REITerating Our Conviction On High Quality Retail REITs: Malls

Summary

• The erosion of value for publicly traded mall REIT has gone well beyond any data we have seen and is approaching a point beyond any scenario we could reasonably imagine.
• From the data we have seen, a brick-and-mortar presence is essential for a retailer to produce profits over the long term.
• While the growth of e-commerce will continue to cause store (and even mall) closings, we believe the high quality locations with well-capitalized owners will survive and thrive.
• Although investing in this out-of-favor segment today carries significant headline risk, there could be numerous catalysts over the next 12 months that will demonstrate the public market mispricing for these companies.

Stock performance over the long term should be based on fundamentals, but short-term performance can be heavily influenced by sentiment. Nearly impossible to quantify, sentiment can most certainly be felt, seen, and heard. We believe the recent collapse in mall and shopping center REIT share prices may be the product of one-sided anecdotes, misleading data, and, frankly, shallow research.

Brick-and-mortar has been and will likely continue to be the most profitable distribution point for retailers. We believe Amazon’s (AMZN) offer to buy Whole Foods (WFM) reinforces the necessity of a physical presence. Importantly, WFM boasts some of the best demographics among its grocer peers, which we believe specifically highlights the attractiveness of well-located shopping centers.

Our bull case on retail real estate is by no means based on a bear case for e-commerce. E-commerce is having a sizable effect on brick-and-mortar retail, but not all real estate was created equal. We believe this pullback has provided investors with a historic buying opportunity in high quality retail REITs as it seems to be completely based on sentiment, while ignoring hard data.

The Truth About E-Commerce

From media reports that highlight only the shuttered malls and speak of Amazon as if it will take over the world, a casual investor might think that a majority of retail sales are done online, and someday, there will be no need for stores. Even using the most generous definition, e-commerce only accounted for about 9.2% of total retail sales (ex-food) in 2015. After making adjustments for mail order drug delivery, items shipped from store inventory, and ‘non-merchandise items’ (includes shipping and handling costs), we estimate the actual number was 5.7% in 2015. By making estimates based on data available today for 2016, we believe our adjusted e-commerce figure was about 6.4% of retail sales in 2016.

However, even after adjusting the e-commerce measurements, it is impossible to ignore the shift towards online spending. E-commerce growth has easily outpaced brick-and-mortar since 2001, as shown in Figure 1, albeit from a much lower base. Figure 1 also demonstrates that e-commerce growth seems to have stalled around 15%, and, in what may be a surprise to many, non-e-commerce has been growing steadily in the low single digits.

Difficulty of Clicks without Bricks

Three of the top reasons it is difficult to be profitable with an online-only strategy include ‘free’ returns, ‘free’ shipping, and low conversion rates.

According to CBRE, e-commerce returns are somewhere between 15% and 30% of products sold. When an e-tailer maintains a policy of free returns, the customer often orders many different items with the intention of keeping only a few (i.e. multiple sizes). Not only is the e-tailer losing money on the shipping back and forth of items to a customer but it also could lead to having to discount or even dispose of the returned item, depending on the type and condition. In contrast, brick-and-mortar returns average about 8% - much lower due to the ability to try on an item, feel the material, and assess quality. In addition, returning an item to a physical store allows the retailer to avoid shipping costs, and, on average, the customer buys additional items equal to 107% of the value of the item returned.

The ‘last mile’ delivery to a customer’s doorstep is extremely costly for a retailer. In response to this, Wal-Mart (WMT) is offering discounts for items purchased online and picked up at a store; in other words, online purchases are at a premium to in-store. If WMT, the largest retailer in the world with the most efficient distribution network, realizes that it needs to charge a premium for e-commerce, it should be just a matter of time before other retailers figure out that they cannot profit (or survive!) without being compensated for the shipping costs. Unless pure e-tailers are able to distribute their products more efficiently than Wal-Mart, many of them will find it difficult to be profitable in the long term.

Finally, conversion rates for online shoppers are very low. Studies show that getting a customer in a store results in a purchase about 20-30% of the time. For outlet centers, it results in a sale over 95% of the time! In contrast, only 2% of visitors to a website will make a purchase.

Store Closings Nothing New

We have stated before that the US is over-retailed (or ‘under-demolished’) and retailers that need to cut expenses are closing under-performing stores at a faster rate than we’ve seen in several years. Some simple math may help explain why retailers are closing so many stores. Many observers suggest that over 100 malls will be closed over the next several years. A typical mall will have 200 stores, without counting anchors. This translates into 20,000 small shop closures. Four department stores are normal in each mall, which suggests the need to close 400 locations. Thus, we believe that headlines of retailers closing stores should not be a surprise.

Additionally, the struggles of department stores are nothing new: the department store category in the census retail sales data has not grown since 2000! E-commerce may have accelerated the need to close some of their stores, but class A mall REITs have been aware of their inability to draw traffic and grow sales for the small shops – and their extremely low rent. For example, class A mall REIT GGP (GGP) has repositioned over 115 anchors since 2011 and boasts 100% anchor occupancy as of March 31, 2017. Simon Property Group (NYSE:SPG), owner of class A malls and outlets, has only one vacancy of 434 anchors in its portfolio as of the same date – and Dick's Sporting Goods (DKS) has agreed to take the vacancy upon reconfiguration of the space! Macerich (NYSE:MAC), another class A mall REIT, has lowered its exposure to department stores from 5.0% of total rent in 2012 to 3.9% as of March 31, 2017. We have discussed the problems with department stores at length in previous REIT outlooks but would like to reiterate that class A mall REITs are actually benefiting from the ability to gain control over space left by a closing department store.

