Description

Summary

Independence Realty Trust (IRT) is a Class B owning multifamily REIT whose stock has been crushed by higher rates this year.  While the entire apartment REIT space has dropped 10% year to date, IRT has fallen by almost 20% from its peak just 3 months ago.  It is a smaller cap name at a $750mm market cap, and carries a bit higher leverage, but it now appears to be the cheapest name on both a cap rate basis and an FFO basis compared to all of its peers (both small and large cap).

Overall, rates are a concern, but using a cap rate of 6% on its current properties in 18-24 months would put the stock at $14 per share (and implies roughly a 15.8x multiple of 2020 FFO).  That is upside of 70% with dividends. In this we assume 3.25% 10 year treasury rates.

On the downside, should rates spike to 4% and cap rates 7-7.5%, IRT would trade to $7.50 to $8.50 on 2018 figures, but could still perform well in a couple years.   With a healthy $0.72 annual dividend and the stock already beaten up, there appears quite a reasonable margin of safety even in a continued unfriendly rate environment.  We would point out that should inflation become a real concern, IRT’s leases are adjusted annually, meaning asset values should over time adjust to higher rates.

Financial Summary

Company

IRT is a smaller cap REIT with $1.6BB in total assets.  They operate in non-coastal areas from the South and Texas, up through the Midwestern states.

The company was spun out of RAIT five years ago, and still suffers from prior management taint (the Cohens whose reputation for poorly managing overleveraged REITs is well known).  The management contract wasn’t finally terminated until December 2016, and the internalization costs meant a dilutive equity issuance in late 2016. The Cohens have zero involvement today.

Efforts to de-lever from 12.4x Debt/ EBITDA at year end 2015, to 8.8x today also meant another equity raise last September 2017 (proceeds also to fund an acquisition).  While there might be one more over the next couple years, the company is quite adamant that they won’t issue any more expensive stock to pay off cheap debt (clearly not a great strategy).  That is, we don’t expect a deal below $10 a share (they lamented the last deal at $9.25).

With target leverage of 7.5x Debt/EBITDA, they are pretty close to their goal anyway, and anticipate getting there in two years perhaps with just an At-The-Money issuance program, organic NOI growth, and a renovation program that should be highly accretive to deployed capital (more on that later).

As for the company’s assets, IRT has been recycling out of Class C apartment units and continues to focus on non-gateway (ie, non-coastal) Class B markets.  The market in the past few years has generally shunned the Class B/C assets/REITs, and instead focused on Class A premier coastal properties (the big cap Avalon Bay’s and EQR’s of the world).  

2015 was the peak year in terms of apartment same store NOI growth for these names, with growth rates exceeding 5% for most bigger names in top markets.  Now however, overbuilding has taken SS NOI way down for almost every name in the industry, with EQR now forecasting only 0.75% SS NOI growth in 2018, AVB at 2% today, UDR at 1.9% rent growth.  BRG actually had negative SS NOI growth in Q4, and was only up 1.6% in Q4 last year by excluding 2 problematic properties in Dallas.

On the other hand, with less supply growth in IRT’s markets, the company grew SS NOI by 4.8% last year, and expects 3-4% in 2018.  

Given that most of the new development has been occurring in the premier Class A markets, now appears to be an opportune time to invest in the Class B names.  Overall, IRT’s markets are seeing better population growth, more job growth, with less competitive development than the rest of the country. Here is a good slide:

Here is another one on apartment supply:

Dividend

On the negative side, IRT is overpaying their dividend.  Here is a summary of their CF:

Not sure this is legible, but FCF after maintenance capex of $8mm looks to be around $0.62 in 2018 (vs a dividend of $0.72).  The company says they will cover their dividend by the 2nd half of 2018, and that looks about right. With almost $100mm available under their revolver plus $10mm of cash and an ATM program, they have ample liquidity to fund their capex as well as the current dividend while they grow into coverage.  There is a chance of an equity raise late 2018, or early 2019, but generally their stock needs to cooperate (eg be a lot higher) for that to happen.

Renovations and Acquisitions

The company has 14 units that they are targeting spending $45mm to renovate.  Often management buys family run apartment complexes, typically without revenue management systems, and often with renovation needs.  IRT estimates they can add $10mm in NOI from existing upgrades. These should be complete in 18 months. That is a 20% type return level, quite a bit better than the 6-7% cap rate acquisitions the company has been pursuing.  

