Earnings Call Transcript - KRG Q3 2020

Operator, Operator

Thank you for being here, and welcome to the Kite Realty Group Trust Earnings Conference Call for the third quarter of 2020. I will now turn the call over to Bryan McCarthy, Senior Vice President of Marketing. Please proceed.

Bryan McCarthy, SVP of Marketing

Thank you, and good afternoon, everyone. Welcome to Kite Realty Group's Third Quarter Earnings Call. Some of today's comments contain forward-looking statements that are based on assumptions of future events and are subject to inherent risks and uncertainties. Actual results may differ materially from these statements. For more information about the factors that can adversely affect the company's results, please see our SEC filings, including our most recent 10-Q. Today's remarks also include certain non-GAAP financial measures. Please refer to yesterday's earnings press release available on our website for reconciliation of these non-GAAP performance measures to our GAAP financial results. On the call with me today from Kite Realty Group, we have our Chairman and Chief Executive Officer, John Kite; President and Chief Operating Officer, Tom McGowan; Executive Vice President and Chief Financial Officer, Heath Fear; Senior Vice President and Chief Accounting Officer, Dave Buell; and Senior Vice President, Capital Markets and Investor Relations, Jason Colton. I will now turn the call over to John.

John Kite, CEO

Thanks, Bryan, and good afternoon, everyone. Thank you for joining us today. The KRG family appreciates that this continues to be a challenging time for everyone, including our investors, tenants, customers, vendors, and employees. We hope this call finds you all doing well. COVID is an opponent that we respect but are not paralyzed by. While COVID is causing a significant dislocation in our society, it will be temporary. Our scientific community continues to make progress regarding testing, therapeutics, and vaccines. We will find a way to stop this pandemic, hopefully sooner than later, but either way, it will come to an end. This is why, even in the face of the spike in cases, it feels like we are closer to the end than we are to the beginning of the pandemic. We are beginning to see this school of thought reflected in our business. Today, I'd like to give you an update on our collection activity and address some of the more common questions that we've been receiving from our investors. As of today, we've collected 92% of third quarter gross rent. Another 2% has been contractually deferred, bringing the total of addressed third-quarter rent to 94%. Currently, October collections are tracking slightly ahead of September. Heath is going to spend some time walking through our methodology. But suffice it to say, our collection numbers are straightforward and pure. A question that was unanimously asked by investors is why our collections have been so strong. We believe our success is the product of the 3Ps: properties, people, and process. In terms of our properties, 74% of our ABR comes from centers with a grocery component. These grocers, together with other essential retailers, continue to drive traffic to our centers, resulting in 97% of our tenants being open and operating as of today. The average size of our centers is only 141,000 square feet, which translates into unparalleled ease and convenience for our customers. With very limited capital investment, we were able to help our tenants successfully adopt and embrace the accelerating click and collect trend. As we discussed last quarter, buy online, pickup in-store is swiftly becoming a central part of operations for retailers. Our open-air centers are uniquely positioned to leverage this trend. With 77% of our ABR coming from the South and West, our properties are located in areas that are benefiting from pre-existing migration patterns that we believe will continue to accelerate post-COVID. We own assets where state and local governments opened their economies earlier and are less likely to close them down again. Furthermore, in our warmer markets, tenants will continue to employ creative measures to ensure current survival and future success, such as temporary outdoor dining and fitness areas. Bottom line, we own assets where people increasingly want to live and shop. It's not just about being in these markets, though; it's about owning the best real estate in these markets and combining that product with our best-in-class operations. Of equal importance are the operational processes at KRG. We have some of the most talented people in the industry, and this dislocation has allowed them to highlight their skills. When COVID hit in early March, our team circled the wagons and went to work battening down the hatches at KRG and preparing. When the lockdowns were lifted, our team shifted to helping our tenants reestablish themselves and open as quickly and safely as possible. As tenants began to get back on their feet, our focus turned to collections and ensuring successful tenants pay their rent while continuously working with our most impacted tenants. Through each of these steps, our team set up a variety of processes to organize all our data, maximize our visibility into the business, and tackle issues at the appropriate time. The process has worked, and our