 80% of our leases having a 3% bump or higher, right? So again, the dynamic is there, and we're not seeing any pressure on health ratios.

And with the higher level of tenant reimbursements that you're realizing, what is maybe a more normalized level to think about going forward for tenant reimbursements as a percentage of revenues? Is the level you're reporting now kind of a function of the -- what kind of the initiatives you've been working so hard on to put in place? What's the sustained level?

Yes. I mean we've obviously been very vocal about having sector-leading NOI margins and recovery ratios. And even after our merger in 2021 with RPAI, we thought it would take 2 or 3 years for us to bring back the combined portfolio to the same sort of ratios we were experiencing as Kite stand-alone. Good news is that 18 months later, and we are back to historical Kite margins. And we're not as highly occupied as we were before as well. So I think by virtue of they're being number one, higher conversion into fixed CAM, we're running about 90% of our leases on a go-forward basis, which means about 50% of our leases are now fixed CAM, that number will only grow. So I think there's opportunity for us to even push the NOI margin and the recovery ratio is higher. Where does it end? I haven't thought that all the way through or done the math. But yes, I think we can even get more efficient on a go-forward basis.

Great. I also want to touch on your watch list. So how would you characterize that list today? And afterwards, I'll turn it over to talking about the latest on your Bed Bath & Beyond boxes.

I would say the watch list is smaller. We continue to benefit from COVID being a very large [ poaching ] event. It actually kind of bifurcated our watch list, right? Those that were really struggling were wiped out. And some of them -- actually it was one of the best things that happened to them because they had fresh new liquidity. Good example of some of the specialty grocers weren't doing very well during COVID and then with the big rotation from dialing out to dining in, they had brand new liquidity, were able to reinvent their businesses. So again, just in general, the watch list feels much more in accordance with historical norms, maybe even a little wider than historical norms because again, we're still benefiting from this fact that a lot of folks just didn't make it through COVID. With that said, watch lists are part of our business. A lot of people like to talk about the watch list. But prior to about having watch list is there's the opposite end of that spectrum is -- what's unique about our business is we can go to some place like ICSC, and we can do 7, 8, 9, 10 transactions with a single tenant. The cost of that is that if that tenant were to go away in the future, then you're going to lose multiple locations. So it's just something that's part of our business. It's [ downwelling. ] Everyone thinks back to what the retail landscape looked like 15 years ago or 20 years ago, it looked a lot different than it does today. There are some survivors and some people that thrive through any environment. but it's just -- it's part of our business. And honestly, what keeps it interesting and keeps our center's flagship. If our tenants never fail [indiscernible] concept coming in, I think it will be a much more boring place for people to visit. So yes, it's -- it's small than it was and feels very manageable, especially in historical terms.

Can you remind us again about how we should think about the impact from the lost rent of the Bed Bath boxes that are ready to be released? Kind of talk about the impact in Q3 versus Q2. And then we are expecting a mark-to-market spread on that. That's quite above 20%. But there's a lot of questions about factoring in the CapEx associated with that. So if we can discuss the economics around that, how you're thinking about that?

So a couple of questions in there. First is what's the impact sort of -- do you want to know a year-over-year basis from that Bed Bath & Beyond? Or is this more of a CapEx? Well, I mean, Bed Bath & Beyond was responsible for about $10 million of NOI on an annual basis, which obviously we won't be realizing in 2024. In 2023, we collected about little over $5 million. So Bed Bath & Beyond paid through July. So in terms of NOI headwind, Bed Bath & Beyond will be much more of a headwind in the back half of this year and into 2024. In terms of occupancy, you'll see a larger hit in our occupancy from Bed Bath. And you'll see the full impact to that occupancy hit -- a lot of it in the third quarter, but you'll see the full impact in the fourth quarter. And then in terms of the CapEx, there's been some discussion as of late in some notes, et cetera, about the cost to re-tenant the Bed Bath & Beyond. So we've been -- we've been very lucky in the past, we've done recently 63 boxes and only 1 of those boxes was a split. So based on what we're looking at now and looking at the progress we're making and the discussions we're having, it looks like -- most of those [ 19 ] boxes that we're dealing with will probably be single-tenant backfills, and we're estimating the cost to backfill those boxes were somewhere around $80 a foot. So it's going to be about a $40 million to $50 million proposition to get those boxes all back online.

