SRVR - Mall REITs: Only The Strong Shall Survive

2023-04-12 10:00:00 ET

Summary

• With recent distress across office markets seizing the headlines, Mall REITs are no longer the "Problem Child" of the REIT sector, particularly after weaker players and lower-tier malls closed shop.
• Following three years of rental rate and occupancy declines, the supply-demand dynamic has recently favored retail landlords, rewarding many retail REITs with some long-elusive pricing power.
• Store openings have outpaced closings by nearly 2x since early 2021, which has helped stumbling mall REITs regain some footing and repair balance sheets in anticipation of tougher times ahead.
• Traffic and sales levels at higher-end mall properties were back to pre-pandemic levels during the holiday season. Simon reported that its FFO is essentially back at 2019-levels, while Tanger also reported encouraging results.
• Outside of Simon and Tanger, however, the remainder of the mall sector continues to teeter dangerously close to the edge. Macerich needs some luck to avoid the fate of the lower-tier REITs that have been stuck in a seemingly endless loop in-and-out of restructurings and de-listings.

REIT Rankings: Mall REITs

This is an abridged version of the full report and rankings published on Hoya Capital Income Builder Marketplace on April 10th.

Mall REITs - which endured a dismal stretch of underperformance from 2015 through 2020 - entered 2023 on surprisingly stable footing as resilient consumer spending and improving supply-demand fundamentals have restored some stability for the three Mall REITs that managed to survive the pandemic intact - Simon Property ( SPG ), Tanger Factory Outlet ( SKT ), and Macerich ( MAC ). Before the pandemic, we warned that several mall REITs were "one recession away from extinction," and since then, three mall REITs - CBL & Associates Properties ( CBL ), Pennsylvania REIT , and Washington Prime - indeed entered and then exited Chapter 11 bankruptcy proceedings, while a fourth - Seritage Growth ( SRG ) is in the midst of a full portfolio liquidation.

The mall sector remains highly concentrated, with these REITs owning the majority of regional malls in the United States, particularly in the more highly-coveted "Class A" segment. Other major U.S. mall owners include France-based Unibail-Rodamco-Westfield - which announced last year that it wants to sell most of its two-dozen U.S. properties by the end of 2023. Canada-based Brookfield Asset Management ( BAM ) is the other major player following its acquisition of General Growth Properties in 2018 - formerly a U.S. listed REIT. For the lower-tier mall segment, the seemingly endless cycle in-and-out of Chapter 11 restructurings and exchange de-listings appears likely to continue given the secular headwinds facing the Class B and C mall segment, combined with their persistently over-levered balance sheets.

Following nearly three years of sharp rental rate and occupancy declines - and an extended period of fundamental weakness dating back to the dawn of the "Amazon age" in the mid-2010s, the supply-demand dynamic has recently favored retail landlords, rewarding many retail REITs with some long-elusive pricing power and helping these long-struggling mall REITs to regain some footing. After a surge in store closings during the pandemic, many retailers have been in 'growth mode' over the past 24 months, fueled in part by the stimulus-driven boom in retail spending and by increased levels of investment in brick and mortar channels relative to the late 2010s. Coresight Research reported that the number of store openings had outpaced closings by nearly 2x since early 2021, with this momentum continuing into early 2023 despite several high-profile retail bankruptcies. After surging to around 10,000 in both 2019 and 2020, just 5,000 retail stores shut down in 2021 while only 2,600 closed in 2022 - the lowest level of store closings on record.

CBRE noted in its Q4 retail report that the availability of retail space hit a 10-year low in the fourth quarter, crediting a mix of factors fueling the improved trends, including online brands looking to expand by opening up brick-and-mortar locations and the "thinning-out" of the Class C and D malls that has pushed retailers to focus on upper-tier locations. Retail asking rents rose by 2.5% year-over-year in Q4 - the strongest since 2015. CBRE also reported that the fourth quarter marked the ninth-straight quarter of positive retail absorption (12.7M SF), with particular strength from the mall segment, which recorded 7.3M SF of net absorption in 2022, the most since 2015. Driven by this positive absorption, malls also recorded the steepest reduction in availability rates in Q4, dipping to 6.0% - the lowest since early 2020.