people outperformed. I can't thank the KRG team enough for their efforts during this trying time. The next most frequent question we get is around the impacts of COVID on our business, more specifically, what will be the extent of the permanent NOI erosion? The first thing we're quick to point out is the word permanent is a misnomer. COVID is a temporary dislocation. It's a fact that we're getting inventory back. But our track record for releasing space at accretive returns speaks for itself. Over a matter of 2 years, we were able to backfill 22 anchor boxes, representing 561,000 square feet while generating over 21% cash lease spreads and over a 17% return on capital. At the end of 2019, our shop space occupancy was at a sector high of 92.5%, and we only had 6 vacant anchor tenants. The second point is the sheer number of remaining unanswered questions and confusion. When will the new stimulus package get passed? Who will be the next President? When will we learn the results? How long will this latest spike in cases last? What is the timing and adoption of disease treatments? Despite all these unanswered questions, we feel the ground underneath us has begun to stabilize, with 8 months of COVID under our belt and in the spirit of transparency, we included additional disclosure on Page 17 of our supplemental. The additional disclosure shows that recurring revenues in the third quarter are approximately 6% lower than in the first quarter. This is a far cry from the dislocation that the industry initially projected in March and April and even a further cry from the continued implied dislocation in our stock price. The last question I'll address is about our path forward. Many investors have asked when will KRG get back to pre-COVID NOI levels? While we don't know exactly when that will occur, I do know that internally, we are asking ourselves a bolder question: When and how do we exceed pre-COVID NOI levels? The good news is that in 2019, we prepared the company for what we thought could be a disruptive 2020 and ensured that we had one of the best balance sheets and liquidity profiles in the sector. We couldn't have predicted a pandemic, obviously. But it is a huge advantage to start from a position of strength, but trying to get back to and ultimately surpass pre-COVID levels. KRG is well-positioned to take advantage of this disruption. The priority, which is well underway, is to fill vacated space during the pandemic and with the retailer bankruptcies that have occurred. Our ABR exposure to retailers that have filed for bankruptcy in 2020 is approximately 5%. It's important to realize that many retailers assume leases at key locations and continue to operate those stores when they emerge from bankruptcy. As further detailed in our investor presentation, two-thirds of the at-risk ABR is leased or in active discussions. During the third quarter, we experienced a significant uptick in our leasing activity, having executed 21 new leases and 57 renewal leases, representing 457,000 square feet. This marks the highest quarterly leasing volume over the past year, and we're further encouraged by the diversity of the new leases, which include two grocery stores, off-price retailers, and a wide variety of small shops. This quarter's comparable leases resulted in blended GAAP and cash leasing spreads of 14.7% and 6.7%, respectively. It's also important to note that the 28 non-option renewals we did, which means that the tenants that have the ability to vacate have blended GAAP and cash spreads of 26.8% and 11%, respectively. This clearly demonstrates the desire of our tenants to stay in our shopping centers. Additionally, let's remember certain vacancies provide opportunities. The Stein Mart locations may be a great example of our ability to unlock value and turn short-term pain into long-term gain. Stein Mart intends on closing all of their stores, including 7 in the KRG portfolio. Stein Mart has been an unproductive retailer for a long time and brought limited value to our properties. The average base rent for these 7 locations is $8.21. We plan on backfilling these locations with high-quality tenants at much higher rents and strong returns on capital. We've long maintained that on a risk-adjusted basis, filling empty boxes is one of the best uses of our capital. We were highly successful with this big box surge, and we plan on doing that again. In addition to leasing, KRG is actively exploring ways to generate accretive returns by putting our strong balance sheet to work. This past quarter, Phase 3 of our Eddy Street Commons Project became an active development. Eddy Street Commons Phase 3 will be anchored by a Trader Joe's and will serve as the crowning jewel of the mixed-use development project. The net capital required by KRG will be $7.5 million, and the project is estimated to return between 8.5% and 9.5% yields on cost. We tip our caps to Tom and the development team, who have spearheaded this very successful development with the University of Notre Dame over the past dozen years. This pandemic has been disruptive to so many people in so many different ways. Despite this disruption, our people have risen to each and every challenge and will continue to. I'll turn the call over to Heath now to discuss the balance sheet and our capital situation.

