2023-12-01 11:26:54 ET
Summary
- SPG is a high quality REIT which is likely to face some short-term as well as long-term headwinds.
- Nonetheless, the company is well positioned for the current high interest environment.
- I discuss these headwinds and my outlook for the stock.
Dear readers,
Simon Property Group ( SPG ) is a shopping mall (and premium outlet) REIT with 90% of operations in the U.S. and 10% internationally.
This is no doubt one of the higher quality REITs out there and as a result it appeals to many conservative investors. And for good reasons. The company is one of only seven REITs with an S&P Global rating of A- or better, the $40 Billion market cap allows for significant economies of scale and it pays a high, relatively well-covered dividend of 6%+.
I've written about SPG before and rated the stock a BUY in April at $110 per share. Since then, the stock has outperformed with a total return of about 17%, while the S&P 500 has has moved about 11% higher. So far, SPG has clearly been a good investment, but there are some potential headwinds that I want to address today to help you understand the investment in more detail.
These headwinds are:
- The ever increasing share of e-commerce
- A weakening consumer
- And interest rate expectations
E-commerce is a likely long-term threat
E-commerce has become a regular part of our lives and as a result, the share of retail sales done online has been on an uptrend since early 2000s.
Currently, the U.S. Census bureau estimates that about 15% of sales are done online. The growth was accelerated by the pandemic and since then has slowed, but really we have just returned to the longer-term trend line. And the long-term expectation remains that e-commerce will account for 30% of sales by 2023. That's double from today and seems very likely since the UK, for example, already has a 26.5% penetration today.
Growing e-commerce penetration will no doubt be a headwinds for SPG as tenant's brick and mortar stores could see their revenues decline. An increase in e-commerce penetration from 15% to 30% effectively means an 18% decline in store revenues. SPG's main segment (fashion) will likely be not as effected as other sectors such as consumables, because people will still want to try their clothes on and have the full shopping experience which you don't get from Amazon Prime.
Still, I expect e-commerce to abstract about 10% of revenues from brick and mortar stores until the rest of the decade and more beyond. SPG's tenants will have to fight this by innovating and changing the in-store experience. We'll see if they manage, but either way I don't expect the shopping mall / premium outlet sector to grow and I see a risk of the sector eventually becoming obsolete. People will surely live in apartments 20,30, even 40 years from now, but will they be shopping for clothes in person? I truly don't know.
A weakening consumer could be a short to medium-term headwind
While e-commerce is a long-term threat, consumer strength is very much a current issue. Many, including myself, have been expecting a recession this year. Not only have we not had one, but GDP growth in Q3 came in at a staggering 4.9%, the highest level since the re-opening after the first wave of the pandemic (Q1 2021). And notably, over half of this was driven by consumer spending.
The consumer has been very resilient, mainly thanks to vast excess savings from the pandemic, but there are some early signs of a weakening already. The savings rate is well below historical averages, excess savings are declining by the day and credit card balances are rising. Moreover, car and credit card delinquencies are also rising and over 7% of borrowers are currently more than 30 days behind in their payments. And student loan payments which resumed in October are expected to lower consumer spending by further 0.3%.
UBS Group ( UBS ) expects GDP growth to slow to only 0.4% in 2024. If such slowdown materializes, SPG's tenants will very likely feel the heat. SPG as a landlord will, of course, be somewhat insulated from these swings, but it will effect their ability to re-lease space. So far, though, leasing has remained strong and the average base minimum rent of the portfolio increased by 2.9% YoY over the first nine months of the year.
Valuation will continue to be driven by interest rate expectations
One of the primary ways in which higher rates affect cash flows is through interest expense. SPG has over $30 Billion of debt, but luckily only 2.2% accrues interest at a variable rate. As a result, interest expense really only increases when the REIT refinances maturing facilities.
Assuming that rates stay at today's levels for a couple years, SPG will have to refinance about $4 Billion of debt in 2024 and in 2025. Refinancing at a 5.5% interest rate (100 bps spread to 10-year yields today should be doable given SPG's A- rating), will result in additional interest expense of $80 Million in each of the following two years. To put this into perspective, that's a negative impact of about 1.3% on total FFO. Significant, but not knee-breaking.
To sum up, SPG's revenues over the short to medium-term will be stable. Sure rent growth might slow if the economy slows, but this will have a +/- 1% NOI effect. The larger risk is that e-commerce could gradually erode the value of shopping mall and outlets over the next 10-20 years. I think this threat is real which is why I'm not treating SPG as a "forever" hold. Finally, the company has a very strong balance sheet and even at today's rates, the interest expense is bound to be stable and lower FFO by at most 1-2% over the next two years. Therefore, I expect SPG's NOI and FFO to be stable over the next two to three years.
With no FFO growth, our investment decision comes down to two things.
- The 6% dividend which I fully expect to stay as is, despite a somewhat higher 85% payout ratio.
- Potential upside from multiple re-rating
Right now, SPG trades at an implied cap rate of 8.4% which represent a solid 390 bps spread to 10-year treasury yields. For a REIT of this quality, the spread feels too high and I'd argue that even with the discussed headwinds a 300 bps spread would provide enough of a margin of safety.
My base case assumes that the 10-year yield will drop from 4.5% to 4% by the end of 2025 and that SPG's spread will decline to 300 bps. Under these assumptions, I expect 37% of upside or a price target of $170 per share.
I want to be clear that this sort of upside is likely to only materialize once interest rates drop and sentiment turns, which won't happen over night. The good thing is that we get paid a solid dividend yield to wait. Moreover, the downside is quite limited, unless interest rates and yield increase well above 5%. All things considered, SPG deserves a BUY rating here at $125 per share, especially if you're looking for income and aren't too concerned about the long-term impact of e-commerce on fashion brick and mortar stores.
For further details see:
Simon Property Group Likely To Face Headwinds But Remains A BUY