There's also been questions around the implications of the Kroger-Albertsons announcement to potentially sell over 400 stores to CNS. Can you talk about what kind of exposure Kite has and your thoughts about a potential deal going through?

So we have 9 locations and in only 2 locations that we actually have overlap, which is within 3 miles we have 2 stores in the Chicago area, which are actually -- currently under the same brand, so they're not cannibalizing each other now, and 2 in Dallas. So the overall Albertsons-Kroger merger isn't a huge proposition for KRG. But what I'll tell you is that we're seeing some consolidation and what's good about the current version, I think, versus the old version is that it's not being spun off as some new independent grocery store chain in order to satisfy the FTC. These stores are being sold to the Piggly Wiggly parent and they've got a good balance sheet and a good operating history. So however this turns out, it feels like when all the dust settles then people should be fairly, fairly stable in terms of that consolidation. And the other grocery consolidation that we saw also was -- what I thought also healthy for the business, which was Aldi and Winn-Dixie. It's good to see that people are joining, it's not being done in a completely highly levered way that -- where you end up with a tenant base that is less secure than it was before. That being said, are there going to be instances where folks have a tremendous exposure to Albertsons and Kroger? Are they going to ultimately review their portfolios and say, okay, do we need to close some of them? Again, we don't have a lot of overlapping stores. It's not something that we're thinking or worrying about, but perhaps a question that some other folks may want to think about.

And then turning to the transactions market. Can you provide any update for us on what you're currently seeing out there in terms of grocery-anchored trades? Any update on cap rate trends and particularly in your own markets?

Yes. I mean in terms of the transaction market, I think it's still pretty quiet; in terms of the one-off market, not seeing -- there's definitely more product in the market. In general, cap rates have moved, but not probably tremendously. And frankly, most of the things that are happening are really more about underwritten expected IRRs than they are about a going in cap rate because a lot of transactions are probably happening where people believe there's below market rent, and there's the ability to mark that. There may be situations where there's some vacancy. So I don't know that going in cap rates is really the best barometer right now. But certainly, the kind of stuff that we own generally trades somewhere in the mid-5s to mid-6 range. I would say that's where most of the stuff trades. And so there's still a big disintermediation between a stock price and a cap rate still a pretty big gap. But I do think as the market stabilizes -- and hopefully, as the kind of capital markets stabilize, particularly the debt markets. If that happens, then I think you're going to see more activity maybe in the second half, although we are obviously well into the second half. So probably it's a '24 thing really when I think about it.

Any thoughts on the recent announcement by Kimco and RPT and just general thoughts on seeing more public-to-public consolidation in the strip space?

Did you say people are listening to this? Is this like public information? Okay. Yes. Congratulations to both of them. I think a good transaction for the market, made sense. Obviously, a lot of open-air shopping center companies, too many of them. Too many of them are really too small to kind of justify the public market process. So I think there was a lot of logic as it relates to what goes forward, it's hard to say. I think it makes sense to see more consolidation when you look at -- when you look at numbers and you look at operating efficiency and you look at how these platforms are all quite different in that level. And then you kind of look at the G&A loads, it's just -- there's some logic to it. Where it goes, it's hard to say.

With more public-to-public combinations in the space, does Kite feel more pressure to acquire or be acquired?

No, I don't know that you ever feel. I mean, we don't -- we're operating the business day by day and trying to grow our cash flow. And I think ultimately, the markets to market and certainly just a deal or 2 doesn't really change the fact patterns. But that being said, I do think companies like ours are obviously are valuable franchises. So where that shakes out, I don't know, but I don't think it puts pressure per se on us, in particular.

When it comes to the portfolio, it's a pretty spread out balance between community and neighborhood, mixed-use lifestyle and power. Do you see any material changes to that mix in the short to medium term? And what about geographically?