Heath Fear, CFO

Thank you, John, and good afternoon, everyone. Prior to COVID, whenever I heard the number 2020, I would recall the phrase '2020 hindsight', that ability to evaluate past choices more clearly compared to the time that choices are actually being made. With that in mind, maybe it's no coincidence that we are facing a global pandemic and one of the most divisive elections in recent history in the year 2020. There is no doubt that we'll spend the next decade analyzing the choices we are making right now and the choices we will make next week. Regardless of what happens in the remainder of 2020 and into 2021, KRG is well-positioned for all potential outcomes. We continue to maintain a strong balance sheet, and our posture remains cautious with a focus on capital preservation. As John stated, we continue to feel incrementally more confident about the business as evidenced by our decision to reduce our outstanding line of credit balance to $50 million, down from $300 million back in March. As of September 30, our net debt-to-EBITDA is 6.9x, lower than last quarter but still elevated due to the impact of the COVID pandemic. As I mentioned last quarter, it's important to note that we calculate NDE by annualizing our most recent quarter of EBITDA. Therefore, the disruption caused by COVID will immediately impact our NDE metric. More importantly, though, our liquidity position remains strong. No debt maturing until 2022, only $15 million of outstanding capital commitments, and approximately $580 million of liquidity available to KRG. Our liquidity position continues to be bolstered by our strong collection results. This past quarter, we collected 92% of gross rents and deferred another 2%. As John mentioned, our collection rate methodology is very straightforward and represents a simple percentage of our total billed rents. As detailed on Page 17 of our supplemental, our billings have decreased by only 1% from the first quarter, and our net revenues, removing any one-time items, have decreased 6.4% over the same time period. Many of you may be tempted to use this 6.4% decrease as a future run rate, but I caution against making any sort of linear assumptions in what we feel will be a very non-linear recovery. As you know, detractors to revenue are usually instantaneous, while any additions take time to come online. As previously discussed, we are in the midst of releasing space, and the financial impact of those deals will be a lagging indicator. The most important takeaway is that the level of disruption implied in our stock price is nowhere close to the current decrease in our recurring revenues. As a reminder, on bad debt, we estimate the quarterly reserve using the same process we do every quarter. We examine each outstanding balance tenant by tenant and determine who is at risk of not paying their balances. Due to the potential confusion with respect to what amounts to a very simple exercise and collectability, we made a conscious effort to provide as much transparency as possible. Please refer to Page 17 of our supplemental for a detailed breakdown of bad debt and accounts receivable. At the end of the third quarter, $5.9 million of our billed rent was outstanding, of which approximately $3.1 million has been deemed uncollectible. The $5.9 million that remains outstanding at the end of the third quarter is a vast improvement compared to the $15.1 million at the end of the second quarter, indicating further improvement. We are pleased with the progress on all fronts, but we are far from out of this crisis, and we remain guarded with our capital. While we are actively looking for opportunities that may come out of this distress, we would be hard-pressed to pursue anything that would be detrimental to our strong capital and liquidity positions. Our total committed capital to new developments and redevelopment projects stands at $15 million, which is just 2.6% of our current available liquidity, a very manageable level, even in the midst of a pandemic. Thank you to everyone for joining the call today. Operator, this concludes our prepared remarks. Please open the line for questions.

Operator, Operator

Our first question comes from Katy McConnell of Citi.

Mary McConnell, Analyst

Great. So for your bankruptcy exposure, can you walk us through the portion of space that's already come back to date versus future fallout to get a better sense for how occupancy could trend going forward? And then for the portion of space that you're currently working on negotiations, can you talk about how replacement rents are trending so far? And what are tenants looking for as far as CapEx commitments or other incentives?

Heath Fear, CFO

It's a good question on the bankruptcy. Some of them are still in the occupancy because they had not rejected their leases at September 30, and some of them will come out after. So again, we don't remove a tenant from occupancy until they actually stop billing them. So it's sort of a mixed bag. So I can't give you an exact number of what the percentage of bankrupt tenants that were out of occupancy at the end of September 30, and which ones will come out of occupancy post-third quarter.

Mary McConnell, Analyst

Okay. And then another one on rent collections. Can you just update us where second-quarter collections stand to get a sense for what you've recovered since the last update? And then did you have to revisit any previous deferral agreements to convert them to abatements?

John Kite, CEO

So, Katy, second quarter, I think, is up to 83%, or second quarter, I should say, up to 83%. So there was another 3% collected, I guess, since the second quarter. And then what's the second part of that? I'm sorry.

Mary McConnell, Analyst

The second part was whether or not you've had to revisit previous deferral agreements to convert any of those to abatements?

John Kite, CEO

No, we are primarily focused on deferrals in those discussions. We do not engage in abatements, and that has made up less than 1% of our activities. So it's negligible and remains so.

Operator, Operator

And our next question comes from Floris Van Dijkum of Compass Point.

Floris Van Dijkum, Analyst

Great. I have a quick question regarding your tenant improvements. I noticed they decreased slightly for your new leases. Do you think this trend is sustainable, especially as you recover some of the space from bankruptcies in the future?

John Kite, CEO

Yes, Floris, if you look at the trend, the average total is around $53. This will vary depending on whether we're engaging in a lot of smaller shop deals or more box deals. We have the Stein Mart situation, and this quarter, we experienced a lot of shop activity. Most deals were for shops, although in terms of square footage, it typically leans towards anchors. I believe this is a reasonable figure. However, if you're handling a box deal that isn’t split, the amount may well exceed the $53 on a case-by-case basis. Box deals can have a wide range of costs, while shop deals involve significantly lower expenditures. Renewals are advantageous for us as they require almost no spending. Tom, do you have anything to add?

Thomas McGowan, President and COO

Yes. I would just say on our standard big box tenants in terms of their standard package, their packages have not changed. So we're going to expect to see the same levels of TI. And that related to, I think, the previous question that, that run rate is to be fairly consistent.

