Let’s start with why a pure-play multi-family housing REIT may be attractive relative to all the other types of REITs as well as other investments. To start, the leases are generally 12 months or less residing between lodging and hotel REITs, which are effectively one day leases, and traditional long-term triple net lease office and industrial properties, which often carry terms of 5 to fifteen years. For this and other reasons, multi-family provides among the best inflation hedge in the real estate sector which it itself has historically performed well in both inflationary periods and during rising interest rates. The cost associated with purchasing typical Class B or better apartment complexes is also well out of the reach financially for average individuals (in comparison to a restaurant franchise or small motel, for instance) yet much more affordable than taking down a new downtown office building or hotel (which often cost well over $100 million in coastal markets) for most real estate investing companies. Multi-family also benefits from government backed leverage options meaning lowering borrowing costs and higher potential loan-to-values.
Multi-family REITs are structurally better suited to take advantage of improving economic conditions. Not only can they raise rents rapidly given tenants are always cycling in and out, but they can improve their units relatively easily to embrace and extract additional value from gentrification and an improving job market. There has also been a powerful tailwind in the form of demographics. Young people waiting longer than ever to buy their first home coupled with a return to urbanization and boosted rents and lowered occupancy throughout the United States for many years. Massive supply has come on line, particularly in tech oriented cities such as Austin, TX, Seattle, Washington, and Denver, CO, but several more years of imbalance in favor of existing properties appears likely. The senior housing division of multi-family REITs (fun fact: senior housing REITs are the only group allowed to discriminate by the federal government while selecting tenants, in this case by age) has also experienced rapid growth as more older citizens leave their homes in search of improving their lifestyle and extracting the equity in their primary residences to help fund retirement.
These factors led to multi-family REITs outperforming all other segments in the first few years of the recovery in commercial real estate. Consequently, the cap rates, or income generated per invested dollar, have declined to historically low levels. This is particularly the case for new Class A buildings in better markets such as the tech hubs mentioned previously.
Why The Midwest?
Investors Real Estate Trust ( IRET) was founded in Minot, North Dakota in 1970 and also maintains corporate offices in Minneapolis and operations across eight Midwest states.
There will be some variability in the below pro forma numbers but not materially so.
Minneapolis has the highest weight at 20.9% of projected 2019 net operating income (“NOI”) as well as most apartment homes of any city albeit by a small margin.
The Age Old Coastal Vs Midwest Argument
Coastal areas, such as San Francisco, Miami, Seattle, and New York City, have historically garnered the vast majority of real estate investment capital in the U.S. This is the case in most but not all foreign markets as well. The bulk of returns on real estate gains have occurred in these areas as well. This trend is so strong that many real estate developers and operators will not wander too far from salty water. Foreign investors reinforce this trend as they invest almost exclusively in the largest metropolitan areas which tend to be located on the coast. China, which overtook Canada as the largest foreign investor in U.S. real estate earlier in the decade, is pouring $20-30 billion annually into this segment of the U.S. economy with the vast majority located in New York, California, and Florida. As a result of these factors, cap rates are currently near all-time lows (higher is better) in many coastal areas, particularly in multi-family, which has forced many real estate developers and investors to begrudgingly invest in the Midwest. In some cases, this is a smart move taking advantage of a less understood market:
Think Midwest. Yes, you heard me. The Midwest is where all the real estate action is. Wake up and smell the roses. City dwellers won’t even believe how far their money can go in the Midwestern states. Here, you’ll end up spending almost one-fifth of what you’ll shell out on real estate in any area on the East or West Coasts.
Cap rates are more favorable on average and there is usually less competition for properties. In other cases, however, capital is flowing into areas where it has no business or experience being with poor economics, no competitive position, and less robust local economies. There are clearly unique risks to both Midwest-type and traditional coastal properties. IRET’s focus in eight Midwestern states must be evaluated carefully in this context.
IRET’s focus geographically has stayed the same over time but not all key aspects of IRET’s business have. In particular, IRET has transitioned from a diversified REIT toward multi-family apartment buildings.
These figures are in the context of a $780 million market cap REIT – it’s a dramatic shift in asset exposure. Markets tend to give pure-play REITs a slight advantage in multiple compared to diversified REITs.
The increase in assets and net operating income derived from multi-family is evident from the above data. Notice that NOI rose 120% while units grew only 50%; IRET is increasing rents and efficiency rather than just properties under management. Part of this is also attributable to the fact recent acquisitions had higher average rents than existing units owned by the REIT.