Speaking of which, they recently closed on a 9-community portfolio (mostly in late 2017, the last 2 communities closed in January 2018), and the Chelsea, a 318 unit property in Columbus OH.  Both deals were done at 6% cap rates, with management expecting that the improve to 7% once renovations are complete.

The company has been recycling out of a few of their Class C properties, but this is mostly done.  They own a few Class A properties (about 10 of their 45), which they acquired in the acquisition of publicly traded Trade Street Residential (in 2015).  Management has said they do not intend to issue equity to fund any more acquisitions (for the time being anyway). I believe they are likely to sell a few of these at the right price to focus on their core Class B assets and avoid issuing shares.    

Valuation and Comps

Here is their comp list below:

Some of the smaller cap names are not great peers to IRT.  APTS owns strip malls and office buildings as well as apartments.  BRG and NextPoint are massively levered. BRG (including preferreds) is 21x levered (on a debt/EBITDA basis).  NXRT owns more Class C properties, and also carries more leverage than I would be comfortable owning (12.5x).

Overall though, at a 7% cap rate today, and 11x FFO, vs peers at a a 5.85% cap rate and almost 15x FFO, IRT is quite cheap.  Market cap rates are low by historical standards, and rates are on an upswing. But likely IRT stock has priced much of this in already.  And, IRT also is almost 100% fixed rate on their liabilities, with no maturities for 3 years (only their revolver then coming due). After the revolver, there are few maturities for another 3 years apart from some mortgage amortizations which should be refinance-able.

It also helps to remember that in an inflationary environment, while cap rates may increase, rents can also be adjusted.  That means the asset side of the balance sheet is not one chock full of long duration fixed cash flows. Rents are adjusted annually.  If inflation rises, then so will rents.

Overall, while a $14 price target (using a 6% cap rate) is perhaps high if rates go up another 100 bps, we feel that a 6.5% cap rate in a couple years would still offer significant upside.  

That is, current runrate NOI is $110mm, with another $10mm to come just from their renovation portfolio.  Thats $120mm of NOI. At 6.5%, implies a TEV of $1.85BB, or a stock price of $12.25. That is 42% return over 18-24 months before dividends.  G&A runs just under $10mm per year, and management estimates they can run a portfolio up to $2.5BB without needing more overhead. (Assets are $1.6BB today).  

Here is a good chart of cap rates.  I don’t think 6.5% is a crazy level.

There is some good macro stuff here:

https://www.reis.com/cre-news-and-resources/apartment-market-trends-q4-2017

http://www.us.jll.com/united-states/en-us/research/investor/trends/multifamily

Insider Buying

Scott Schaeffer, the CEO here who we really like, recently picked up 17,500 shares at $8.52.  He has a history of buying in the open market, with another purchase in late 2016 at $8.37. The company has no capacity unfortunately to buy back shares in the open market (given deleveraging goals), but won’t be an issuer at these levels.

Risks

Different from the triple net lease guys, who are typically locked into 10 year leases or longer, apartment rents adjust annually.  However, higher rates can impact asset values. In this case, it seems priced in, but is a big risk. Oversupply does continue to dog the apartment REITs too, and could be an issue down the road for IRT.  We note new supply in Louisville KY will start in mid 2018 (its 11.5% of NOI for IRT and its biggest market). But big markets like Raleigh NC, Tampa FL, Atlanta GA, Chicago IL, Charlotte NC, Indianapolis and Columbus OH look solid from a supply demand perspective (those are about 35% of NOI and grew in the 5%+ range last year).  Guidance of 3-4% SS NOI growth this year is already lower than the 4.5% they did in 2016, and 4.8% they did in 2017. Last year they guided to 4-4.5% SS NOI growth, and came in above the high end of the range. Perhaps the biggest risk would be a dividend cut. The CEO says that they will absolutely not do that, as they know it would crush the stock.  But stranger things have happened. The good news is that the assets are being valued in the market at a cap rate well above private levels, meaning a dividend cut ultimately may be irrelevant.

Catalyst

Deleveraging, improving FFO/share, insider buying