John Kite, CEO

To clarify, the $53 figure is an average and a trailing average that includes both shops and boxes. Therefore, this number can fluctuate significantly in a given quarter, particularly if it is skewed toward boxes, especially for a company of our size.

Floris Van Dijkum, Analyst

Got it. And so would that be a reasonable assumption to make for the 2.6% of unaddressed bankrupt tenants? Is that sort of spend required to get new tenants in there?

John Kite, CEO

Yes, when looking at the average, the current bankrupt tenants are mainly small shop tenants with a few larger box deals. However, once we regain possession of the Stein Mart spaces, we can expect several box deals to materialize in the next couple of quarters, which would increase that number. Currently, the unresolved bankruptcies are skewed towards smaller spaces from companies like Ascena and Pier 1. I just want to caution you not to view that number as static, as it will fluctuate.

Heath Fear, CFO

Yes. Floris, this is Heath. I think the best way of giving a sense for let's just go look back 2.5 years of our prior cost to lease space. And you can see sometimes you got lumpy, come up and come down again, like John said it could be bit of a volatile number. But if you go back and look at what we did during the big box surge where we had a lot of boxes in a particular quarter, they would get elevated, and we have mostly small shops would come down. So I think it just look back at our record, and probably a pretty good indicator of what it's going to look like on a go-forward basis.

Floris Van Dijkum, Analyst

Great. I have another question for you. You've done a commendable job with your balance sheet. As you consider future opportunities, where do you anticipate finding potential acquisitions? What criteria will you be using? Presumably, they will be in your existing markets, but will these opportunities arise from private owners with excessive debt, banks managing assets, or how do you envision things developing in 2021?

John Kite, CEO

Yes, as Heath mentioned, we're focused on our strong balance sheet, which provides us with some protection against current market conditions. He noted that we will look at opportunities selectively. We need to differentiate between two areas: acquisitions and redevelopment properties. Next year, we have a few redevelopment projects planned, which will involve joint ventures and mixed-use developments. These projects will have some capital requirements while promising strong returns, but they will be limited in scope. On the acquisitions front, our current cost of capital suggests that any near-term activity will need to be matched with funding. You might see us divest one or two assets in regions that don’t align with our long-term strategy, allowing us to invest in areas that support our warmer, cost-effective initiative, which has proven beneficial during COVID and is expected to grow faster than markets experiencing population decline. We believe this is a smart long-term strategy.

Operator, Operator

Our next question comes from Alexander Goldfarb of Piper Sandler.

Alexander Goldfarb, Analyst

So I have a few questions. First, there has been a clear improvement in bad debt. You mentioned Stein Mart and the 5.4% bankruptcy, along with the fact that you've already backfilled about 65%. At this point, around the end of October, do you feel confident about understanding which of your tenants will succeed and which will not? Can you outline how much more fallout you anticipate from tenants that may not survive, or do you not have that level of clarity yet?

John Kite, CEO

Yes. I mean, I think we certainly have a feeling internally that we will have a lot of work to do, and we have work to do. It's too early to say who won't make it. I mean the one thing about COVID, as you know, that it's kind of created an interesting situation where tenants that we thought were weak going into this have come out stronger. And then there have been some that were stronger going in and have come out weaker. So I think it's a little early to say, but we definitely track all of the tenants. We track their health. We look at the rents we plan out over a 3-year period, what we think might happen so that we're prepared. And also, Alex, remember, some of these tenants that people are talking about they're not going to close all their stores, but they may close some stores, right? So we may get back a few stores out of a retailer that we have multiple locations with. And then we also may get, as Heath pointed out, some of the bankruptcy tenants will keep their spaces when they come out of bankruptcy. So net-net, I think we have a pretty good handle on it. And it's why we talked about the successes that we had with the original big box surge. So I guess we're going to have to have a resurge and get this done, and that's what we do.

Heath Fear, CFO

Yes. Alex, it's Heath. It's kind of interesting. The question you're asking is really the same exercise we're doing when we're looking at collectability, who's going to survive and who is not. As you can see, even in the last quarter, so folks that we didn't think were going to pay, they pay. Some folks we thought they were going to pay, they didn't pay. So it's dynamic. It moves all the time. So to say that we have a tremendous amount of conviction, plus we do our best job. But at the end of the day, listen, it's not about tenant survivability, but it's also about having the best real estate. So we feel confident either way.

Thomas McGowan, President and COO

And the way we've handicapped this, we have never had as many discussions. Direct discussions with tenants, probably in our history through this COVID period. So we've learned a lot. We understand what their pinch points are and there are situations where we can help, but in terms of what we've handicapped, I think we have a pretty good sense of where we're headed.

