BRT Apartments: Positioned To Benefit From Cap Rate Compression (NYSE:BRT)

Introduction

BRT Apartments (NYSE:BRT) has underperformed the Vanguard Real Estate Index Fund (VNQ) so far in 2024, delivering a circa 3% loss against the 5% total return for the benchmark ETF:

I think the REIT may outperform going forward thanks to an attractive valuation in terms of adjusted FFO multiple, as well as from a market-implied cap rate perspective. Furthermore, the company’s debt-heavy capital structure will benefit should real estate cap rates move lower following Fed rate cuts, while operational performance may improve from long-term Sun Belt growth drivers such as population and job growth.

Company Overview

You can access all company results here. BRT Apartments is a residential REIT focused on the Sun Belt region, with the company operating its own consolidated portfolio (roughly 81% of net operating income, or NOI), as well as having equity interests in joint ventures with other property developers in the unconsolidated portfolio (19% of NOI). For the company’s consolidated portfolio Mississippi accounted for 16% of Q2 2024 NOI, followed by Tennessee at 14.6% and Alabama at 12.2%:

The unconsolidated portfolio, reported on a pro-rata basis, is dominated by Texas (45% of Q2 2024 NOI) and South Carolina (29.2%):

Operational Overview

In Q2 2024 BRT Apartments reported an adjusted FFO of $0.35/share, down 5% Y/Y, impacted by larger adjustments for straight-line rent and rent concession accruals, as well as lack of an upward adjustment for loss on debt extinguishment that boosted prior-year results.

Occupancy was flat Y/Y, at 94.3%, with gains in the unconsolidated portfolio offset by declines in the consolidated portfolio. Net operating income increased 1.8% Y/Y, driven by increases in both the consolidated and non-consolidated portfolios.

Overall we should note BRT Apartments is showing weaker operating performance compared to some peers such as Independence Realty Trust (IRT) which I covered here. For example, BRT Apartments did not manage to grow occupancy like IRT and its NOI growth was weaker as well.

2024 Outlook Commentary

BRT Apartments noted that Q2 2024 developments were in line with its previously provided comments for 2024, with the company highlighting (Q2 2024 supplemental information):

• New supply muting new and renewal lease rent growth until at least the second half of 2024 as the new supply is absorbed.
• BRT intends to emphasize stable average occupancy within the portfolio until it can achieve a lift in rental rates.
• A more favorable transaction environment in the second half of 2024 with smaller, private operators experiencing capital, ownership and/or refinancing challenges.

Capital Structure

BRT Apartments ended Q2 2024 with net debt of $553 million (including pro-rata share in joint ventures), implying that net debt accounts for 62% of the company’s $897 million enterprise value. The REIT has no preferred shares outstanding.

Overall, given the outlook for Fed rate cuts, I think BRT’s capital structure is well-positioned to get a valuation boost from a compression in real estate cap rates. Current futures prices indicate the Fed is likely to bring its target range for the Fed funds rate to 3.25-3.50% in July 2025, some 2% lower than today.

BRT Apartments’ weighted average interest rate stood at 4.03% as of Q2 2024, with an average maturity of 6.1 years. The company will immediately benefit from Fed rate cuts on its floating-rate junior subordinated notes which account for 6.5% of total debt. The remaining 93.5% of the REIT’s debt consists of mortgages which are likely to see a stable cost of interest, given that current market rates on fixed-rate mortgages are above what BRT has locked in for the next few years.

Prospects and valuation

While the company does not provide an adjusted FFO outlook for 2024, annualizing the Q2 2024 amount is a good starting point, even though BRT is anticipating some near-term pressure as a new 240-unit development begins leasing and is yet to be stabilized. Even so, it is reasonable to believe the REIT manages to deliver an adjusted FFO of about $1.35-1.40/share in 2024. This would translate into an adjusted FFO multiple of about 12.75, which is quite attractive for a residential REIT, notwithstanding BRT’s elevated leverage.

The market-implied cap rate based on NOI stands at about 7.1%, assuming a run-rate NOI of about $63.6 million. Again this is very appealing relative to peers such as Independence Realty Trust.

The drag from general and administrative expenses is about 1.78% of enterprise value, indicating significant room for improvement relative to peers, something you see quite often at smaller REITs such as BRT. A lack of improvement on this front may also make BRT an acquisition target down the line.

Given the outlook for monetary policy, I expect the shares to outperform thanks to compression in real estate cap rates and some stabilization in NOI performance on slower supply growth.

Risks

Considering that net debt accounts for 62% of enterprise value, the key risk to consider is whether Fed rate cuts develop as the market currently projects. This risk is somewhat mitigated by the high proportion of fixed-rate mortgages in the company’s debt (about 93.5%) and long average maturity of 6.1 years.

The company’s high leverage may also put it in a disadvantaged position should smaller operators experiencing operational issues come up for sale at an attractive price. That said, I think it may be wise to expand the portfolio even by issuing common stock since it will help spread out the already high general and administrative expenses.

While we may argue the lack of occupancy growth Y/Y is already priced into the shares given the 7.1% market-implied cap rate, deterioration in occupancy or NOI dynamics will negatively affect the shares, given the cap rate premium residential REITs command relative to more cyclical commercial REITs.

Conclusion

BRT Apartments apartments reported lower adjusted FFO but higher net operating income Y/Y in Q2 2024. I believe the REIT is well positioned to outperform peers considering:

• Its debt-heavy capital structure which will benefit if real estate cap rates compress on Fed rate cuts.
• Room for occupancy growth relative to peers.
• Attractive valuation based on adjusted FFO multiple and market-implied cap rate.

As such, I recommend going long BRT Apartments.

Thank you for reading.