Bankruptcies are quite common in the retail business. Historically, bankruptcy has been a solution for retailers that have over-expanded. Due to the contractual nature of leases, bankruptcy is the only option to get out of leases early without paying hefty lease termination fees. By declaring bankruptcy (Chapter 11 reorganization), the company can shed underperforming stores and increase profits, thereby making the remaining stores and the company more healthy. Assuming the location is still relevant, the best landlords today have been using closures and bankruptcies as an opportunity to improve the tenant mix oriented toward ‘the experience’, which includes multiple dining venues, entertainment, and fitness.

High Quality Retail Wins

What is not emphasized enough when closings are announced is where the closing stores are located. Most often, announced closures have been at low quality malls and power centers. It is rare for a closure to occur at a class A mall or outlet center. Closures that occur at high quality centers are manageable and backfilled rather quickly, usually at higher rents. As the low-quality centers struggle to fill vacancies and are forced to take lower rent, or even re-purpose the center, we believe high quality malls and outlet centers will push rents higher and maintain their market leading occupancy as they gain market share from competing centers.

The outlet center has consistently been mentioned as the most profitable distribution channel for retailers. It is particularly resistant to e-commerce as retailers are not likely to offer outlet center items online due to the competition with full price items. Comprising only 0.2 sqft of retail space per capita, or less than 1% of the total retail square footage, it is not oversupplied. Outlet center REIT Tanger Outlet (NYSE: NYSE:SKT) has maintained occupancy over 96% since its IPO in 1993, and we believe it will continue to be a beneficiary of the current retail shake-up.

Class A malls have been discussed at length in prior Chilton REIT outlooks, but we would like to point out that even draconian scenarios would not have a dramatic effect on the high quality mall REITs. Malls comprise about 3.4 sqft per capita, which compares to about 24 sqft per capita for all retail real estate. Assuming only malls rated B+ or higher survive, the remaining 500 malls would comprise about 1.6 sqft per capita. This would eliminate 600 malls or 80% of mall square footage!

Even in this draconian scenario, we estimate that the shuttering of those 600 malls would only result in a 15% decline in total value of all US malls. High quality mall REITs SPG, MAC, GGP, and Taubman (NYSE:TCO) own so few malls in the bottom 600 that it would affect between 0% and 5% of their combined portfolio net operating income (or NOI) and much less than that in terms of value. These numbers seem nowhere near the 20-40% discounts at which they are trading today.

Forget the Property Type, Look at Cash Flow

Importantly, class A mall REITs should have positive growth in NOI this year, albeit at a somewhat lower pace, after digesting the store closings from the first half of the year. With most management teams guiding to same store NOI (or SSNOI) growth of 2.5-4.0% for the full year, we expect second half SSNOI growth numbers to be in the +3-5% range, which could be an excellent catalyst for stock prices.

We believe the current sentiment and pricing do not assume there will be much growth, if at all, for the foreseeable future, thanks to the e-commerce threat. Despite what may be purported by the media, as shown in Figure 2, the occupancy and SSNOI growth for class A mall REITs have been healthy, even when compared to the REIT major sector average. This cash flow growth should translate to significant dividend growth over the next few years, averaging close to 9% annualized according to our estimates for SPG, GGP, SKT, and MAC. With an average Adjusted Funds from Operations payout ratio of only 70%, these companies can use their significant retained cash flow to repurchase stock or fund profitable redevelopment projects.

Risk vs. Reward

In addition to the value creation from redevelopment, the other positive catalysts for the stock might include: private market sales of class A and B malls at cap rates below mall REIT implied cap rates, strategic alternatives (M&A or privatizations), stock buybacks, the unwinding of hedge fund shorts, an increase in generalist interest due to low valuation and high yields, balance sheet strength leading to higher dividends, and the ability to give back malls to lenders where mortgages are higher than the value.

The story doesn’t come without risks, however. Store closures, even in high quality malls, take time to backfill, so cash flow growth can take a pause as space is re-leased. In addition, maintenance capital expenditures in the form of tenant improvements have a tendency to increase when the pricing power shifts to the side of the retailers. Specifically, we believe 2017Q2 will post unimpressive SSNOI growth numbers as landlords re-lease the tenant closures from the first half of the year. Also, there have not been any transactions of high quality malls in the private market for over a year, so there is a risk that values have moved lower.

A Warning to Short Sellers

Momentum, sentiment, and headline risk each suggests that mall REITs will remain out of favor for an extended period. However, there is a price for everything, and prices on the public market should not deviate too significantly from the assets’ intrinsic value. The pullback in mall REIT share prices has been a bloodbath no matter the strength of the assets, balance sheet, management team, and dividend. We believe this carnage might be justified for some of the class B and C mall REITs, but we have yet to see any data that could even come close to a scenario in which it could be justified for the class A mall REITs.

We expect fundamentals, cash flow, and dividend growth to eventually win out, and short sellers that have not covered their position could be left as bloodied as those who were long on the way down. If cash flow growth alone is not enough of a catalyst, we believe there will be significant interest from private equity, pension funds, and sovereign wealth funds to take these companies private at historically attractive valuations. We encourage dubious readers to go to a class A mall on a weekend or weekday evening, open a financial supplement to observe the cash flow growth, and read a financial statement to marvel at the balance sheet strength.

A final word of warning: malls can do well even when their tenants do not. For example, a $100 investment in the top nine publicly traded tenants* of SPG from December 31, 2003, would be worth about $250 on June 28, 2017, while $100 invested in the less risky and more diversified SPG would be worth almost $620!

*Includes L Brands (LB), Gap (GPS), Foot Locker (FL), Zale Corp. (now Signet (SIG)), Sterling Jewelers (now Signet), Abercrombie & Fitch (ANF), Luxottica (LUX), Trans World Entertainment (WMC), American Eagle (AEO)

Analyst’s Disclosure: I am/we are long GGP, SPG, MAC, SKT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.