John Kite, CEO

The only thing I would add to that, Alex, is you mentioned the bad debt. Our bad debt has obviously gotten better, but the reality is the visibility is much better right now than it was last quarter. I think that's reflected in the sense that last quarter, we had $15 million of billed and unpaid rent, which is down to less than $6 million this quarter. That's the story. I mean, that's a massive change which kind of shows that strengthening stability that we have. So as we move into needing to lease these boxes, we're doing it from a much stronger position. And like last time, we will take our time to do these deals. We've said before that the hits come immediately and then it takes time to build these spaces. That's just the way it works.

Alexander Goldfarb, Analyst

Right. But I guess, putting it simplistically, you guys have addressed 94% of your rents. So it's like there's 6% left. I mean, it would seem like the simplistic thing is to say, half of those make it, half don't. So I mean, is that too simplistic of a way to look at it, at most, you could only suffer sort of 6% hit from this? Hopefully, it's not that far. But I mean, is that too simplistic of a way to look at it?

John Kite, CEO

Yes, I think it's important to clarify that this is just a snapshot in time. As of now, the numbers reflect a certain situation, but it's not a straightforward calculation. There will be other tenants who may face challenges down the line, which is widely recognized. For example, we previously mentioned Stein Mart, and there are several leases we will need to fill. We expect to encounter some setbacks. However, the key takeaway is that we have a solid foundation; the tenants that are operational and reliable are consistently paying their rent. This is why we experienced a drop from $15 million to under $6 million. In the upcoming quarters, some tenants who have been struggling may not succeed, and that is something everyone is aware of. Our team is already focused on this issue and taking action. The challenges will arise quickly, but we will find new tenants that provide better returns on capital, as we have successfully done in the past. Therefore, I believe investors should avoid a short-term perspective at this moment.

Alexander Goldfarb, Analyst

I mean, John, agreed. I mean, it's evident in your results. So I think the hard work that you guys have done has shown off. As far as FFO, I mean, we analysts need to have something that we can show. So apologies on FFO. Just a final question. COVID, I know you guys are all health experts. You're in Indy, so it's sort of COVID capital for research. But when you look at your properties across the different markets now that you've had 6 months of experience, you certainly have done a lot of leasing, record levels. So have the spikes in COVID or the waves in COVID affected any impact from tenant leasing thoughts or customer shopping or these waves that come and go are sort of news headlines, I won't say fake news, but are news headlines. So the reality is that the retailers and the shoppers, it doesn't really phase them and they continue to get back to normal. I'm just trying to understand how the headlines affect what's going on at your properties?

John Kite, CEO

Yes, I think that when I said we respect COVID, I meant we will not let it stop us. This has been evident at our properties. We acknowledge the situation and have implemented every possible measure at the property level to assist our customers and tenants in serving their customers efficiently. This includes curbside pickup, thorough cleaning, and fostering a sense of safety. While the news can be dramatic, our experience on the ground, enhanced by our properties' locations and types, shows that the impact has not been significant so far. However, we remain aware that circumstances could change. We understand that people want to feel safe, and we are supporting that along with our retailers. Currently, our open-air spaces seem to provide a greater sense of comfort. For instance, during the summer spikes in the South, there was no noticeable decline in our tenants' ability to pay rent or in their business, and we assisted them in maintaining their offerings in a way that inspired trust. Ultimately, the situation varies by location, and we are fortunate because of our geography.

Heath Fear, CFO

Alex, you started the question by making an apology on the FFO. I just want to put the FFO miss, I would put that in quotes, 'of $0.02 this quarter.' Just to put in perspective, if we would have done half of the bad debt reserve, in other words instead of $3 million, we did $1.5 million, which we've been 25% of our unpaid rents. That would have been $0.02. So when we're reading some of the notes and saying that the headline is that we missed on $0.02, it feels a little unfair. In light of the fact that we've collected 92%. So it's actual real erosion. We have the least amount to date. So again, just want to say that, that $0.02 based on what people are doing with bad debt, which by very definition is a very subjective measure. We think that we hit every metric and every mark this past quarter.

Operator, Operator

And our next question comes from Todd Thomas of KeyBanc Capital Markets.

Todd Thomas, Analyst

Heath, first question and sort of following up, I guess, on the previous discussion a little bit and your comments that the change in revenue from the first quarter to the third quarter is not going to be linear. After taking into account the revenue that you've reserved against and sort of offsetting that with leasing in the pipeline and scheduled commencements, are you expecting that decline in recurring revenue to stabilize around these levels? I presume the hits like Stein Mart are accounted for in those adjustments. I'm just curious if you have any sense of how much more of a decline in recurring revenue you might expect in the near term?