CIO Perspective – How Allocations Work In The Real World
To answer this question, let’s take a step back and consider the perspective of a Chief Investment Officer (“CIO”) of a large diversified mutual fund, college endowment, or pension fund. The lead portfolio manager of Williams Equity Research knows this role well; his day job is sourcing, analyzing, and allocating between investment managers and opportunities for a large financial services company. As CIO, your team with the support of the board and or executive management determines allocations among different types of private and public equities, fixed income, and real assets spread across the globe. Within real assets or alternative investments, the group likely maintains a significant allocation to real estate divided by type ( office, hotels, retail, et cetera) depending on their macroeconomic assumptions.
Now imagine that a REIT is 30% medical office building, 20% multi-family, and 50% industrial properties with no clear indication of how the portfolio will evolve over time. Where do you put them when their allocations will constantly throw off your desired exposure? Long story short: you don’t. Unless the REIT is extremely well managed with consistent allocations, diversified REITs are more difficult for institutional asset managers to invest in. Subsequently, they’ll only do so when there is a significant discount relative to pure-play alternatives.
Recent Performance Shows Much Needed Improvement
Analysts have been critical of IRET’s NOI performance and justifiably so given the series of red columns shown above. Keep in mind this is on a same-store basis so there is minimal penalty or adjustments needed for divestments. There are a few takeaways here starting with the dispersion in NOI. Q2 2016 was the “bottom” of NOI deterioration though it spiked to a (7.4%) decrease in Q3 2017. In Q3 of 2018, however, a strong showing of 5.8% occurred followed by three consecutive quarters of meaningful (>2.5%) year over year growth in same-store NOI. The divestiture of Williston assets flowed into Denver and Minneapolis representing an exit from the commodity and oil and gas sensitive North Dakota real estate market into two of the most robust in the country. This was the primary driver of last quarter’s impressive 8.7% year over year growth. In fact, that’s among if not the highest figure we’ve come across despite analyzing dozens of REITs’ performance. Maintaining this kind of momentum based on a one-time redeployment of capital, however, is no easy task and we should expect growth closer to half that going forward.
One of IRET’s longstanding issues is cost management. REITs are relatively simple businesses that are nonetheless difficult to execute well. Without prudent management and a disciplined strategy, REITs tend to overpay for everything. They’ll pay too much for the building, too much for the personnel managing the building, too much for the acquisition and disposition teams, buy properties not aligned with their core strategy, and inevitably form a large, inefficient bureaucracy in the process. The RMR group of REITs are a good example of this phenomenon. Looking closer at the above chart, we see that revenues increased in 10 of IRET’s 11 markets (91%). This absolutely should be the case given real estate market fundamentals. On the expense side all but two markets (73%) saw meaningful declines in costs. Topeka, KS saw a very large 16.4% spike in year over year expenses but represents only 5.4% of the portfolio by NOI. Grand Forks and Topeka, two of the three segments experiencing an increase rather than decrease in cost, unsurprisingly are the only markets that generated falling NOI.
I give credit to IRET for listing the geographies consistent with their impact on the overall portfolio. As such, we can quickly ascertain that the top two markets, which represent approximately 35.2% of the portfolio, experienced material growth as did Omaha and St Paul which rank 3rd and 5th in size, respectively. Overall, this paints a good and improving picture but the volatility in the results reinforce the execution risk inherent with IRET as well as the fact the portfolio is still developing.
The Right Kind Of Financial Engineering
A key component of that “simple but difficult” REIT management responsibility is structuring the REIT’s leverage profile. In the perfect world, we want low leverage relative to the REIT’s ability to pay, low weighted average interest rates, and staggered maturities that extend well into the future (e.g. 10 years). IRET has redeemed $29 million and $115 million of its Series A and Series B preferred stock, respectively, while issuing $103 million in Series C preferred stock. This looks odd on the surface. A more careful analysis explains the purpose; Series A and B carry interest costs 162.5 basis points and 132.5 basis points lower, respectively, than Series C. While there are some costs associated with the redemption and issuance process, overall this will save IRET money over time and is a smart move. The REIT’s unsecured borrowing capacity was recently increased to $395 million and the two most recent term loans were done on an unsecured, rather than secured basis which are positive as well.
IRET is targeting debt metrics in line with investment grade issuers and its slowly making its way in that direction. Aligned with this were the actions taken with the proceeds from recent dispositions. In addition to buying back preferred and common stock, IRET managed to lower total leverage from 58% of gross assets to 41%.
Change Is Sometimes Necessary – Including The CEO
The precursor to the various changes to IRET’s business model and asset base, many of which appear positive, was the hiring of Mr. Decker originally as President and CIO and later as CEO in April of 2017.