A microcosm of broader retail trends, however, mall sector dynamics remain a story of "haves and have not" and there are ever-present storm clouds looming that could quickly disrupt the momentum. Data from Placer and other data providers of geolocation data - shows that foot traffic at upper-tier indoor U.S. malls rebounded to pre-pandemic levels for full-year 2022, but traffic at lower-tier malls remains more than 10% below pre-pandemic levels - no doubt hurt by persistently high inflation which has been particularly taxing on lower-income earners. The sustainability of the retail momentum - especially in the lower-tier segment - is also in question as credit card balances have swelled to pre-stimulus levels while the personal savings rate has dipped to near-15-year lows. Credit card debt as a percent of personal incomes rose to 4.6% in February, which is now above the 2010-2019 average of roughly 4.3%.

While we’ve avoided the mall REIT sector for the past several years, Simon’s underperformance this year has dragged its Price-to-FFO multiple into the single digits, which we’ve flagged in recent reports as an attractive entry point. Notably, there are just three other REITs that trade with single-digit Price-to-FFO multiple while also having a Debt Ratio below 40% and a Dividend Yield of above 4%. In addition to Simon, this list includes Apple Hospitality ( APLE ), Cousins Properties ( CUZ ), and Innovative Industrial ( IIPR ) – all three of which we already own in our portfolios. Simon has raised its dividend six times over the past two years, lifting its current dividend yield to 6.57%.

Mall REIT Earnings Analysis

Consistent with CBRE data, mall REITs reported upbeat results last month, highlighted by a continued recovery in occupancy rates and a second-straight quarter of positive leasing spreads. Encouragingly, occupancy rates appear to have stabilized and halted a multi-year downtrend - at least for the moment - as each of the five REITs reported a sequential improvement in same-store occupancy for a fourth-straight quarter. Notably, Tanger Factory Outlet reported comparable occupancy rates of 97.0%, which matched its pre-pandemic level from Q4 of 2019 while Simon reported that its comparable occupancy climbed to 94.9% in Q4 - up 150 basis points from last year and exceeding the average pre-pandemic occupancy rate of 94.8% in full-year 2019.

Helping to juice these occupancy figures a bit, however, has been the increased use of shorter-term lease structures and temporary "pop-up" stores which would also likely be quick to vacate the space if we are indeed heading for a recession. In addition to short-term rental agreements, landlords have also made increased use of "percentage rent" deals which can result in higher rent payments when times are good, but sharper declines in rent during downturns. Same-store Net Operating Income ("NOI") averaged nearly 5% for the three higher-productivity REITs - reflecting some of this added "boost" from the percentage rents. Improving tenant sales was also a highlight as well with all five REITs reporting that sales per square foot were back above pre-pandemic levels in Q4, averaging nearly 10% above Q4 of 2019.

Leasing spreads - perhaps the best leading indicator of future same-store NOI - have finally stabilized following a period of sustained deceleration from 2015 to 2019 and outright declines from early 2020 through early 2021. Of note, Tanger Factory Outlet recorded rent spreads of 10.1% on new and renewed leases on a trailing twelve-month basis - its strongest rent growth since 2016 and marking the fourth-straight quarter of positive spreads. Simon Property, meanwhile, noted that its average base rents rose 2.3% in Q4, which was the highest since Q1 2020, while Macerich recorded a second-straight quarter of positive spreads. Downward rental rate pressure continued for the lower-tier mall REITs, however, as both PREIT and CBL Properties noted that their renewal lease rates declined by about 5% from last year in Q4.

Property-level fundamentals only tell part of the story, however, as mall REITs that were caught over-levered heading into the pandemic incurred permanent value destruction through the combination of forced restructurings and dilutive equity raises. For the middle and lower-tier mall REITs, the recent positive property-level momentum has been more than overwhelmed by headwinds from their high debt burdens. Simon Property managed to restore its FFO to within 2% of pre-pandemic levels in full-year 2022, but the other mall REITs trail far behind. Tanger expects its FFO to remain about 20% below 2019-levels in 2023. Despite its relatively high-quality portfolio, Macerich faces significant headwinds from its heavy debt load and high variable rate interest exposure and expects its FFO to dip another 8% this year to levels that are nearly 50% below that of 2019, and will need some luck to avoid the fate of the other three recently-bankrupt mall REITs - CBL , PREIT , and WPG.

Recession Concerns Weigh On Mall REITs

Following a dreadful six-year-long streak of underperformance from 2016-2020, Mall REITs managed to notch a second-straight year of outperformance over the broader Equity REIT Index in 2022. Recession concerns have put renewed pressure on mall REITs in early 2023, however, with the Hoya Capital Mall REIT Index - a market-cap weighted benchmark - now lower by 6.0% this year compared to the 0.4% advance on the broad-based Vanguard Real Estate ETF ( VNQ ) and the 7% gain on the SPDR S&P 500 Trust ETF ( SPY ).

