Playing the Retail Opportunity with REITs

Includes: KIM, O, SKT, SPG, WRI
by: Marc Gerstein

With expectations for further U.S. interest-rate increases cooling, it may seem like an opportune time to boost exposure to interest-sensitive areas. Retail is particularly tempting given the good press one seasonally-ripe segment, teens, has been getting as back-to-school season kicks into high gear. But given persistent headwinds, retail may be a short-term opportunity. A better play may be Real Estate Investment Trusts (REITs) that specialize in retail properties.

However benign Federal Reserve policy may become in the weeks or months ahead, selection of individual retail stocks is likely to remain especially challenging.

First, there are the standard macro considerations - uncertainty over how tame inflation really is, whether foreign-currency trends may prevent rates from staying low even if the economy is lackluster, whether good news on rates is associated with an unacceptable degree of economic sluggishness, and whether U.S. consumer's have simply become spent-up, particularly in light of the emotional and financial consequences of softening home prices.

Although these issues are challenging, they may take a back seat for now as the market digests the possibility of a more dovish Federal Reserve. If that occurs, retail could be a worthwhile short-term play.

Note, though, that the market seems lately to be harsher than usual in responding to company-specific slips. Recent examples include the fate of one of the best retail growth stories of this decade, Chico's FAS Inc. (NYSE:CHS), whose stock is down 30.6 percent since June 30. Other quality retailers whose imperfect results incurred Wall Street wrath include Pacific Sunwear of California Inc. (NASDAQ:PSUN), down 25.5 percent; Costco Wholesale Corp. (NASDAQ:COST), down 16.9 percent; Best Buy Co. (NYSE:BBY), down 13.7 percent; and key teen retailer Hot Topic Inc. (NASDAQ:HOTT), down 15.7 percent. Even Coldwater Creek Inc. (NASDAQ:CWTR), a current growth story whose shares are up 36.8 percent year to date, experienced a wicked 35 percent correction from May 5 through Aug. 8.

However confident one may be in good "comps" reported by a particular company, all bets are off as the next, usually monthly, reporting date rolls around, and more so as we move through autumn and approach the period when investors engage in the annual ritual of worrying about the upcoming holiday season.

Situations like this, where a sector play seems viable notwithstanding an especially treacherous individual-stock-selection climate, usually call for consideration of Exchange Traded Funds (ETFs). Table A shows that so far this year, that would have been a decent, albeit unspectacular, course of action for retail. The ETFs that focus on this area didn't suffer unduly during the bad periods, and fared reasonably well in August, when the market snapped back in anticipation of a more accommodative Federal Reserve.
Table A - Retail ETF share price % changes

12/30/2005- 6/30/2006- 7/31/2006-
09/01/06 09/01/06 09/01/06
PowerShares Dynamic Retail Portfolio (NYSEARCA:PMR) 4.28% -3.00% 1.76%
Retail HOLDRS (NYSEARCA:RTH) 0.16% -1.23% 3.22%
SPDR Retail ETF (NYSEARCA:XRT) - - ** -2.90% 2.55%
Average 2.22% -2.38% 2.51%

* HOLDRs are ETF-like securities that must be traded 100-share lots. It is more feasible for individuals to convert HOLDRs shares to direct ownership of the individual stocks than is the case for ETFs, where conversion is usually plausible only for institutional investors.
** XRT began trading 6/22/06.

But as reasonable as the ETF alternative seems, there may be an even better approach: REITs that specialize in retail properties. Key firms are:

  • Kimco Realty Corp. (NYSE:KIM): neighborhood strip shopping centers, often anchored by large drug stores or supermarkets.
  • Realty Income Corp (NYSE:O): free-standing single-tenant neighborhood-oriented retail stores.
  • Simon Property Group Inc. (NYSE:SPG): regional malls, many of which are upscale and most of which include many of the major nationwide specialty merchants and department stores.
  • Tanger Factory Outlet Centers Inc. (NYSE:SKT): factory outlet shopping centers.
  • Weingarten Realty Investors (NYSE:WRI): neighborhood strip shopping centers often anchored by large drug stores or supermarkets.
  • These offer retail exposure that differs a bit from what one could get by owning shares of a particular merchant, or even a diversified portfolio of merchants.

    Same-store sales trends, a key retail metric that often drives short-term stock prices, is relevant for REITS, because part of the rent they receive is based on a percentage of store revenues, but to a less-intense degree: a modest variance in sales performance at a particular store will, in and of itself, have little impact on REIT-wide revenues. Margin trends experienced by particular retailers - a big concern at times when Wall Street fears excessive markdowns, as is often the case when investors start fretting over upcoming holiday trends - are not relevant to REITs unless they are sharp enough to threaten the ongoing viability of a particular store location: a situation that would require much more severity than it would take to cause Wall Street to punish a retail stock for missing expectations or disappointing guidance.

