Mall REITs: Narrative Vs. Reality

Summary

Malls continue to be the ugly of the REIT sector. The “death of the mall” narrative does jive with the reality of solid fundamentals and sales performance at top-tier malls.

Tenant sales per square foot have surged nearly 5% over the past year at Class-A malls. Macy’s strong first quarter same-store sales further confirmed this trend of tenant rejuvenation.

The bifurcation between top-tier and lower-tier mall REITs continued in 1Q18. High-productivity mall REITs reported another solid quarter, while lower-productivity malls continue to struggle.

Elevated levels of store closings, however, continue to be an issue. Traditional e-commerce retailers including Amazon are rapidly expanding their physical presence as they pursue a “brick and clicks” strategy.

For several mall REITs, particularly Simon, GGP and Taubman, redevelopment remains a substantial source of untapped long-term value. Top-tier mall assets are ideal for the “live-work-play” mixed-use residential expansion.

REIT Rankings: Malls

In our REIT Rankings series, we analyze one of the fifteen real estate sectors. We rank REITs within the sectors based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives.

REIT Rankings malls

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Mall REIT Overview

Mall REITs comprise roughly 12% of the REIT Indexes (VNQ and IYR). In our Hoya Capital Mall REIT Index, we track eight malls, which account for roughly $85 billion in market value: CBL & Associates (CBL), GGP, Inc. (GGP), Macerich Co. (MAC), Pennsylvania REIT (PEI), Simon Property Group (SPG), Tanger Factory Outlet (SKT), Taubman Centers (TCO) and Washington Prime Group (WPG).

mall REITs

Above we note the characteristics and strategy of each mall REIT. More than other sectors, it's critical to note the "quality focus" of these REITs. There has been a significant divergence in fundamentals and stock performance between higher-productivity malls and lower-productivity malls since the end of the recession. Top-tier malls, as measured by tenant sales per square foot, continue to perform well across all metrics including tenant sales, average rent, and occupancy.

bull malls

Downsizing retailers have focused their investment into higher-performing stores and have continued to close weaker-performing stores in lower-tier malls. Amid the unusual binge in retail bankruptcies in early 2017, this bifurcation in performance has accelerated.

bear mall REITs

Recent Stock Performance

Despite improving fundamentals and tenant performance, mall REITs continue to be the laggards of the real estate sector. Further pressured by the broader interest-rate-related sell-off in the REIT sector, mall REITs have dipped more than 12% so far in 2018, outperforming only their shopping center REIT peers. The underperformance is especially curious in light of the strong recent performance of their retail tenants. The S&P Retail ETF (XRT) has climbed 2% during this time and 10% since the start of 2017 compared to a 20-30% dip in retail REITs.

retail REIT performance

More and more, the mall sector is diverging into two distinct categories with vastly different fundamentals, growth prospects, and share price performance. Over the past 52 weeks, the four lower-productivity malls have dipped an average of 25%. Meanwhile, the four higher-productivity malls have dipped a more modest 15%.

mall sector performance

Mall REIT delivered strong performance in the immediate aftermath of the recession, but have been relative underperformers in the REIT sector since the start of 2016. The sector was the second-worst performing sector in 2016 and 2017.

real estate sector performance

Recent Fundamental Performance

The bifurcation in operating performance between higher-quality mall REITs and lower-quality mall REITs has intensified over recent quarters. The four high-productivity mall REITs reported solid metrics highlighted by 4.8% growth in tenant same-store sales compared to a more modest 2.6% rise from the four lower-productivity REITs. Despite the uptick in store closings in 2017, occupancy remains solid across both categories, but the wide disparity in leasing spreads between the top-tier and lower-tier mall REITs highlights the sharp discrepancy in negotiating leverage.

mall REIT performance

Same-store NOI averaged 3.3% for the four higher-productivity mall REITs compared to -3.5% for the four lower-productivity REITs. This gap has further widened in recent years, and leading spreads indicate that this trend will continue until at least 2020.

high low quality mallsOver the past quarter and during earnings calls, several key themes are being discussed as new developments have emerged.

Stronger Retail Outlook for 2018

While the financial media was relentlessly pushing the retail apocalypsenarrative, we’ve been discussing for months that retail sales data has actually been solid and accelerating after a strong holiday season. Our Hoya Capital Brick & Mortar Index showed an average 3.2% rise in spending at brick and mortar locations over the past twelve months through April. Including online sales from brick-and-mortar retailers and in-store pickups (which are ordinarily included in the nonstore category), that growth rate climbs to 3.6%.

brick and mortar retail sales

Below we show the performance of each individual retail category. Restaurants, furniture stores, grocery stores, and building/home improvement retail sales continue to see solid growth. Even in the “retail losers” category, we’ve seen a recovery in the general merchandise and clothing categories in recent months, which are now in positive growth territory YoY. Out of all of the retail categories, only the sporting goods/books segment has seen negative YoY growth. Mall-based categories, notably clothing and electronics, have seen significant improvement since early 2017.

retail winners losers

Elevated levels of store closings, however, continue to be an issue. 2017 was the first year since the recession that saw a decline in the total number of stores in the US, but the decline was quite modest considering the headlines citing a "retail apocalypse." Research from Fung Global shows the recent trends in net store openings and total square footage.