Heath Fear, CFO

Todd, I really hate to speculate. And I said in my comments that 6.4% certainly wasn't meant as some run rate that I want folks to start using on a go-forward. It was really just a data point to say, okay, here we are. We're at 6.4%. We've got lots of questions. John mentioned, when is the next round of PPP coming? Who's going to be the President? What's the composition of the Senate? When are we going to find out? What are the vaccines? When are people going to adopt? There's so many unknown questions. I just would think it would be irresponsible for me to take that 6.4% and draw any kind of conclusions around it. But again, John said the hits have been right away and the lease-up takes longer, so it's not going to be something that's going to be very smooth line when you look at the sort of where this thing settles out. It's going to be a dynamic trajectory.

John Kite, CEO

Yes, Todd, just to clarify, even though you mentioned Stein Mart, it represents less than 1% of our annual base rent. They're currently conducting going out of business sales following their bankruptcy filing, so they are still paying rent. We will experience some impact from that in the future, but it's minimal, and we're leasing other spaces to offset it. Looking at recent trends over the last two quarters, for every tenant that goes out of business, another one steps in. The retail landscape is changing; for instance, DICK'S, Bed Bath, Best Buy, Ross, TJ, and a variety of grocery companies are all potential tenants for those Stein Mart locations. These grocery players, who previously might not have invested in these spaces, are now financially positioned to do so. I encourage the investment community to adopt a longer-term perspective, as we will emerge stronger from this period. Ultimately, we expect an increase in net asset value for our properties since the tenants that are leaving are being replaced by superior long-term retailers. It's actually beneficial for us because we had difficulty removing Stein Mart from those locations for years, and now we have the chance to attract better retailers, enhancing the property value. If people consider the long-term outlook, particularly for a company like ours with a solid balance sheet and strong foundation, they will see substantial rewards.

Thomas McGowan, President and COO

No doubt. When you look at Stein Mart, you're about a $8 range ABR, you're a tenant that generates very little traffic. So it is a huge opportunity in a situation like that to bring someone much better, better co-tenancy. So we're actually looking forward to those.

Todd Thomas, Analyst

What do you think about Stein Mart being at $8? Regarding the 64 spaces, what do you estimate the potential impact will be on those spaces as you address the situation with the bankrupt tenants?

John Kite, CEO

It’s difficult to make predictions at this stage. Regarding Stein Mart, given its $8 rate, it's clear we'll exceed that. I prefer not to discuss the specifics of the 5% of the bankrupt tenants. However, the shop spaces differ significantly from the box spaces. Our performance has been robust in this area, and we expect to continue our approach effectively. Okay. Can you talk about the grocery demand that you're seeing across the portfolio? And maybe in some of the various formats? I know you signed a lease with Trader Joe's to anchor Phase 3 at Eddy Street. But just curious if you're seeing demand across the portfolio at centers that currently do not have a grocery component today and whether we should expect to see maybe an increase in grocery lease deals in the coming quarters? Yes. From my perspective, and then I'll turn it to Tom. But from my perspective and on a macro level, the difference today versus pre-COVID is that the specialty grocer component or section, whatever you want to call it, has really strengthened post the COVID crisis. The traditional grocer has also strengthened. But when you look at the real change, I'd say the real change would be in the specialty area, guys like Sprouts and The Fresh Market, but also a little traditionally in the sense that someone like an Albertsons is now putting up really strong numbers, and you see Winn-Dixie looking to file an IPO, et cetera. So macro thought, there's just a lot more going on. But Tom, why don't you get into the...

Thomas McGowan, President and COO

Yes. One of the things we like about the space right now is just the diversity in square footage. You have a Trader Joe's scenario where you're 13,000 to 15,000 and then you have Whole Foods, Aldi, you got some expansion of Lidl, Sprouts. So we have a wide array of square footages to look at, which is always helpful as we're trying to slot spaces inside these centers. But the conversations have improved without question, there's more energy, even some of the companies that struggled pre-pandemic are talking to us. So we're looking good on that front. And then on the box side, we feel like we got a strong stable. The value guys, even in some of the smaller spaces, the Five Below is being very active, Total Wine, et cetera. So the inventory is out there for us to react just like we did last time.

Todd Thomas, Analyst

Okay. And John, you talked about some of the fulfillment and omnichannel strategies that the retailers are employing in the current environment here and sort of accelerating those efforts. Are you seeing any incremental investments by them in the stores? And are they coming back looking at all to lock in term or exercise early options or anything like that?

John Kite, CEO

In terms of omnichannel, what I mean is that our properties, especially those in open-air formats, can easily adapt to the necessary changes. Like many others, we quickly transformed our parking lots, added signage, and set up areas for curbside pickup. However, not all small retailers can implement curbside services easily. Overall, we have adapted quickly, creating another layer of operations for us. As for retailers approaching us to request spending money to modify their stores, that isn't happening. The changes are primarily focused on signage and modifications inside the stores.

