Reading The Mall Debt Tea Leaves

| About: CBL & (CBL)
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Summary

I have written on CBL and WPG from an equity and preferred viewpoint.

The risk embedded in these REITs warrants the closer scrutiny of the bond markets.

Trading levels and my thoughts on the REITs.

Recently I have written on the following mall REITs:

CBL & Associates (CBL) and

Washington Prime Group (WPG)

My thesis for both is that while they do have tier 2 assets in their portfolio, they are being discounted as if they were already dead. I have an equity position in both, taking a contrarian value approach.

Many readers have (rightfully) pointed out that tier 2 mall exposure with some shaky anchors (a feature most malls share) is a risky proposition. It is. My point has been (and I invested based on) the malls have been so severely discounted - despite decent NOI and FFO stability and a healthy degree of success with redevelopment and re-tenanting - that the upside outweighs the downside and the dividends should be sustainable.

After discussions with multiple readers and REIT guy Brad Thomas (with whom I often work), I decided that it might be helpful to look at the next level in the capital structure, the senior unsecured debt. Being a credit guy for many years, I firmly believe that bonds tell a story that is closer to the fundamental truth of corporations. Bond investors have an asymmetric risk profile - tons of downside and very little upside. As a result, they tend to view companies through cynical eyes, especially when there are some "warts" on the credit. What better way to get a feel for the perception of fundamental risk than the credit market.

Let's kick it off with Washington Prime.

Washington Prime has one publicly traded bond, the details of which are:

WPG is investment grade rated (weak triple B) and currently trades nearly 2% above the risk-free rate. The following is a chart of the price of the bond since January of 2016:

During the same time period, the following has taken place with the equity:

Chart WPG data by YCharts

The equity has been much more volatile, reflecting a more pessimistic view of the sector and the company.

The following is the spread on the WPG bond, reflecting the required risk premium:

The reduction in risk premium is due in part because of the treasury rally and in part because the credit isn't seen as distressed (I provide other REIT spreads later).

Given the covenants provided by the bonds and the shorter tenor of the bonds, I find them reasonably attractive at current levels, but they will underperform upon the event of a downgrade below investment grade.

Next, a look at CBL.

CBL has three outstanding debt issues, the details of which are:

The table above shows that the risk premium or spread is much greater for CBL than it is for WPG. This is a function of bond tenor (CBL has longer dated bonds than WPG) and asset mix and quality.

The following shows the prices of CBL's bonds since June of last year (as far back as I could get it and the 5.96% were issued later in the year):

for comparison, the equity looks like the following over the same time period:

Chart CBL data by YCharts

The directionality is consistent, but the magnitude is much different. Below, the spread shows that concern about the credit has been increasing lately as multiple anchors have been stumbling:

I believe the shorter dated bonds are attractive and provide a spread cushion should the bonds get downgraded to mid/high BB.

Finally, I thought a comparison between the two might be helpful. Note that the spread between the two had been narrowing until recently, but it still remains below its average and well below its highs. You will also note why the spread has widened - CBL has gapped out while WPG has tightened. The credit market views the two differently - more so than the equity market.

For purpose of comparison, the following are REIT bonds issued since the middle of last year:

Kimco (KIM) (BBB+/Baa1) 2.70% 03/01/2024 - $95.35 to yield 3.46% at a spread of 126/curve

Realty Income (O) (BBB+/Baa1) 3.0% 01/15/2027 - 94.54 to yield 3.66% at a spread of 129/10yr

UDR (UDR) (BBB+/Baa1) 2.95% 09/01/2026 - 93.42 to yield 3.79% at a spread of 144/curve

Regency Centers (REG) (BBB+/Baa1) 3.60% 02/01/2027 - 99.84 to yield 3.62% at a spread of 127/curve

Equinix (EQIX) (B1/BB+) 5.375% 05/15/2027 - 102.66 to yield 4.97% at a spread of 270/curve

DuPont Fabros (DFT) (BB+/Ba1) 5.875% 9/15/2021 - 104.19 to yield 3.00% at a spread of 211/curve.

It should be noted that the two high yield REITs demand less of a risk premium than CBL and DFT only slightly more than WPG.

The credit market views these credits as high yield - I believe it is only a matter of time before the rating agencies take their cue from the market and downgrade the bonds of both - with CBL being the first to go.

It is vital to realize that due to the debt covenants in both REITs bonds, there are sufficient unencumbered assets to make the bonds whole in a bankruptcy, the preferred and equity have no such protections and will fall faster and harder as a result.

The debt markets show that there is indeed risk in these names, but it views the risk in WPG as lower. The spread required by CBL bond investors indicates the risk is significant.

I fully appreciate this risk and hope investors and potential investors do as well. Until such time as I believe the valuations on the equities reflect the reality of the situation, however, I will remain invested in both of these REITs. My positions are not large, but they remain intact as they are in a higher risk bucket.

The capital structure in yield context:

Washington Prime Group:

Equity: 11.75%

Pref: WPGpH - 7.53%

Pref: WPGpI - 6.86%

Bond: 3.85% 4/1/20 - 3.46%

CBL & Associates:

Equity: 11.39%

Pref: CBLpE - 7.18%

Pref: CBLpD - 7.74%

Bond: 4.60% 10/15/24 - 6.04%

Bond: 5.95% 12/15/26 - 6.75%

I hope this is helpful when assessing the risk in these two mall REITs and in determining whether the risk level is appropriate for your objectives.

Disclosure: I am/we are long CBL, WPG.

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.