    The business fundamentals most relevant to REITs are macro factors relating to the overall health of consumer spending, as manifested by whether demand for selling space is healthy or not, as chains expand or contract. Related to that is tenants' willingness to pay up for choice locations.

    Such factors impact a REIT's ability to maintain or grow its distribution (dividend), that being the main allure of this investment vehicle. In fact, REITs are required to distribute pretty much all of their net income (with all income tax being paid by shareholder recipients, not the REIT entity).

    Table B summarizes key aspects of the income-oriented investment cases: yields, dividend growth rates, and perhaps most important, payout ratios. For REITs, the latter isn't based on net income, as it is for ordinary business corporations. REITs measure payouts against Funds From Operations [FFO], a metric not defined by Generally Accepted Accounting Principles but commonly used by REITs to determine how much they can actually afford to pay to shareholders. Table B uses net income plus depreciation as a ballpark proxy for FFO.

    Table B - Income aspects of Retail REITs

    Payout 3 Year 5 Year
    Yield (%) Ratio (%) DGR% (1) DGR% (1)
    Kimco Realty Corp. (KIM) 3.49% 62.48% 6.55% 7.01%
    Realty Income Corp (O) 6.16% 80.46% 5.34% 4.28%
    Simon Property Group Inc. (SPG) 358.00% 55.87% 8.78% 6.75%
    Tanger Factory Outlet Centers Inc. (SKT) 3.85% 45.65% 1.51% 1.05%
    Weingarten Realty Investors (WRI) 4.39% 64.25% 5.95% 5.71%
    Market Capitalization Weighted Average 4.29% 61.74% 5.63% 4.96%

    (1) DGR: Dividend Growth Rate

    Based on ballpark FFO, most of the retail REITs have comfortable payout ratios, meaning there is room for dividend growth and, perhaps more important at a time when there is so much concern about the future of consumer spending, some leeway to at least maintain payouts if times turn tight.

    Not surprisingly, Table B shows that the tightest payout ratio is associated with the highest yield. Note that the metrics for a diversified portfolio of retail REITs, assuming market capitalization weighting, seem quite respectable.

    With yield plays, it is often assumed there is a tradeoff in the form of lesser share price appreciation. Table C shows that in 2006, this has not been the case with retail, as the REITs substantially outperformed the ETFs.

    Table C - Retail REIT share price % changes

    12/30/2005- 6/30/2006- 7/31/2006-
    09/01/06 09/01/06 09/01/06
    Kimco Realty Corp. (KIM) 30.86% 14.10% 5.15%
    Realty Income Corp (O) 17.54% 12.50% 7.16%
    Simon Property Group Inc. (SPG) 13.96% 3.32% 0.19%
    Tanger Factory Outlet Centers Inc. (SKT) 26.85% 10.30% 7.42%
    Weingarten Realty Investors (WRI) 14.70% 10.66% 6.01%
    Market Capitalization Weighted Average 19.34% 7.86% 2.83%

    Especially interesting is that much of this strong REIT performance occurred while rising interest rates, which usually hit income-oriented investments, were at the forefront of investor concerns.

    This underscores the role dividend growth plays in these REITs, this being why yield stocks might not fall even as rates rise. Growth can come through generally strong business trends or company-specific initiatives such as acquisitions that expand the property portfolio. Acquisitions have been especially prominent at Simon Properties Group.

    The real-estate-bubble issue does not play much role one way or the other. With REITS equally likely to buy or sell properties, its hard to articulate an iron-clad principle as to whether they should prefer rising or falling property prices.

    Looking ahead distributions are expected to continue to rise for now. But it's hard to say how buoyant or prolonged further gains can be if weakening consumer-spending trends cause chains to close stores, thus boosting vacancy rates, cutting into rental income, and removing some of the cushion contained in present payout ratios.

    So over a longer time horizon, consumer-spending may, indeed, restrain REIT share price performance. But for now, if interest rates rest or even stage a modest retreat, retail REITs could enjoy some short-term zest without the guidance-related risks inherent in individual stocks, or even retail ETFs.

    The catch is that REITs lack the home-run potential offered by individual stocks. But with leaders like Chico's FAS or Pacific Sunwear being hit as hard as they've been, and with Coldwater Creek having experienced such a sharp correction despite strong ongoing fundamentals, it's obvious that it's all to easy for those swinging hard to strike out.

    At the time of publication, Marc H. Gerstein did not own shares of any of the aforementioned entities. He may be an owner of one or more of the stocks, albeit indirectly, as an investor in a mutual fund or another Exchange Traded Fund.

    Note: This is independent investment and analysis from the investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by