As the pace of store openings has slowed, the productivity of existing space has increased materially over recent years. Each square foot of retail space generated 7% higher sales in 2017 than in 2014 according to Fung Research. Traditional e-commerce retailers including Amazon (AMZN), Warby Parker, UNTUCKit, and Duluth Trading Company are rapidly expanding their physical presence as they pursue a “brick and clicks” strategy. On earnings calls, several mall REIT executives noted the uptick in demand and expect the pace of bankruptcies to slow in 2018. From the Simon Properties earnings call:

Well, we talk to our sales folks and they tell us demand’s picking up... We feel better about the business than in ‘17. We gave your judgment that bankruptcies would be less than 18. So, far we’re right.

Private Market Values Remain Relatively Firm

A sharp disconnect has emerged between private market valuations of malls and the REIT-implied valuation. With only 1,000 malls in the US, and REITs owning the majority of them, there are only a few transactions per year to confirm or deny the estimated private market valuations. Analyst consensus is that lower-quality mall assets have depreciated 10-20% over the last two years while higher-quality asset valuations have remained relatively flat.

The two significant transactions in 2017, however, indicated that there is still strong private market demand for mall assets. Forest City Realty Trust sold 10 class B malls to Queensland Investment Corporation at an estimated 5.0% cap rate. Unibail's $16 billion deal to buy Westfield was done at an estimated 4.9% cap rate. Malls of a similar quality would have an implied cap rate of 6-7% in the public REIT markets. After the most recent round of selling, mall REITs now trade at an estimated 30% discount to private market values. The persistent NAV discount has forced these REITs to be net sellers since the end of 2015.

mall REIT net acquisitions

This NAV discount is the widest since the end of the recession for mall REITs. While US REIT investors may have soured on malls, private market investors still see significant value in these assets. The question is: Will private market valuations be revised down, or will REIT valuations be revised up?

Redevelopment Remains Huge Opportunity For Top-Tier Malls

For several mall REITs, particularly Simon, GGP and Taubman, redevelopment remains a substantial source of untapped long-term value. Top-tier mall assets are ideal for the “live-work-play” mixed-use residential expansion. From the Simon Properties earnings call:

We continue to invest in our product with a long-term view of creating compelling, integrated environments or consumers to live, work, stay, play, and of course shop. We completed several significant redevelopment projects, are under construction on others, and announced more activity that will further enhance the value of our real estate and grow our cash flow. And we continue to identify unique, strategic, new development opportunities globally, that will extend our reach and create world-class destinations.

Simon is one of the few REITs spending on redevelopment, having spent more than $5 billion on redevelopment projects over the last five years, realizing significant 8-10% development yields on these projects. The balance sheet conservatism exhibited by the top-tier mall REITs over the past several years, particularly Simon, has given these REITs the flexibility and spending power to pursue accretive development over near and medium term.

development pipeline malls

M&A And Activism Amid Persistent NAV Discounts

The sharp NAV discount and underperforming share performance have attracted a broad range of M&A and activist interest. Most notable on the M&A front has been Brookfield Asset Management's (BAM) interest in GGP. Brookfield, which currently owns 34% of GGP, reached a deal to purchase the remaining stake for $23.50, a deal that implies a cap rate around 6%, a valuation that disappointed mall REIT investors. The deal is scheduled to close in the second half of this year.

On the activist front, Taubman remains in the cross-hairs of REIT activist firm Land and Buildings, who have criticized the firm's corporate governance. Land and Buildings believes that the company "continues to be run for the benefit of the Taubman family." The firm, which owns one of the highest-productivity portfolios of mall assets, is one of three REITs to utilize a dual-class share voting structure and scores low on most measures of corporate governance.

Macerich is also continually at the center of buyout rumors and activist activity. Third Point took a stake in the firm in late 2017 but recent filings indicate that the firm has since exited the position.

Low-Productivity Malls Fight For Survival

To the victor go the spoils. While the high-productivity mall REITs continue to chug along relatively unphased by the uptick in store closings in 2017, the lower-productivity malls are in an all-out fight for survival. Investors fear that some of these assets could fall into a "death spiral" whereby vacancy levels cross a critical threshold, which leads to further and faster occupancy losses. The value of the mall format is that retailers benefit synergistically from the success and foot traffic of neighboring stores. Retailers are willing to pay a premium for mall space because of these network effects.

For that reason, CBL and other lower-productivity malls have put the focus on maintaining occupancy rather than maintaining rents, a strategy that we think is the right move for long-term viability. While this strategy shifts the negotiating power to the tenants and will result in significant same-store NOI decreases, we think this is in the best interest of long-term shareholders. From last quarter's CBL earnings call:

"Our leasing strategies throughout the year were concentrated on mitigating rent loss and maintaining occupancy. New leasing efforts targeted a diversification of our tenant base towards nonapparel users as well as renewing and expanding with successful retail concepts."

