Can Small Caps Lead to Big Growth and Good Value?

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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 12th and –13.4% quarter-to-date through May 12th. [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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Investors should consider the investment objectives, risks, charges and expenses carefully before investing. For a prospectus or summary prospectus with this and other information about the Fund, please call (800) 693-8288 or visit our website at www.armadaetfs.com. Read the prospectus or summary prospectus carefully before investing.

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To view the ETF’s holdings and standardized performance, click here. References to other securities is not an offer to buy or sell. Dividends are not guaranteed, and the dividend yield may fluctuate. Through their investments in REITs, the Funds are subject to the risks of investing in the real estate market, including decreases in property revenues, increases in interest rates, increases in property taxes and operating expenses, legal and regulatory changes, a lack of credit or capital, defaults by borrowers or tenants, environmental problems, and natural disasters. The Funds may invest in derivatives, which are often more volatile than other investments and may magnify the Fund’s gains or losses. The Funds invest in residential mortgage backed securities (RMBS), which are subject to the risks generally associated with fixed-income securities and mortgage-backed securities. Delinquencies and defaults by borrowers in payments on the underlying mortgages, and the related losses, are affected by general economic conditions, the borrower’s equity in the mortgaged property, and the borrower’s financial circumstances. The Funds may invest in debt securities which are subject to the risks of an issuer’s inability to meet its obligations under the security; failure of an issuer or borrower to pay principal and interest when due; and interest rate changes affect the prices of fixed income securities. In addition, an increase in prevailing interest rates typically causes the value of existing fixed income securities to fall and often has a greater impact on longer duration and/or higher quality fixed income securities. Unlike typical exchange-traded funds, there are no indexes that the Funds attempt to track or replicate. Thus, the ability of the Funds to achieve their objectives will depend on the effectiveness of the portfolio manager. In general, ETFs can be tax efficient. ETFs are subject to capital gains tax and taxation of dividend income. However, ETFs are structured in such a manner that taxes are generally minimized for the holder of the ETF. An ETF manager accommodates investment inflows and outflows by creating or redeeming “creation units,” which are baskets of assets. As a result, the investor usually is not exposed to capital gains on any individual security in the underlying portfolio. However, capital gains tax may be incurred by the investor after the ETF is sold. Investment Objective: Residential REIT ETF (HAUS) seeks total return. Investment Objective: Intelligent Real Estate ETF (REAI) seeks total return.

Glossary Terms

Basis Point (BPS): A basis point is a common unit of measure for interest rates and other percentages in finance. Basis points are typically expressed with the abbreviations bp, bps, or bips. One basis point is equal to 1/100th of 1%, or 0.01%.

Beta: Beta is a measure of a stock’s volatility in relation to the overall market. 

Book Value: Book value is equal to the cost of carrying an asset on a company’s balance sheet, and firms calculate it netting the asset against its accumulated depreciation.

Cap Rates: The capitalization rate (also known as cap rate) is used in commercial real estate to indicate the expected rate of return on an investment property.

Dow Jones: A stock market index that tracks 30 large, publicly-owned blue-chip companies trading on the New York Stock Exchange (NYSE) and Nasdaq.

Dow Jones US Real Estate Index: This index is designed to track the performance of real estate investment trusts (REITs) and other companies that invest directly or indirectly in real estate through development, management, or ownership, including property agencies.

Earnings Per Share (EPS): Earnings per share (EPS) is calculated as a company’s profit divided by the outstanding shares of its common stock. The resulting number serves as an indicator of a company’s profitability.

EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortization.

Funds From Operation (FFO): The most commonly accepted and reported measure of REIT operating performance. Equal to a REIT’s net income, excluding gains or losses from sales of property and adding back real estate depreciation.

Gated: The practice of temporarily blocking withdrawals from an investment fund

Loan-to-Value: The loan-to-value (LTV) ratio is an assessment of lending risk that financial institutions and other lenders examine before approving a mortgage.

Margin Call: A broker’s demand that an investor deposit more cash or securities into a margin account to cover potential losses. 

NARIET: National Association of Real Estate Investment Trusts

Nasdaq 100: The 100 largest, most actively traded U.S companies listed on the Nasdaq stock exchange. Includes sectors such as health care, retail, industrial, technology, biotechnology and others. Does not include financial sectors.

Net Asset Value (NAV): The “market value” of all a company’s assets, including but not limited to its properties, after subtracting the “market value” of all its liabilities and obligations.

NOI: Net operating income (NOI) is a calculation used to measure the profitability of income-generating real estate investments. NOI equals all revenue from the property, minus all reasonably necessary operating expenses.

Real Estate Select Sector SPDR ETF Index: The Real Estate Index contains companies from Real Estate Management & Development and REITs, excluding Mortgage REITs. Components include American Tower, Crown Castle, ProLogis and Equinix.

REIT: A REIT (Real Estate Investment Trust) is a company that owns, operates or finances income-producing real estate.

S&P 500: A market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.

S&P Mid Cap 400: The S&P Mid Cap 400 is a benchmark index comprised of 400 companies that broadly represent companies with midrange market capitalization between $3.6 billion and $13.1 billion.

SEC 30-Day Yield:  The yield is calculated with a standardized formula and represents net investment income earned by a fund over a 30-day period, expressed as an annual percentage rate based on the fund’s share price.

Smart beta: The goal of smart beta is to obtain alpha, lower risk, or increase diversification at a cost lower than traditional active management and marginally higher than straight index investing.

The Dow Jones U.S. Select REIT Index: Tracks the performance of publicly traded REITs and REIT-like securities and is designed to serve as a proxy for direct real estate investment, in part by excluding companies whose performance may be driven by factors other than the value of real estate.

S&P 500 TR: is the Standard & Poor’s index calculated on a total return basis. Widely regarded as the benchmark gauge of the U.S. equities market, this index includes a representative sample of 500 leading companies in leading industries of the U.S. economy.

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