As President and CIO, Mr. Decker will focus on furthering operational excellence, prudent capital allocation and balance sheet strength as part of the Company’s overall mission to maximize value for shareholders. Mr. Decker most recently served as Managing Director and US Group Head of Real Estate Investment & Corporate Banking at BMO Capital Markets, where he helped grow the platform into an active participant in real estate debt, equity and M&A transactions. He has worked for nearly 16 years as a real estate investment banker at BMO Capital Markets, Robert W. Baird & Co. and Ferris, Baker Watts and during that time, was responsible for more than $90 billion in real estate capital markets and advisory transactions.
Mr. Decker A new CFO and General Counsel also joined the team under Mr. Decker’s guidance. One due diligence tactic we like to employ is reviewing the public statements of management over time in different venues. If their projections, much less promises of a few years ago never materialized, it’s hard to expect it to be any different now. On the other hand, if management develops a track record of consistently executing on their business plans, this gives us more confidence. At the 2017 NAREIT conference, for instance, Mr. Decker stated his goal was to focus more on Minneapolis and that Denver was also an area of interest. Less than a year later, IRET acquired its $129 million Denver property. Its results in Minneapolis have improved as well with an 8.6% year over year increase in Q1 2019 NOI to $3.72 million. IRET also just added another 272-unit property to its Minneapolis portfolio. This has contributed to the six straight quarters of NOI growth and fifth quarter in a row where IRET’s NOI growth landed it in the top third of its multi-family peer group. This is a seismic shift from IRET pre-Mr. Decker. Bottom line: IRET’s new management team has done what it says it would.
Precursors To A Higher Stock Price
As of April 30, the IRET had an additional $23.6 million available under its buyback program which is in addition to the 2.5% of its shares repurchased in recent quarters. $23.6 million might not sound like a huge number but that is the equivalent of 3.1% of all outstanding shares. With 55% of IRET’s revenue now coming from Denver and the Twin Cities, the quality and robustness of its asset values and funds from operations (“FFO”) is superior to prior periods. An area of weakness is the 40% exposure to Class A properties which are most susceptible to pricing pressures from new construction which has been a growing concern nationwide. The remaining 60% in Class B properties remains the strongest rental market due to the high cost of Class A units coupled with poor economics associated with the new development of Class B and lower buildings. Class B buildings are also generally easier to implement rental increases rents and enhance operating efficiencies. As an example, Anne Olsen, COO, mentioned in the last quarterly call NOI growth due to the transition from coin operated to electronic card laundry machines in some of their properties as well as retrofitting their properties with LEDs. Q1 FFO came in at $10.1 million or $0.77 per share. Using a conservative full year estimate of $45.1 million results in a 17.3x multiple alongside the current 4.75% yield. That extrapolates the average FFO growth rate of the last four quarters of 5.5%, which is potentially a better estimate of the trend set by the new management team and strategy. FFO rises to $4.14 in 2020 using the same assumptions which brings the multiple down to an improved 14.25x.
Peer Comparison Sheds Light
On the surface, these valuations seem decent but not necessarily highly attractive. We need to compare them versus other multi-family REITs such as Equity Residential ( EQR), AvalonBay Communities ( AVB), American Campus Properties ( ACC), and Essex Property Trust ( ESS).
This context helps explain IRET’s move from the low $50s to its current price near $60. Even after the strong 19% gain year to date, IRET remains the best value among apartment REITs. Using 2019 FFO estimates, the payout ratio stands at 82% which is higher than we’d prefer and 8-12% greater than its peer group. A move toward 90% will give us significant pause while earning a 70 rather than 80 handle is likely to push the FFO multiple moderately higher. The stock needs to move approximately 15% higher to reach the sector’s average FFO multiple and would experience another 15-20% in capital gains in 2020 if the 5.5% average quarterly FFO growth is sustained (assuming the distribution policy isn’t modified which could move capital gains into income resulting in about the same total return for investors). Including distributions, this setup results in an approximately 45% total return over the next two years. This will be modestly more difficult to achieve than it seems given the market generally hesitates to give small cap REITs equal valuations to larger ones due to the benefits of scale and lower leverage costs.
While some execution risk is mitigated by the fact management has already proven themselves for six straight quarters, this REIT is exposed to a couple of the hotter real estate markets in the Midwest making them susceptible to a steep correction if the overall economy declines. There is also no guarantee that the recent NOI gains derived in part from a redeployment of assets, which cannot be repeated with equal magnitude in the future, will occur going forward. Overall, this results in a price target for IRET in the mid to low $50 range. This raises the two year target return to well over 50% which compensates us adequately for the aforementioned risks.
Williams Equity Research ("WER") is led by two portfolio managers with 30 years of combined market experience as hedge fund analysts, traders, due diligence officers, and leading complex and alternative investment research for large institutions. The portfolio managers have a CFA, BS in Business, BA in Economics, and MS in Engineering between them as well as numerous security licenses. WER analyzes individual stocks across all asset classes and global markets with a specialization in income, commodities, international stocks, and special situations.