While we continue to be a believer in the value of the mall format to retailers, it's clear that the low-productivity malls certainly have their work cut out for them. We are watching the 90% occupancy level as a critical threshold. If these REITs can hold above that level by offering rent concessions, we think rental rates will firm up over the coming years. Investors, however, will likely have to endure several more quarters of dismal same-store NOI declines.

Valuation Of Mall REITs

Compared to the other REIT sectors, mall REITs appear attractive across all metrics. Mall REITs trade steep discounts based on Free Cash Flow (aka AFFO, FAD, CAD) valuation metrics. Mall REITs trade at the widest NAV discount in the REIT sector at roughly 30%.

mall REIT valuation

Within the sector, we note the significant divergence in valuations between the high quality and the lower-quality mall REITs. CBL and WPG trade at mid single-digit FCF multiples, even after revising estimates significantly lower. The high-quality mall REITs, while trading above the sector average, are also cheap relative to REITs in other sectors.

mall REIT valuation

Dividend Yield And Payout Ratio

Based on dividend yield, mall REITs rank towards the top, paying an average yield of 5.3%. They pay out 82% of their available cash flow, roughly in-line with the REIT average. This relatively modest ratio leaves mall REITs with enough cash to redevelop and improve existing properties.

mall REIT yield

Within the sector, more than other REIT sectors, investors need to be cautious not to fall into common "value traps." CBL and WPG, both yielding over 14%, appear to be diamonds in the rough. The valuation analysis above, though, shows that these high yielders have a bleak growth outlook in the near term and could very well see declining free cash flows and declining dividends if the demand for lower-quality suburban mall space doesn't reverse the current downtrend.

mall REIT dividend

Interest Rate And Equity Sensitivity

Mall REITs tend to exhibit more growth-like qualities than other real estate sectors and respond favorably to a strong economy regardless of its impact on interest rates. Mall REITs exhibit above-average sensitivity to the equity market and below-average sensitivity to the 10-year Treasury yield.

interest rates mall REITs

We separate REITs into three categories: Yield REITsGrowth REITs, and Hybrid REITs. As a sector, mall REITs fall into the Growth/Hybrid REIT category. For investors worried about rising interest rates brought about by stronger economic growth, mall REITs may be well suited to outperform.

growth REITs

Within the sector, we note that CBL, MAC, and PEI have more Growth REIT characteristics while the rest of the sector falls into the Hybrid or Yield REIT category.

mall REIT equity sensitivity

Bottom Line

Malls continue to be the ugly of the REIT sector. The “death of the mall” narrative does jive with the reality of solid fundamentals and sales performance at top-tier malls. Tenant sales per square foot have surged nearly 5% over the past year at Class-A malls. Macy’s strong first quarter same-store sales further confirmed this trend of tenant rejuvenation.

The bifurcation between top-tier and lower-tier mall REITs continued in 1Q18. High-productivity mall REITs reported another solid quarter, while lower-productivity malls continue to struggle. Elevated levels of store closings, however, continue to be an issue. Traditional e-commerce retailers including Amazon are rapidly expanding their physical presence as they pursue a “brick and clicks” strategy. For several mall REITs, particularly Simon, GGP and Taubman, redevelopment remains a substantial source of untapped long-term value. Top-tier mall assets are ideal for the “live-work-play” mixed-use residential expansion.

As a sector, mall REITs continue to appear attractively valued across most metrics. Of course, this has been the case for most of the past two years during which the sector has underperformed the REIT averages. We believe that retailers will continue to value the synergistic benefits of the mall format, but 2018 will be a critical year for many malls, particularly the lower-productivity malls fighting for survival.

If the surge in store closings in early 2017 was indeed a relatively one-off year, we should expect to see improved results in 2018 and a strong bounce-back in price performance. If not, we may have to reevaluate the long-term viability of lower-productivity malls.

We aggregate our rankings into a single metric below, the Hoya Capital REIT Rank. We assume that the investor is seeking to maximize total return (rather than income yield) and has a medium- to long-term time horizon. Valuation, growth, NAV discounts/premiums, leverage and long-term operating performance are all considered within the ranking.

We continue to view the higher-productivity malls - SimonTaubman, and GGP - as the most attractively valued names within the sector at these levels. For further analysis on all fifteen real estate sectors and how they all stack up, be sure to check out all of our quarterly updates: IndustrialData CenterApartmentsShopping CenterHotelOfficeHealthcareIndustrialSingle Family RentalCell TowerNet Lease,Manufactured Housing, Student Housing, and Storage sectors.

Please add your comments if you have additional insight or opinions. Again, we encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps and analysis on the REIT and broader real estate sector.

Disclosure: I am/we are long VNQ, AMZN, TCO, GGP, SPG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: All of our research is for educational purposes only, always provided free of charge exclusively on Seeking Alpha. Recommendations and commentary are purely theoretical and not intended as investment advice. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. For investment advice, consult your financial advisor.

Source

This article was written by Hoya Capital Real Estate


May 18, 2018

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