Yes. I mean, we like our kind of the composition of our portfolio, and we think that our -- more importantly, we think that our customers -- which is how we run the business, what does our customer want us to do, how we execute for our customer, how do we deliver for our customer. That's a big part of how we think. And so that has led us to have a portfolio like this because it's been attractive to the customers. So look, the majority of our assets are essentially neighborhood and community shopping centers, and that's a -- that's where we want to be. We want to have the majority of our assets be those type. But we also have exposure to mixed-use lifestyle and power and it kind of complements that. So I think we like that structure, and I don't think we would ever say, "Oh, we want to be 100% into a particular product" because then you're basically taking some significant risk into that 1 product. So we like current structure. That being said, as we move down the road, I'm sure we will tweak it over time. Heavy drop in vendors, I can tell you. And -- as far as geography, we -- I would say the same thing about the geography. It's that, as I said, majority of our assets are in the Sun Belt. We have the largest exposure that I know of to Texas and Florida on a percentage basis. But yet, we are complemented by some of these gateway markets like Seattle and Chicago, and New York. And that's what our customer wants us to be offering them, and we're seeing good growth in all these geographies. So over time, I'm sure we will hone that over time. But at our size, I think, we can operate and do some acquisitions and dispositions and [ PODS ] that won't be a material move in any one direction. But again, that's always subject to us analyzing it. We do a bottoms-up analysis a couple of times a year on every deal. And we always are looking to understand why are we in that deal.

When it comes to the mixed-use portion of your portfolio, you've been ramping up some efforts there. When do you think you all would be more comfortable with taking on higher risk return with redevelopment and added use, given that your future capital commitments is a bit light?

Yes. I think -- right now, our primary focus in terms of capital allocation is the leasing because we're getting the highest returns on capital there. It's the lowest risk-adjusted -- the highest risk-adjusted returns. And due to the Bed Bath situation, there is a significant amount of spend in the next 2 years to backfill those spaces and also get us back to where we were pre-COVID in our occupancy levels. All that being said, there's no question that the densification that we're doing in some of our assets has been very productive. We now have a kind of like an equity interest, so to speak, and just under 2,000 multifamily units. That is something that we will continue to do on the margin. That being said -- but we're also not looking to put 100% of our own capital at risk on these things. We're generally doing this in partnerships. We're generally bringing in other people to help execute and to help bring capital. So I think our process right now is pretty good, and we are leaning into it in certain places. But overall, the focus is let's get our leasing percentage back to where it was pre-COVID, let's get all these Bed Bath leases signed and open and operating, and then you're going to be sitting on significant free cash flow that we can look at how we want to deploy that.

Do you see more opportunities to partner with, say, some of the multifamily REITs on more of these resi projects? Or is it kind of limited in what's out there?

No, I think for us, it's very -- it's just project by project. We're not looking at 1 big joint venture with a particular apartment REIT. We're really like who is the expert in this particular location. And so we'd much rather do that than a wholesale deal with someone just for convenience. I think, especially in that business, it's very local. And so we want to make sure we have the right local partner.

Right. What are your plans for the balance sheet over the next 6 to 18 months?

So as you know, the balance sheet, it's in really great shape, net debt 5x, net debt to EBITDA, which is the lowest in the company history. So the fact that the balance sheet is in such great shape, we really have a lot of optionality over the next 6 to 18 months. We have $95 million of maturities occurring this year. That will probably just be being put on our line -- with our line and free cash flow. And looking to next year, we have $270 million coming due. And we've been very open and been spending a lot of time with the fixed income community. And we are committed to being an unsecured borrower. So when the time is right and we have the ability to be patient, we'll look to tap the unsecured bond markets. Good news is, as compared to the beginning of the year, our indicative rates have come in a lot, probably have lost some of that to benchmark, but our all-in rates are probably a little bit better than they were -- at the beginning of the year, we've been spending a lot of time with our rating agencies. I think if you look at our credit metrics and our ratings, I think we're often worried that there's a bit of a disconnect. So I've been spending a lot of time with them. And keeping our fingers crossed and hoping to convince them that it's time to relook at our credit. So again, our balance sheet is in such great shape that we'll tackle 2024 as it comes, the average weighted maturity date for our debt coming due in 2024 is June 30. So it's not like we have a bunch of Jan 1 maturities. So you'll see us, though -- you'll see us eventually tap the market somewhere in the fourth quarter or the early part of 2024.

And where can you issue new 10-year debt today?

So indicative spreads are somewhere between 225 and 250 over.

And just where the cost of capital are today and they've just become -- it's an increasingly higher, how have capital allocation priorities shifted for you all over call it the last year or 2 and your overall investment thresholds?

Yes. I think the good news for us is that the main item or items 1 through 5 and a list of 6 for capital allocation is really leasing, right? And the best part about leasing for us over the next 2 years, we'll be spending $200 million, it's the best risk-adjusted return for the company, right? We're looking at 30% returns on leasing. So we're sort of relieved right now of having to look at what's our return hurdle, if our lever to grow was acquisitions or redevelopments. Sure, we're working on those things. And as John mentioned, we're transacting in [ PODS. ] So we're sort of buying and selling, trading in line. I will tell you when we're looking at acquisition is our unlevered IRR expectations higher than they were previous environment where rates were rising? Yes, they are. But -- so again, it's -- the great news for Kite is that we have a really low hanging fruit in terms of our ability to grow which is it's all internal. It's leasing. But yes, that we have -- we are looking at underwriting and taking into account our higher cost of capital.

