Market Commentary | August 21, 2024

Motion

Newton’s Laws of Motion define action in the physical world. The third law states that for every action there is an equal and opposite reaction. Because we are believers in science, we tend to apply these principles to arenas beyond the physical world. Economics and finance, for example.

In its effort to reduce the high rate of inflation, in March of 2022, the Federal Reserve began an aggressive sixteen-month-long campaign of interest rate hikes. In reaction, bonds and other rate-sensitive assets, like real estate, experienced significant declines in market value.  Bond yields rose to match investor return demands. To the extent real estate assets were encumbered with variable-rate debt, their net operating income declined in response to the higher interest expense. But not all real estate experienced an equal, or even opposite, response.

We have previously been enthused about what we perceive to be a secularly favorable supply and demand dynamic for retail real estate. Certain markets have experienced sustained population growth without corresponding shopping center development to meet the new demand. Rising interest rates translated into higher cost of capital (borrowing), which has made new construction prohibitively expensive. Kite Realty Group (KRG), one of our favorite grocery-anchored shopping center REITs, has managed to anticipate those growth markets and has likely benefited from higher interest rates’ effect on quelling new development. A look at KRG’s recent activity might explain why we think rising interest rates are not necessarily bad news for real estate.

On July 30th KRG reported 2Q24 operating results and these are just some of the highlights:

• Company raises 2024 NAREIT FFO and Same Property NOI guidance (for the third quarter in a row!)
• Leased approximately 1.2 million square feet at 15.6% comparable blended cash leasing spreads
• Received a credit rating upgrade to BBB from S&P Ratings (the 3rd ratings upgrade this year!)
• Improved Net Debt to Adjusted EBITDA to 4.8x, an all-time low for KRG (that’s how you get your credit upgraded)
• Board of Trustees raises quarterly dividend on common shares by 8.3% on a year-over-year basis (2nd hike of 2024!)

Higher lease rates and higher occupancy translate to higher net operating income. Better credit ratings translate to lower borrowing costs, and lower borrowing costs let KRG continue to raise its FFO guidance. Taking full advantage of their new Balance Sheet strength, on August 13th  Kite announced the offering of $350MM of 4.95% Senior Notes due 2031. This is very accretive capital for a REIT with rapidly growing earnings.

Kite Realty’s shares are up over 15% this year but it still trades at a significant discount to its retail REIT peers. The supply-demand dynamic remains in place, so we anticipate continued strong performance from KRG and other retail REITs like BRX, CTO, KIM, SSRTF, and WSR.

Expectations are now that the Fed will begin cutting interest rates in September and that bonds and interest rate-sensitive sectors like real estate will react positively. We don’t know how retail REITs will react to interest rate cuts, but improving operations should keep shares moving higher.

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