Killam Apartment REIT: At A 13% Discount To NAV (TSX:KMP.UN:CA)

Many REITs have fallen out of favor over the last couple of months due to rising interest rates and recession fears. I wouldn’t say that blood is flooding the streets in this sector but we may be seeing some trickles. When there is blood in the streets the curious and prudent investor can find fantastic investment opportunities.

I believe Killam Apartment REIT (OTC:KMMPF) which trades under KMP.UN on the TSX is such an opportunity. Please note all figures are in CAD throughout the article as that is the company’s reporting currency.

Background

Killam is primarily an apartment REIT that owns, operates, manages and develops multi-family apartments, manufactured home communities (MHCs) and commercial properties. 90% of the portfolio is in apartments throughout Canada but primarily operates in Novia Scotia (35% of portfolio), Ontario (22% of portfolio) and New Brunswick (20% of portfolio). Killam has the largest exposure to the Canadian Maritime provinces of all REITs.

Killam is one of the largest Canadian apartment REITs by market capitalization, revenues, and properties under management and one of the safest income plays as it boasts a 98% occupancy rate and has among the greatest geographical diversity.

Year-to-date Killam has grown their portfolio through $60.5MM in acquisitions in Halifax, Waterloo, Guelph and Victoria, complementing their existing portfolio and growing their presence in their key markets. They also expanded their BC presence and expect to close their first acquisition in Courtenay, BC, later this month with 150 newly built units, for $55.6MM.

The key numbers such as revenue, FFO, and investment properties have continued to grow on an annual basis even in 2020 and 2021. Revenue and FFO per share has grown at a CAGR of 12% and 4% respectively and has had the impact of reducing the payout ratio. This trend continued in Q1 2022 with revenue and NOI increasing 5% and 3% respectively from the comparable quarter in Q1 2021. NOI was also up in all markets except Alberta which is only 9% of the portfolio.

The Bugaboo of Rising Interest Rates

Interest rates across all time horizons have been on the rise as the Bank of Canada begins its crusade against inflation which has reached its highest level since the early 90s with rates expected to rise even further over the next few quarters.

None of the Canadian Apartment REITs have been spared from the carnage being wreaked by the massive selloffs, but Killam and Boardwalk REIT (OTCPK:BOWFF) have been especially hit hard as a result of their higher leverage. Killiam’s leverage is at a debt/EBITDA of 10x which exposes them to the increasing rates through higher interest expense.

Although the leverage figure seems high, Killam has a very well laddered maturity schedule with only 12% of mortgage debt maturing in fiscal 2022 and 64% of total mortgage debt maturing before fiscal 2025. Killam has taken advantage of very low interest rates with its weighted average rate at 2.58%. Current CMHC rates are at 3.7% and 4.0% for the 5-year and 10-year insured interest rates respectively. During Q1 2022, Killam refinanced $36.2MM of maturing mortgages with $58.8MM of new debt, the majority of which was for 10-year terms at a weighted average interest rate of 3.08%, slightly lower than 3.11% for the maturing debt. If Killam was to refinance their debt each year at 4.5%, this would only increase interest expense by $2.5MM for debt maturing in fiscal 2022 as only $237M in debt matures. However, higher interest rates will take their toll in 2023-2026 with $1 Billion in debt maturing and accounts for 52% of debt outstanding. Interest expense would rise by ~$13MM or ~82% through to 2026 and this is ignoring planned acquisitions that will mean greater debt.

Interest expense has always been their largest cash expense at 20-27% of revenue, but has always been well covered as the interest coverage ratio is always at least 3x. Only modest revenue increases should be required at 1-2% to offset rising interest rates, and as mentioned previously have grown revenues at a 12% CAGR since 2017.

Killam has three new multi-family properties that have concluded or will conclude development in 2022 and will add 256 high quality suites to their portfolio. These units are being leased ahead of schedule. These properties are the Latitude, The Kay, and the Luma. Latitude and Luma are in Ottawa and the Kay is in Mississauga. The Latitude and Kay are over 70% leased and the Luma is 18% leased despite opening in June. The units are forecast to contributed $2.2 million to NOI in 2022 and over $5.5 million of NOI on an annualized basis thereafter which will offset interest expenses.

Valuation

Killam currently trades at 13% below NAV which is a rarity for the REIT as the only other time in recent history it traded below NAV was in early 2020 (we all know what happened then). This provides a substantial buffer in spite of the risks of rising interest rates and inflation, as these risks are unlikely to make NAV decline by that much.

In addition, Killam has a development pipeline of $1.3 Billion with over half of the future projects located outside of Atlantic Canada and yield spreads of 50-150 bps higher than the expected market capitalization on completion and should create in excess of $300 million in net asset value (NAV) growth for Unitholders.

Housing Market Fundamentals

The nation wide rising property values have been rendered housing unaffordable to the median income, and has made renting a plausible alternative.

This is precisely what has been the story in Killam’s primary markets of Halifax, Moncton, Fredericton, and Saint John. The larger Maritime cities have not only caught domestic interest but also international interest as immigrants have begun to see the benefits of living in these cities and has been the primary driver for the population growth rates in these cities which have been at all time highs.

The result of this population growth has put vacancy rates at all time lows in these cities and housing starts have not kept up the pace. These low vacancy rates should allow Killam to lock in higher rental rates to offset inflation on their existing properties located in the Maritime cities.

Conclusion

Killam offers a compelling 4% yield which is the highest of the larger Canadian apartment REITs. I can’t promise that the market won’t inflict more pain on the stock price in the coming months and that there won’t be a better entry point at some point down the road. However, the REIT is still a compelling opportunity for income investors as the dividend should be well covered by cash flows despite rising interest rates and inflation and the low payout ratio of ~80% provides additional comfort. In the long run I think low double digit total returns are likely as market fears dissipate and the REIT gets back to trading at NAV or even above NAV as it has in very “bullish” markets.