Right. And just on the -- back to the embedded rent bumps that you mentioned earlier, and it's been really a focus just even from the last earnings call. Where again, does this stand on average? What is this for small shop retailers? And really, if you could kind of explain to the audience how Kite is differentiated from its peers on that standpoint, that would be great.

So our current embedded rent bumps are 150 basis points. And as we disclosed in our last call, for the first half of this year, I'm holding aside 2 renewals because we can't control that. But for our nonoption renewals and for our new leasing, those rent bumps averaged 230 basis points. So that's an 80 basis point improvement. So for us, again, it's taking advantage especially on the shop side of the current environment and charging our leasing team with getting better internal bumps and 80% of our leases, as I mentioned before, had 3% or better -- 3.5% or better bump in those leases. So what's the end game? Can we take our total blended rent bumps at 150 basis points and over time as we're turning over leases turn that to 200 basis points? Yes. Once we hit 200 basis points, can we push that to 250 basis points. So I think we've really taken this as an opportunity to reevaluate -- we're a 2.5% to 3.5% business. Can we change that to be a 3% to 4% business, but -- just by dealing with internal bumps. So listen, we're in the early innings, Part of this is afforded by the environment, right? And if the environment changes, we'll probably have less success. In terms of anchors, it's harder. It's a grind. They are very stuck on this typical 10% bump after every 5 years. But we are doing our best to ultimately try to see if we can change that. Can we get 12%? Can we get 15%? And we're picking our spots. And it's going to take more time, but we're optimistic that ultimately, we can even get better growth out of the anchors as well. But as I mentioned before, this is something that's really incumbent upon our entire industry. We have the leverage. Our tenants aren't shy when things are hard pushing on us about rent concessions or different structures of leases, et cetera. So now that the pendulum has swung into our court, I think it's incumbent upon us and our peers, to really revisit growth and try to change the growth profile of our business. So that's kind of how we're looking at it. Times are right, and we're going to take advantage of it.

Right. And on a separate topic, I think it's interesting that you all have really increased the cash rent spreads, especially on lifestyle centers and especially for new leases. And so the return on capital is similar to community neighborhood power centers or the new leases and a bit lower compared to these center types on the renewals. So how should we think about the returns on each of those center types going forward?

I mean I think in our disclosure materials, we're incredibly different, right? But listen, one of the things -- and one of the thesis behind the merger was the exposure to lifestyle and during the pandemic the lifestyle portion of the business was disproportionately impacted because a lot of it was discretionary spending. So a lot of these places were just closed. It just couldn't be open, right? So when we were looking at the merger, and we saw that RPAI had assets like One Loudoun and like South Lake, we thought to ourselves what a better way. There's not a better way for us to play the reopening trade, and for us to get exposure to these kind of assets. And that thesis is absolutely panned out. So we are seeing just incredible rent growth in asset like South Lake when we first took over the asset, we were printing -- the prior company was printing $45 rents. And now we're printing something much north of that. So it's been great to see that happen. So yes, so again, as we disclosed that the returns are terribly different but we'll tell you that we've been pleasantly surprised with our conviction around the ability to continue to drive rents at lifestyle and look forward to what some of our assets hold.

Okay. I think we're just about out of time. But I'd like to end with 3 rapid fire questions for the team. So first question on the Fed. Do you believe the Fed is done hiking? Yes or no? Do you expect the Fed to cut rates in 2024? Yes or no?

No, on the first one. The second one, can say maybe?

[ Either ] -- no, it's yes or no.

This is a deposition -- probably not.

And number two, do you believe real estate transactions will meaningfully pick up by the fourth quarter of '23, the first half of '24 or the second half of '24?

I think I said first half of '24.

And third, are you using AI today to help you run your business? Yes or no? Do you plan to ramp up spending on AI over the next year? Yes or no?

AI for us really right now is more like what are our enterprise software platforms offering us. So we are looking and researching but it's in very early stages, but it will eventually be a part of the business.

Thank you very much.

Thank you everyone.

Thank you.