Diving deeper into the company-level performance, Tanger Factory Outlet has been an upside standout this year with gains of nearly 10%, continuing its stretch of strong performance beginning last October sparked by improving property-level performance and a series of four dividend hikes since late 2021. Also of note, a year after delisting from the NYSE, CBL Properties is back on the big board after shedding $1.6B in debt and preferred obligations through its Chapter 11 and is among the better-performing REITs this year. Pennsylvania REIT has been the laggard this year after being delisted by the NYSE after failing to maintain at least a $15M market cap for 30 days. PEI now trades the OTC Markets under the symbol PRET. Seritage Growth - which is technically no longer a REIT - has also lagged this year as it attempts to complete its portfolio liquidation in a particularly challenging transactions market.

On that note, Seritage announced last week that it has generated $290.4M of gross proceeds from the sale of 27 assets since the start of 2023 to bring its portfolio to 72 properties, down from its peak in 2019 of over 200 properties. SRG noted that the $255 million from the sale of 21 stabilized properties were sold at a blended cap rate of 9.2%, up roughly 200 basis points from early 2021 when it reported a similarly-size portfolio sale closed at a cap rate of 7.5%. Last month, Unibail-Rodamco-Westfield announced the sale of Westfield Trumbull in Trumbull, Connecticut and Westfield South Shore in Bay Shore, New York to Namdar Realty Group for $196M, representing a cap rate of 9.5% on the in-place NOI, notably above its 2022 sale of Westfield Santa Anita mall at a sub-6% cap rate. Mall asset sales have been few-and-far-between over the past decade - particularly when excluding the trades and mergers between these REITs' themselves - so these Westfield and Seritage portfolio sales have provided an illuminating valuation read-through for these mall REITs.

The largest mall owner - Simon - has been notably absent from major mall acquisitions since its ill-timed purchase of Taubman Centers announced several weeks before the pandemic shutdowns. Instead, Simon has invested in non-real estate assets including a retail brands portfolio through its 50/50 joint venture with Authentic Brands on the SPARC Group - and a separate partnership with Brookfield. This vertical retail integration strategy is consistent with our long-held view that mall REITs would actually benefit if they performed more like retailers - which have substantially outperformed their REIT landlords across most measurement periods - and has provided the immediate benefit of keeping these tenants in business and paying rent.

Mall REIT Dividend Yields

Helped by a series of dividend increases from the higher-tier mall REITs this year, malls have now become one of the higher-yielding REIT sectors with an average yield of 6.4% - well above the REIT sector average of 3.9%. Helped by the large weighting of Simon and Macerich which have relatively low payout ratios, mall REITs appear to have plenty of dividend-paying capacity remaining as the sector distributes less than 60% of their FFO.

Four mall REITs - SKT , WPG , CBL , PEI - eliminated their dividend in 2020 while two others - SPG and MAC - reduced their dividend during the pandemic. The tide has turned - at least for the higher-tier mall REITs - since mid-2021 as Simon has raised its dividend seven times over the past eighteen months while SKT - which was formerly a so-called "dividend aristocrat" - resumed its dividend in 2021, as did MAC. Both REITs, however, continue to pay dividends well below their pre-pandemic rate and mall REITs remain near the basement of the REIT Rankings on 3 and 5-year dividend growth.

Balance sheet quality is a key determinant of dividend-paying capacity and future dividend increases. Mall REITs entered the pandemic with elevated debt ratios, which subsequently surged to nosebleed levels during the worst of the drawdown with all mall REITs besides Simon reporting debt ratios above 80% in mid-2020. Improving fundamentals have stabilized balance sheets, particularly for Simon Property - which still owns one of the few coveted A-ratings from S&P on its long-term debt. Elsewhere, Tanger's balance sheet has essentially been fully-repaired after seeing its debt ratio spike in 2020, but Macerich still has work to do. The situation is far more urgent for the lower-tier mall REITs - CBL and PEI - which operate with debt levels above 80%.

Takeaways: Only The Strong Shall Survive

Following three years of rental rate and occupancy declines, the supply-demand dynamic has recently favored retail landlords, rewarding many retail REITs with some long-elusive pricing power. Simon reported that its FFO is essentially back at pre-pandemic levels, while Tanger also reported encouraging results. Outside of Simon and Tanger, however, the remainder of the mall sector continues to teeter dangerously close to the edge. Recent trends across the retail industry have indicated that well-located, high-productivity malls that have the critical mass and "network effects" to offer a value-added retail experience can remain relevant in a world where retailers value a physical presence in the digital retail environment.

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