Can Small Caps Lead to Big Growth and Good Value?

Residential Small Caps Excelling in Q1 of 2022

Coming out of a strong first quarter 2022 earnings season for the residential REIT sectors, it is worth highlighting three small cap names within the residential universe which produced exceedingly strong results in the period and put forth outlooks for the coming quarters that were also extremely constructive. We note that the improving fundamental underpinnings for these names also coincide with the broader meltdown in equity markets being driven by a host of concerns ranging from high inflation and supply chain constraints to the risk of violence escalating in eastern Europe.

NXRT Raises Earnings Forecast After Strong Q1

NexPoint Residential (NXRT) reported funds from operation (FFO) in 1Q22 of $0.78/share, a 39.5% increase over 1Q21. The primary contributors to this large year-over-year increase in FFO were same-portfolio increases to revenue in excess of 11%, a relatively modest increase in operating expenses of 4.7% leading to same-portfolio net operating income (NOI) growth of 16.4%. The company specializes in the renovation and upgrade of older assets which generate sizeable rent increases upon the completion of refurbishment projects. For 1Q22, the company reported a strong 26.3% return on investment (ROI) for the units renovated and leased during the period. While it is still early in the year, and residential REITs typically do the bulk of their leasing during the second and third quarters, NXRT had enough confidence in the operating environment to modestly raise their earnings forecast for the year, along with assumptions for operating level metrics. During the company’s earnings webcast, they highlighted Orlando, Tampa, Nashville, Phoenix and south Florida as being their strongest markets all exceeding prior expectations for rent growth. The better-than-expected market performance was attributed to continued migration of households into their markets and the wide “spread” in pricing for various segments of the market such as class A versus class B rents, with the rise in the former bring up rental rates in the latter.

Small Caps Capitalized with Higher Debt Levels

One important area of distinction for NXRT specifically, and smaller cap names in general is that they tend to be capitalized with higher debt levels than their larger capitalization peers, and they also utilize a higher percentage of floating rate debt. NXRT has been reducing its floating rate debt exposure via asset sales, which will continue through the balance of this year. They also hedge their exposure using swap instruments and, in their case, a large percentage of the floating rate exposure is hedged through 2026. [1]

Similarly, IRT Exceeds Expectations in Q1

Independence Realty (IRT) has some overlap with NXRT in that they have sizeable exposure to several fast-growing sun-belt markets. They also have a strategy centered on the renovation and upgrade of older properties which are repositioned to a higher rental price point. IRT closed its merger with a non-traded REIT earlier in 1Q22, contributing to the near doubling of the size of the company over the past year. IRT also achieved strong same-property net operating income growth for 1Q22 of 16% and achieved return on investment on its renovation capital of 32%, very similar to NXRT. Operating results included momentum in occupancy, ending the quarter at 95.4% and average effective rent growth of 10.4%, with new lease rates up 15.7% and renewal rates up 10%. Strong rental trends are anticipated to continue through the spring/summer leasing season. Other highlights for IRT in the quarter included a decision to enter the single-family-rental market via a joint venture program in Huntsville, Alabama. IRT’s ability to generate substantial growth in earnings is impressive, especially given that the company is also de-levering at the same time. The company ended the quarter with a net debt/adjusted EBITDA metric of 7.6x, down materially over the past few years. The company expects to end 2022 in the low 7.0x range and get down to the mid-6.0x range by the end of 2023. [2]

Residential Small Cap “TCN” Building Positive Momentum

Tricon Residential (TCN) is one of the interesting new entrants onto the residential REIT scene. The company’s common stock is dual-listed in Toronto and the US. While the company’s primary asset base is a portfolio of 20,000+ single-family-rental (SFR) homes across sun-belt markets in the US, it also owns an “adjacent residential” portfolio of multi-family development projects in Toronto and the US which could eventually be monetized for reinvestment into SFR. As with its small cap apartment peers, TCN reported solid 1Q22 operating results with same home revenue up 9.6%, operating expenses up 8.1% and net operating income (NOI) up 11.6%. Positive momentum continued into April with blended rent growth of 8.6% coming from a 17% increase on new leases and a 6.5% increase on renewal leases. Occupancy remained very high at 98.4%. While TCN did affirm and not raise its full year 2022 funds from operations (FFO) guidance, it did raise assumptions for net operating income and an earnings raise could certainly come later in the year. TCN has set a goal of acquiring at least 8,000 homes per year over the next few years and plans to be at 50,000 homes by the end of 2024. During the company’s 1Q22 earnings call, the management team highlighted its ability to perform well during inflationary times, emphasizing their resident rent/income profile of 23%, a loss-to-lease or discount to current market rents of 20% and the ability to purchase homes at capitalization rates of 5-5.5% in the current environment.

TCN Improving Operating Inefficiencies

Not unlike other smaller capitalization peers, TCN utilizes joint venture and third-party capital to augment its own balance sheet. Given TCN’s newer arrival into the public market space, its leverage level is still higher than peers, but coming down. It ended the quarter at 8x net debt/EBITDA and is committed to improving its debt profile. One of the challenges for SFR centric names tends to be keeping operating expenses in check and property taxes and repairs/maintenance expenses are typically two of the larger line items which can hinder property level operating metrics, and this was the case for TCN to some degree in 1Q22. These operating inefficiencies should improve as the company scales up and achieves critical mass across its markets. [3]

Favorable Risk/Reward Opportunity From Smaller Capitalization Residential Names

As mentioned earlier in this discussion, the equity market dislocation has been severe, with broad market indexes such as the S&P 500 and Nasdaq producing negative results for five consecutive weeks. The residential REIT component of the FTSE Nareit Equity REIT index was down –9.6% month-to-date through May 12^th and –13.4% quarter-to-date through May 12^th. [4] The trio of small cap residential REITs highlighted above have corrected 12-17% since the start of May[5], underperforming the broader peer group. The small caps have very good earnings visibility going into the balance of 2022 as demonstrated by recent 1Q22 financial reports and their overall earnings growth profile is as good, or better than that of the larger cap names. They also trade at discounted valuations relative to the large cap basket and this discrepancy has increased in recent weeks leading to what appears to be an interesting buying opportunity. We would also point out that even with the recent rise in interest rates, private market buyers have remained active across markets and asset pricing has remained firm. There has also been substantial activity reported of late in public-to-public and public-to-private mergers and acquisitions (M&A) activity. The strong fundamentals coupled with high buyer demand increases the potential for buyout activity in the REIT space and smaller portfolios of residential properties in attractive markets are likely on the top of many shopping lists. For these reasons, we see an opportunity for favorable risk/reward from the smaller capitalization residential names and view the recent sell-off in stock prices as an attractive point of entry.

Definitions:

• EBITDA - Earnings before interest, taxes, depreciation, and amortization, measures the overall financial performance of a company.

• The FTSE Nareit All Equity REITs - An index of the U.S. equity REITs that is free-float adjusted and market capitalization-weighted.

Footnotes:

[1] NexPoint Residential Trust, Inc. 1q22 Financial Statements

[2] Independence Realty Trust, Inc. 1q22 Financial Statements

[3] Tricon Residential Inc. 1q22 Financial Statements

[4] Nareit – FTSE Nareit US Real Estate Index Series Daily Returns – May 12, 2022

[5] Yahoo Finance

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