Operator, Operator

And our next question comes from Craig Schmidt of Bank of America.

Craig Schmidt, Analyst

The small shop occupancy fell a little bit in the third quarter. I just wonder if this is the bottom? Or do you think it could go a little lower from this point going ahead?

John Kite, CEO

Craig, it was a significant decline in one quarter. When you examine the last three quarters, especially the last two, it centers around a few major players like Ascena. We've seen challenges from Ascena, Pier 1, and Destination Maternity. Given the amount that occurred in one quarter, it feels substantial compared to our previous experiences. However, it's important to note that we also faced notable ups and downs in the restaurant sector, where we lost a few restaurants but also managed to replace them. I believe it's too soon to conclude that this situation couldn't recur, but it was indeed a considerable amount in one quarter, primarily focused on a small number of national retailers.

Thomas McGowan, President and COO

And Craig, one other thing is as we're moving into November, the time it takes to do a deal, get through a lease, get through natural occupancy, we're starting to put tenants in positions where they will be able to open in a much better situation. So that growth on the small shop is a much easier forecast for us moving forward.

Craig Schmidt, Analyst

Okay. But aside from some restaurants, it sounds like the local players are pretty healthy. Is that true?

John Kite, CEO

Yes, during the quarter, we completed a total of 78 deals, with 64 of them being in the small shop category. While we faced some challenges due to the concentration on national brands with multiple locations, there is definitely a demand for smaller shops across various types of retailers. One of the most noteworthy developments heading into 2021 will be the emergence of new operators in the small restaurant and fitness sectors, offering different but similar products. The demand is evident and the market environment appears healthy. Additionally, as we've seen in the recent GDP report, when businesses open, we are able to operate effectively, which is a crucial factor in all of this.

Heath Fear, CFO

And Craig, I want to point out that the decrease in our small shop occupancy is partially due to the high level we started with, as we were at 92.5% at the end of the year, leading the sector. This shows that we are very effective at utilizing our small shop space. I believe we will continue to make advancements in that area moving forward.

Craig Schmidt, Analyst

Okay. And then just last, how long will it take to refill some of that smaller national space to attract new tenants with higher rents?

John Kite, CEO

Yes. I mean, we can't tell exactly. We can only tell you that generally, small shop leasing from vacancy to the next tenant paying rent is significantly less than what we see on the box side. So depending on the shop, depending on the location, it could be as quick as 3 or 4 months, it could take 9 to 12. It really depends on the situation, Craig. There's so much variability. I would tell you, on the small shop side, you have a much better chance of a tenant stepping in and taking the space as is, which means that our turnaround time could be 3 months. That almost never happens in the box category, right? So that's, I think what Tom was just saying a second ago is that our ability to turn these spaces quicker is absolutely there. But I don't want to make a macro statement that we know that it will be x because there's too much variability.

Operator, Operator

And our next question comes from Barry Oxford of D.A. Davidson.

Barry Oxford, Analyst

Great. John, when we think or look at valuation in the retail sector and at your property-type level, well-located assets. And we look at pre-COVID and post-COVID. I know you're not in acquisition mode, but I'm sure you're looking at some of the stuff that is up for sale. My guide is telling me that for properties like that, the cap rate expansion probably hasn't been as great as maybe some people think that it is.

John Kite, CEO

Yes, Barry. We discussed this last quarter, and I want to emphasize that the concept of cap rate expansion doesn't apply to the types of properties we aim to own and generally do own. As we mentioned previously, there may be a few transactions, but they will be rare. When trades do occur, they are likely to be at or below the historical cap rates for high-quality properties. We anticipate a phase with minimal trading activity, followed by a sudden increase in trades. I believe as we approach 2021, we will see more activity due to increased capital flow, and cap rates will likely remain similar to previous levels. Looking at properties like ours, the dislocation we've witnessed and the decline in values seems completely off-base, indicating unrealistically high cap rates for numerous reasons. To summarize, I don't foresee significant changes in this area. There might be a limited number of trades with aggressive cap rates, but the increase in cap rates for certain deals is in a different part of the retail sector. Some weaker open-air centers may trade and be reported as part of the retail market, but that's misleading. Smart institutional investors recognize that what we own is quite unique and difficult to find.

Thomas McGowan, President and COO

Barry, I would add, actually the stuff that we own or would like to own, you’ll probably see cap rates tighten on a nominal basis because they're going to have folks go in there and realize there's some upside in the occupancy. So I think when you start seeing the transaction market open up again, on a nominal basis, you're going to see some pretty eye-opening cap rates.

John Kite, CEO

Yes. If you look at our investor presentation, Page 12 highlights this point. Honestly, the cap rates we apply, even the lowest, might be too high. We are simply trying to indicate that this situation is unreasonable.

Barry Oxford, Analyst

Right, right. And John, just carrying through on that. What is the appetite for banks to do retail loans? Or look, there, you got to kind of bifurcate it.

John Kite, CEO

Yes. I'd say the latter. I'd say there's a bifurcation. I'd say that banks, insurance companies, and other institutional investors, clearly, during this summer were saying, 'Woah, we don't know what's going on in retail.' And then you have the confusion of the mainstream media pounding away at a narrative that is a broad-brush stroke on retail that, again, makes no sense. So, I think that right now, there's probably very little in the way of that activity. But when you look at the stuff that we own, insurance companies and banks, they're going to begin to lend in our lending against that high-quality retail that has a grocery component, neighborhood centers that are smaller. And remember, tons of liquidity as we sit here today with October 31 activity, maybe that even rolls heavy into the fourth quarter if people worry that, that's potentially a risk, but who knows? So, I think that it's starting to trickle, Barry, and there'll be a lot more later.

Operator, Operator

We have a follow-up question from Floris Van Dijkum of Compass Point.

Floris Van Dijkum, Analyst

Just a follow-up question here on something that Heath, you mentioned on your renewal spreads on non-option tenants of 11%, which seems pretty healthy. If I were to ask you guys, so if you were to mark your whole portfolio to market, is that sort of the delta? Or I mean, what is the risk of rents going down in your opinion?

Heath Fear, CFO

I would say, Floris, to put it differently, that's the best indicator of what's happening in our portfolio. When it's a non-option renewal, the leverage is equal, and the tenant and the landlord are directly negotiating. We haven't set the rent yet, but the tenant has expressed interest in staying, leading us to negotiate the rent. Last quarter, the increase was 12%, and this quarter it's 11%. Even during the height of the pandemic, some tenants were willing to raise their rent. I believe that's the best measure to consider when evaluating the overall mark-to-market in the portfolio since it doesn't involve the tenant improvement dollars that can distort your spreads.

Thomas McGowan, President and COO

And sometimes these tenants will actually look at alternatives to compare it to our real estate. And that has consistently worked in our favor where people assess options and say, 'Hey, this is where we want to be. This is the center, this is the location.' So I think all of those point towards positive trends for us.

John Kite, CEO

The other thing to note is that in this quarter, there were 28 instances, which is significant. Additionally, they were all small shops. There isn't a direct connection to anything else, but as Heath mentioned, two consecutive quarters of double-digit non-option renewal spreads suggest that we are operating in a healthy business environment. That's the key takeaway. We often get overwhelmed by countless metrics, but the truth is the business doesn't fluctuate dramatically from quarter to quarter. It’s essential to focus on long-term trends. That's why I believe it's not necessary to be overly concerned with quarter-to-quarter figures. We’ve experienced a substantial shock to the system and are in the process of recovery. Our company remains robust in terms of balance sheet stability and is well positioned for future opportunities, though this will take some time. However, from an investor's perspective, the stock seems to be trading as if these challenges will last indefinitely, which is quite irrational. I believe we are now in a phase of progress and are actively managing the situation. We acknowledge the challenges and took early measures that others didn't, which is why we are able to operate as we are now. So, without getting too carried away, I truly believe we are ready to move forward.

Floris Van Dijkum, Analyst

I just want to clarify my understanding. The 11% figure refers entirely to small shops, and it doesn’t include any anchor boxes. From what I've heard, some of your competitors have indicated that the profit margins on their anchor boxes are generally much higher. Has that been your experience in the past as well?

John Kite, CEO

It really depends on the specifics of the deal. Typically, anchor deals include built-in options. There are not many anchor deals, and it's rare to have an anchor lease expire without options remaining. Most anchor agreements feature four or five five-year options with automatic increases, usually around 2% to 3% every five years during that option period, depending on the agreement. Therefore, this requires a different analysis. We believe it reflects the overall industry's health because if a shopping center were failing, a small shop tenant wouldn't be inclined to pay 10%, 11%, or 12% more rent when they could simply leave without accepting any rent increases. This illustrates that the industry does exhibit health; otherwise, we wouldn’t see this trend, particularly in our properties. In this last quarter, all leases were from small shops, with no anchors involved. However, when an anchor lease does expire, we can experience significant rent increases, especially if it was a long-standing lease that had exhausted its options, though such cases are quite rare.

Operator, Operator

And ladies and gentlemen, this does conclude our question-and-answer session. I would now like to turn the call back over to John Kite, CEO, for any closing remarks.

John Kite, CEO

Okay. Well, again, thank you, everyone, for dialing in today, and we hope that you continue to stay healthy. Thank you.

Operator, Operator

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.